What this lesson teaches
I can use price, income and cross elasticities to judge how large those changes will be.
Syllabus 9570, 2.1.2(g). Demand and Supply Analysis and its Applications: These outcomes can be affected by price elasticities of demand and supply, income and cross elasticities of demand
Make a guess
A gym finds that demand for off-peak visits is price elastic. It cuts off-peak prices by 10%. What can it be sure of?
- Off-peak revenue should rise, but profit is not certain.
- Profit will rise, because demand is elastic.
- Revenue will fall, because each visit now earns less.
Show the answer
Off-peak revenue should rise, but profit is not certain.
Elastic demand means visits rise by more than 10%, so revenue rises. Profit also depends on extra costs, and the estimate may not hold in future.
Firms and governments use elasticity estimates to set prices and taxes, but estimates are only a guide.
Firms use PED to set prices. If demand is inelastic, raising the price raises revenue. If it is elastic, discounts may raise revenue.
Governments use PED to choose what to tax. Goods with inelastic demand, like tobacco and petrol, bring in steady tax revenue. If the aim is to cut consumption, they need to know demand may barely fall.
But elasticity estimates have limits. They come from past data for a particular group and period. Tastes change, rivals respond and other factors change at the same time.
Revenue is also not profit. A firm must check its costs and capacity before acting on an estimate.
- Firms
- Use PED to set prices.
- Governments
- Tax goods with inelastic demand for revenue.
- Limits
- Estimates come from past data for one group and period.
Worked example: Should a sports centre cut weekday prices?
A sports centre estimates the PED for weekday visits by students to be -1.5. It is considering a 4% price cut and has spare capacity on weekdays.
- Predicted change in visits: 1.5 x 4% = about 6% more visits.
- Demand is elastic, so revenue from students should rise.
- Spare capacity means little extra cost, so profit may rise too.
- But the estimate is for students only. Weekend visitors and tourists were not studied, so do not apply the cut to them.
Watch out for this
If PED is -1.5, a price cut is guaranteed to raise profit.
PED predicts revenue, not profit. Extra customers bring extra costs, and the estimate may not hold for other groups or times.
Check your understanding
A government wants to raise revenue with a new tax. Which good should it tax?
- A good with a positive YED.
- A good with price elastic demand, so many buyers are affected by the tax.
- A good with price inelastic demand.
Show the answer
A good with price inelastic demand.
Right. Sales fall only a little, so the tax is collected on most of the original quantity.