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 government wants to raise as much tax revenue as possible. Which kind of good should it tax?
- One with price inelastic demand
- One with price elastic demand
- One with perfectly elastic demand