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Prompt: To what extent is it truly important for firms and governments to have a

proper understanding of the Price Elasticity of Demand (PED)?

It is completely important for firms and for governments to have a proper understanding
of price elasticity of demand. Price elasticity of demand illustrates the changes
that will happen to the quantity demanded of a product if the price of said product
is changed. If this is not taken into consideration when a firm changes the price of
a product or the government imposes a tax on a product, the repercussions could
either harm or benefit the firm, the government or the consumer.

Elasticity of demand is the measure of responsiveness of a change in quantity


demanded for a good or service when a change occurs in one of the
determinants of the demand curve. Price elasticity of demand measures how
much the quantity demanded of a product changes when a change occurs the
price of the product. It is commonly calculated by using the following equation:

𝑄𝑑 𝑓 − 𝑄𝑑 𝑖
× 100
∆%𝑄 𝑑 | 𝑄 𝑑 𝑖 |
𝑃𝐸𝐷 = =| |
∆%𝑃 𝑃 𝑓 − 𝑃𝑖
× 100
𝑃𝑖

In simpler terms, price elasticity of demand measures how much more or less of a
product will be bought if the price is lowered or raised. The value of PED can
range from zero to infinity, zero and infinity being theoretical values. Depending
on the values of PED, demand can be categorized in three ways:

1. Inelastic demand: if the values of PED is between zero and one, then a change in
price will cause a correspondingly smaller change in quantity demanded.
2. Elastic demand: if the value of PED is bigger than zero, then a change in price
will cause a correspondingly bigger change in quantity demanded.
3. Unit elastic demand: if the values of PED is equal to one, then a change in prince
will cause a corresponding, opposite, change in quantity demanded.
To understand the importance of understanding PED within firms, see the following
example: the price for a bag of chocolate chip cookies is raised from $1 to $1.50,
and the firm selling this product noticed that the quantity demanded per week
dropped from 20 000 to 15 000 bags of chocolate chip cookies. This can be
observed in the following diagram:

The PED for this product is:

15000 − 20000
× 100
𝑃𝐸𝐷 = | 20000 | = 0.5
1.50 − 1
× 100
1

The PED is equal to 0.5, meaning the demand for bags of chocolate chip cookies is
inelastic. This means that, even thought the price per bag was increased 50%,
there was only a 25% reduction in quantity demanded. The total revenue of the
firm before the price increase was 20000 × $1 = $12000. After the price increase,
TR = 15000 × $1.5 = 22500. There is an increase in total revenue, in spite of
there being a decrease in quantity demanded. Therefore, it is beneficial for a firm
with products of inelastic PED to increase the price of the product if they wish to
increase total revenue.

Why governments must understand PED, a second example may be: in the market for
iPhone X®, a product with an elastic demand, the government decides to place an
indirect specific tax of $100. This causes the price to change from $1000 per unit
to $1100, due to producers trying to pass the burden of the tax to consumers.
This is shown in the next diagram:

The PED for the iPhone X® is:

4000000 − 8000000
× 100
𝑃𝐸𝐷 = | 8000000 |=5
1100 − 1000
× 100
1000
In the diagram, the blue rectangle shows the tax burden on the producers, and the red
rectangle shows the tax burden on consumers. Because the PED is very elastic,
the tax burden cannot be passed onto the consumers, so producers have to bear
most of it. In this scenario, the government will receive high tax revenue; the
consumer’s price only rises a little bit. But the tax causes the market to fall in size,
from producing 800 thousand to 400 thousand iPhone X®’s. It also causes the
producers revenue to fall from $800 000 000 to $280 000 000.
There is also a need to take into consideration the consequences of firms and
governments not taking into account nor understanding PED to further
demonstrate the beginning thesis. Firstly, if firms do not have a proper
understanding of PED, then it will not be able to increase its revenue, and if in the
long run, the cost of the factors of production increase, then the firm might have
to shut down in view of the fact that the firm did not increase its revenues. The
firms might also have to shut down if they increase the price of a product with an
elastic PED, since the quantity demanded would decrease exponentially. And this
would prove harmful to both producers and consumers, since there would be
people left unemployed as a result of them shutting down. Secondly, if
governments do not understand PED, if they were to place an indirect tax on a
product with an elastic PED, then they would harm the producers of the product,
because the tax burden would be heavier on them, and this would cause a
decrease in revenue, which would potentially cause an increase in
unemployment, since producers would have to start making cuts to be able to
maximize revenue and minimize costs. Additionally, if the government were to
place an indirect tax on a product with an inelastic PED, then the heavier tax
burden would fall on the consumer, this being very likely to harm the consumer
financially or as a whole. And the priority of the government in the market is to
stabilize it in case there is any downturn, but not understanding PED could prove
counterproductive. This is why I firmly believe that it is of extreme importance that
firms and the government understand properly the price elasticity of demand.

References
Blink, J; Dorton, I. (2011). Economics: Course Companion. Oxford. Oxford.

Juan José Gutiérrez Peláez 10A