IB Economics - Applications of price elasticity of demand

This study note for IB economics covers Applications of price elasticity of demand

Pricing Decisions and Total Revenue

• Elastic Demand (PED > 1):
  • A price decrease leads to a proportionately larger increase in quantity demanded.
  • Total revenue increases with a price decrease.
  • Example: Luxury goods like designer handbags. When prices are lowered, demand increases significantly.
• Inelastic Demand (PED < 1):
  • A price increase leads to a proportionately smaller decrease in quantity demanded.
  • Total revenue increases with a price increase.
  • Example: Essential medications. Even with higher prices, consumers need these products, so demand changes little.
• Unitary Elasticity (PED = 1):
  • A change in price leads to a proportionate change in quantity demanded.
  • Total revenue remains unchanged when prices change.
  • Example: Some agricultural products where consumers can substitute between similar goods.

Strategic Decision Making

• Marketing and Sales Strategy: Firms with elastic products may use sales and discounts to boost demand, while those with inelastic products might focus on maintaining price levels to maximize revenue.
• Product Differentiation: Firms can invest in branding to make demand more inelastic, as unique products face fewer substitutes.

PED of Primary Commodities vs. Manufactured Products

Primary Commodities

• Definition: Raw materials and agricultural products.
• Low PED:
  • Necessity: Often essential for daily life (e.g., rice, wheat).
  • Lack of Substitutes: Few alternatives are available.
  • Example: In India, the demand for staple grains like rice and wheat is inelastic because they are dietary essentials.

Manufactured Products

• Definition: Goods produced from raw materials through manufacturing processes.
• Higher PED:
  • Non-essential: Often considered luxury or discretionary spending (e.g., electronics, fashion items).
  • Availability of Substitutes: Many alternatives exist, increasing sensitivity to price changes.
  • Example: In South Korea, demand for smartphones is highly elastic because of the wide variety of brands and models available.

Significance of PED for Government in Relation to Indirect Taxes

Indirect Taxes

• Definition: Taxes imposed on goods and services rather than on income or profits.
• Types: Sales tax, excise duties, VAT.

Government Revenue and PED

• Price elastic Goods:
  • Higher taxes can significantly reduce demand, leading to lower-than-expected tax revenue.
  • Example: In the UK, high excise duties on alcohol have led to a noticeable decline in consumption, affecting tax revenue.
• Price Inelastic Goods:
  • Higher taxes result in smaller reductions in demand, maintaining or even increasing tax revenue.
  • Example: Tobacco products in many countries. Despite high taxes, demand remains relatively stable due to addiction.

Policy Implications

• Public Health: Governments may tax inelastic goods like cigarettes to reduce consumption and improve public health while generating revenue.
• Equity Considerations: High taxes on necessities with low PED may disproportionately affect lower-income households.

Glossary of Key Terms

• Elastic Demand: Demand that is sensitive to price changes (PED > 1).
• Inelastic Demand: Demand that is not sensitive to price changes (PED < 1).
• Indirect Tax: A tax levied on goods and services rather than income or profits.
• Luxury Goods: High-end products with high elasticity of demand.
• Necessities: Essential goods with low elasticity of demand.
• Price Elasticity of Demand (PED): Measure of responsiveness of quantity demanded to price changes.
• Primary Commodities: Raw materials and agricultural products.
• Unitary Elasticity: Situation where a change in price results in a proportional change in quantity demanded (PED = 1).

Related Topics for Further Exploration

• Income Elasticity of Demand: Examines how quantity demanded changes with income variations.
• Cross-Price Elasticity of Demand: Studies the effect of price changes in one good on the demand for another good.
• Supply Elasticity: Looks at how quantity supplied responds to price changes.
• Market Structures: Understanding how different market structures (e.g., monopoly, oligopoly) influence pricing and output decisions.
• Consumer Behavior: Delving into how consumers make purchasing decisions based on preferences, budget constraints, and utility maximization.

Multiple Choice Questions

1. If the price elasticity of demand for a product is 2, this means that the demand is:
   • A) Inelastic
   • B) Unit elastic
   • C) Elastic
   • D) Perfectly inelastic
   • Answer: C) Elastic
2. Which of the following is likely to have the lowest price elasticity of demand?
   • A) Luxury cars
   • B) Bread
   • C) Smartphones
   • D) Designer clothing
   • Answer: B) Bread
3. If a government imposes a tax on a good with highly elastic demand, the most likely outcome is:
   • A) A large decrease in quantity demanded
   • B) A small decrease in quantity demanded
   • C) No change in quantity demanded
   • D) An increase in quantity demanded
   • Answer: A) A large decrease in quantity demanded
4. Firms are likely to lower prices if the demand for their product is:
   • A) Inelastic
   • B) Elastic
   • C) Unit elastic
   • D) Perfectly inelastic
   • Answer: B) Elastic
5. The demand for primary commodities tends to be inelastic because:
   • A) They have many substitutes
   • B) They are considered luxury items
   • C) They are essential for daily life
   • D) They have a high cross-price elasticity of demand
   • Answer: C) They are essential for daily life

IB Economics Essay-Style Questions

1. Discuss the importance of understanding PED for a firm when setting prices for its products.
2. Examine how the PED of primary commodities and manufactured goods affects their market stability.
3. Evaluate the impact of indirect taxes on goods with different PED values on government revenue and consumer welfare.
4. Analyze how PED influences a firm's decision to enter a new market.
5. Explore the relationship between PED and the effectiveness of government policies aimed at reducing the consumption of harmful goods.

Model Essay AnswerQuestion:

Discuss the importance of understanding PED for a firm when setting prices for its products.

Understanding the price elasticity of demand (PED) is crucial for firms when setting prices, as it directly impacts their total revenue and overall profitability. PED measures how responsive the quantity demanded of a product is to a change in its price. By understanding whether demand for their product is elastic, inelastic, or unitary elastic, firms can make informed decisions about pricing strategies to optimize their revenue.

For products with elastic demand (PED > 1), a price decrease leads to a proportionately larger increase in quantity demanded, thereby increasing total revenue. This is because consumers are highly responsive to price changes, often due to the availability of substitutes or the non-essential nature of the product. For example, in the luxury fashion industry, brands like Gucci or Louis Vuitton might lower prices during sales periods to boost demand significantly, thus increasing their overall revenue.

Conversely, for products with inelastic demand (PED < 1), a price increase results in a proportionately smaller decrease in quantity demanded, leading to higher total revenue. This typically occurs with essential goods or those with few substitutes, such as medications. Pharmaceutical companies, for instance, might raise prices on life-saving drugs knowing that demand will remain relatively stable despite the increase, ensuring higher revenue.

When demand is unitary elastic (PED = 1), changes in price do not affect total revenue, as the percentage change in quantity demanded is exactly equal to the percentage change in price. Firms in this situation might focus on other competitive strategies, such as improving product quality or customer service, rather than altering prices.

Additionally, understanding PED helps firms in strategic planning and marketing. Firms can identify opportunities to differentiate their products and make demand more inelastic by creating brand loyalty and reducing the perceived availability of substitutes. For instance, Apple has successfully created an inelastic demand for its iPhones through strong brand loyalty and an integrated ecosystem of products and services.

In conclusion, comprehending the PED of their products allows firms to set optimal prices, maximize revenue, and implement effective marketing strategies. By considering how consumers respond to price changes, firms can navigate competitive markets more effectively and achieve long-term profitability.