What this lesson teaches
I can explain why PED matters for the decisions of consumers, workers, firms and governments.
Syllabus K343, 2.6.5. Significance of PED: implications of PED for decision-making by consumers, workers, producers/firms and government
Make a guess
A government taxes a good with price inelastic demand. What does the tax do best?
- Raise revenue, because people keep buying.
- Cut consumption sharply, because the price rises.
- Nothing, because inelastic goods cannot be taxed.
Show the answer
Raise revenue, because people keep buying.
Quantity falls only a little, so the tax is collected on nearly as many units as before. It does little to cut consumption.
PED helps firms set prices, governments choose what to tax, and explains who bears a price change.
Firms use PED when setting prices. A firm with inelastic demand, such as a power company, can raise prices to raise revenue. A firm with elastic demand, such as a fast food chain facing many rivals, may cut prices or advertise to make demand less elastic.
Governments use PED when choosing what to tax. Taxing goods with inelastic demand, such as petrol or cigarettes, raises a lot of revenue because quantity falls little. But if the aim is to cut consumption of a harmful good, inelastic demand means the tax works less well.
Consumers are hit hardest by price rises in goods with inelastic demand. They keep buying, so they spend more and have less left for other things.
Workers are affected too. If demand for their firm's product is elastic, a price rise can cut sales sharply, threatening jobs.
- Firms
- Inelastic demand: can raise price to raise revenue.
- Government revenue
- Tax goods with inelastic demand.
- Government reducing consumption
- Tax works better when demand is elastic.
Worked example: A tax on sugary drinks
Suppose demand for sugary drinks is fairly elastic, because water, tea and diet drinks are substitutes.
- A tax raises the price of sugary drinks.
- Because demand is elastic, quantity demanded falls by a larger percentage.
- Good for the health aim: consumption falls noticeably.
- Less good for revenue: the government collects tax on fewer drinks than it would with inelastic demand.
Watch out for this
Taxing a good with inelastic demand is the best way to reduce its consumption.
Inelastic demand means quantity falls only a little. Such a tax raises revenue well but does not cut consumption much.
Check your understanding
A firm faces many rivals, so demand for its product is price elastic. Rising costs force it to raise its price. What is the most likely result?
- Sales fall sharply, which may cost workers their jobs
- Revenue rises, since each unit sells for more
- Customers keep buying the product and simply pay more for it
Show the answer
Sales fall sharply, which may cost workers their jobs
Right. Elastic demand means a price rise cuts sales by a larger percentage, which can threaten jobs.
Check your understanding
A government wants a tax to cut purchases of sugary drinks as much as possible. For which drink would the tax work best?
- One that buyers are hooked on
- One with no close substitutes
- One that costs a tiny share of income
- One with many close substitutes
Show the answer
One with many close substitutes
Right. Close substitutes make demand elastic, so a price rise cuts the quantity bought sharply.