Applications of PED and Cross-

price elasticity of demand

 Applications of PED
• Price elasticity of demand is an important concept
in economics and has a range of different
applications.
• In the following video, we’ll be looking at three
different applications:
* PED and total revenue
* PED in relation to primary and manufactured
goods
* PED and indirect taxes
 PED and total revenue
• Total revenue (TR) refers to the amount received
by firms upon selling a good or service.
• It is equal to the price (P) of the good times the
quantity (Q) of the good sold; hence TR= P× Q
• The change in total revenue depends on the price
elasticity of demand of the good
• Let’s look at what happens to the firms’ revenues
from the viewpoint of three different possibilities
 a). PED> 1
• When demand is elastic, an increase in price
causes a fall in total revenue, while a decrease in
price causes a rise in total revenue.
• For example, a 10% price increase will result in a
larger than 10% decrease in quantity demanded
• The impact on total revenue of the decrease in
quantity is bigger than the impact of the increase
in price; therefore, total revenue falls.
• If there is a price decrease, a 10% price fall results
in a larger than 10% increase in quantity
demanded, and total revenue increases.
D
• Since we are considering elastic demand, we
examine a price change in the upper left portion of
the demand curve.
• At the initial price and quantity, P and Q, total
revenue is given by the sum of the rectangles A
and B.
• When price increases to P1 and quantity drops to
Q1, total revenue is given by the sum of the
rectangles A and C.
• Following an increase in price, the rectangle B was
lost and the rectangle C was gained. Since the loss
B is larger than the gain C, total revenue fell.
• Similarly, a decrease in price from P1 to P results
in an increase in quantity from Q1 to Q
• The gain in TR is given by rectangle B, which is
greater than the loss shown by rectangle C, hence
total revenue increases.
 b). PED< 1
• When demand is inelastic, an increase in price
causes an increase in total revenue, while a
decrease in price causes a decrease in total
revenue.
• For example, a 10% price increase will result in a
smaller than 10% decrease in quantity demanded
• The effect on total revenue of the increase is larger
than the effect of the decrease.
• If price falls, a percentage decrease results in a
smaller percentage increase in quantity demanded
and total revenue falls.
• As we are considering inelastic demand, we
examine a price change in the bottom right
portion of the demand curve.
• With a price increase, total revenue gained
(rectangle C) is larger than total revenue lost
(rectangle B); hence the total revenue increases.
• If price falls from P1 to P, the gain in total revenue
(rectangle B) is smaller than the loss (rectangle C)
and total revenue falls.
 c). PED= 1
• When demand is unit elastic, the percentage change
in quantity is equal to the percentage change in
price, and total revenue remains constant.
• As price and quantity change, the gain in total
revenue is exactly matched by the loss, and total
revenue remains unchanged.
• This is seen in the following diagram where the
firms’ new revenue AC is equal to the loss of B in
the previous revenue AB, following the changes in
price. Hence the firms’ revenue remained constant.
 PED in relation to primary and
manufactured goods
• Primary goods are those arising from the direct
use of natural resources.
• These include products from agriculture, fishing,
forestry, and extractive industries.
• They tend to have a low PED (inelastic demand)
• For example, food tends to have a very low PED
since it is a necessity and has no substitutes
• This applies to other primary goods such as oil,
minerals, coal, natural gas, etc.
• By contrast, manufactured goods tend to have a
relatively higher PED (elastic demand).
• They tend to have a wider range of substitutes
compared to primary goods.
• A change in price causes quantity demanded to be
more responsive in comparison to primary goods.
• However as an exception, medicines tend to have a
low PED despite them being manufactured goods
since they are a necessity and individuals’ lives
depend on them
 Primary Goods

Manufactured
Goods
 Consequences of low PED for primary
goods
• Low price elasticity of demand, together with
short- term fluctuations in supply creates serious
problems for primary commodity producers,
• They result in large fluctuations in the prices of
primary goods, which also affect producers’
incomes.
• Let’s explore further using some diagrams on the
impacts of price fluctuations on both primary and
manufactured goods
(a). PED in relation to primary goods (highly inelastic demand)
(b). PED in relation to manufactured goods (highly elastic demand)
In (a):
• PED and primary goods- highly inelastic demand
• An increase in supply (from S to S2) or a decrease in
supply (from S to S1) result in larger price
fluctuations
• These fluctuations are referred to as price being
volatile; highly unstable changes in price
• Prices of primary goods fluctuate widely, resulting
in fluctuations in producers’ incomes which depend
on the revenues received from selling their output.
In (b):
• PED and manufactured goods- highly elastic demand
• An increase in supply (from S to S2) or a decrease in
supply (from S to S1) results in smaller price
fluctuations
• Quantity demanded has a larger responsiveness to
changes in price; a small change in price results in a
large change in quantity
• As seen in the diagram, a small increase in price from
P to P1 resulted in a large drop in quantity demanded
from Q to Q1
 PED and indirect taxes
• Governments often impose taxes on various goods,
called indirect taxes.
• It’s important to consider the PED of the good if
they wish to increase tax revenues.
• The lower the PED of the taxed good, the greater
the government tax revenues.
• Let’s analyse the influence of PED on indirect tax
revenues using a set of diagrams.
(a). PED and indirect taxes- inelastic demand
(b). PED and indirect taxes- elastic demand
• When a tax is imposed on a good, it results in an
upward shift in the supply curve
• This is because for every unit of output supplied,
firms must receive a price higher than the original
price by the amount of the tax
• The vertical distance between the shift of the
supply curve such as from S to S1 represents the
tax per each unit of output produced.
• The intersection of the demand and supply curves
D and S forms the initial equilibrium at price P
• A tax imposed on the good results in a decrease in
supply, resulting in a shift of the curve from S to S1
• This forms a new equilibrium, resulting in a new
after- tax price Pt, and quantity demanded Qt
• The shaded area represents the government
revenue, obtained by multiplying the tax with the
final quantity demanded, Qt
Comparing the two diagrams (a) and (b), it can be
inferred that:
• Governments receive larger tax revenues when the
demand for the good is inelastic, as seen in (a).
• This implies that when the demand is inelastic, an
increase in price results in a smaller
responsiveness of the quantity demanded
• This results in an increase in government revenue,
due to which indirect taxes are mainly imposed on
goods having a low PED such as cigarettes.
 Cross- price elasticity of demand
• As seen earlier, the prices of substitutes and complements
influence the demand for a good/ service, resulting in
demand curve shifts.
• Now we’ll be analysing by how much is the
responsiveness of demand to the changes in the price of
substitutes and complements.
• Cross- price elasticity of demand (XED) is a measure of
the responsiveness of the demand for one good to the
changes in price of another good.
• It provides us with information on whether the demand
increases or decreases, and on the size of the shifts in the
demand curves.
 Formula for XED
• We use the same basic formula as PED to calculate
XED, only now we consider the relationship
between the price of one good X, and the quantity
demanded for another good Y
• In short, the formula for XED can be represented
as:
XED=
• The value of XED is derived by calculating the
percentage change in the quantity of Good X by
the percentage change in the price of Good Y.
 Interpretation of XED
We can derive two kinds of information from cross-
price elasticity of demand:
• The sign of XED: Unlike PED where we ignore the
negative sign, the value of cross- price elasticity of
demand can either be positive or negative which is
essential for interpretations
• The value of XED: how small or large is the
absolute value of XED (regardless of its sign).
 Substitutes and the degree of
substitutability
• Cross-price elasticity of demand for two goods is
positive when the demand for one good and the
price of the other good change in the same
direction, which occurs when the two goods are
substitutes.
• For example, Coca- Cola and Pepsi are substitutes.
Let’s consider what happens to the demand for
Pepsi as the price of Coca- Cola changes
This can be explained using the following diagram:
• If the price of Coca- Cola increases, the demand for
it decreases, and the demand for Pepsi increases
• This enables consumers to switch from Coca- Cola
to Pepsi, causing a rightward shift in the demand
curve for Pepsi.
• If the price of Coca- Cola falls, the demand for it
increases, and the demand for Pepsi falls
• Consumers would now switch to Coca- Cola,
resulting in a leftward shift in the demand curve for
Pepsi
 Complements and the degree of
complementarity
• Cross-price elasticity of demand for two goods is
negative when the demand for one good and the
price of the other good change in opposite
directions. This occurs when the two goods are
complements.
• Complementary goods are those that are jointly
consumed (ex. tennis racquets and balls).
• Let’s consider what happens to the demand for
tennis racquets as the price of tennis balls changes
using the following diagram:
• If the price of tennis racquets increases, the
demand for it decreases, along with the demand
for tennis balls, resulting in a leftward shift in the
demand curve for tennis balls
• If there is a fall in the price of tennis rackets, the
demanded for it increases, resulting in a rightward
shift in the demand curve for tennis balls
 Applications of XED
Substitute goods:
• Substitutes produced by a single business- firms
producing similar goods, such as Coca- Cola and
Sprite; both produced by the same firm , must
consider the XED for these products while making
pricing decisions.
To decide on the price of a good (ex. Coca- Cola), the
firm needs to aware of:
a). The PED of Coca- Cola: to determine whether a
price cut will increase or decrease total revenue
 b). The XEDs of Coca- Cola and Sprite: to determine
the degree of substitutability between them.
This is because:
* If the XED is positive but low (low substitutability),
a decrease in the price of Coca- Cola will only result
in a small drop in the demand for Sprite
* On the other hand if the XED is positive and high,
a fall in the price of Coca- Cola will result in a large
drop in the demand for Sprite
* The sales of Coca- Cola would only increase at the
cost of a possible drop in sales for Sprite, which
firms would choose to avoid in general.
• Substitutes produced by rival businesses: Firms are often
interested in knowing the XED of substitutes produced by
their rivals
* For example, Coca- Cola would be interested in knowing
the value of XED between Coca- Cola and Pepsi
* A large XED indicates that a drop in the price of Coca- Cola
would result in a large drop in sales for Pepsi, while a low
XED would prevent Pepsi from loss of sales
* Coca- Cola would also consider this value of XED in order
to predict its sales, and the revenues of Pepsi in case of a
change in price.
• Substitutes and mergers: two firms merge when they unite
to form one single firm. Firms producing close substitutes
with high XED are likely to merge in order to eliminate
competition (although considered illegal).
Complementary goods:
• Knowing the XED of complementary goods helps
firms make better pricing decisions
• Products having a low absolute value of a negative
XED are weakly complementary, while a high
absolute value means that lowering the price of one
good would increase the demand for the other.
• Businesses producing strongly complementary
goods often collaborate, such as sports clothing
and equipment, charter flights and hotels, etc.
 Let’s recall!
In the following video we have seen:
• The applications of PED
* PED and firms’ total revenue
* PED in relation to primary and secondary goods
* PED and the effect on indirect tax revenues
• Introduction to cross- price elasticity of demand
(XED)
• Interpretation of XED
• The applications of XED
* Substitute goods and complementary goods
 Looking Ahead!
In the next video we’ll be looking at:
• Introduction to income elasticity of demand (YED)
* Interpretations of YED
* Applications of YED
• Introduction to price elasticity of supply (PES)
* The range of values for PES
* Determinants of PES
 Thanks for watching!

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