Firms can use $PED$ to maximise revenue by changing prices:
- If the demand is currently elastic, then decreasing prices would lead to a higher revenue.
- If the demand is currently inelastic, then increasing prices would lead to a higher revenue.
- If the demand is currently unit elastic, $PED=1$, then there can be no effect.
In essence, when focusing on a straight line curve, the price where $PED=1$ will lead to the highest revenue because:
- If $PED < 1$, the prices can be increased, leading to the $PED$ to increase as well (HL section 2.5.2) until $PED = 1$ as otherwise your revenues will fall.
- Similarly if $PED > 1$, then the prices can be decreased as $PED$ decreases (HL section 2.5.2) until eventually at $PED = 1$ as otherwise your revenues will fall.
The firm's profit and total revenue should not be confused with each other!
- $\text{Profit} = \text{Total Revenue} - \text{Total Costs}$
- Meanwhile: $\text{Total Revenue} = \text{Price} \times \text{Quantity Demanded}$
Government
Governments can also use information about the price elasticity of demand to set indirect taxes to earn revenues and influence consumer behaviour.
Indirect taxes
Taxes levied on spending on goods and services. They are called indirect because while consumers contribute to part or all of the tax, it is the suppliers (firms) who collect and transfer these taxes to the government authorities (consumers pay the taxes indirectly).
Government revenue is calculated by:
$$ \text{Government Revenue} = \text{Tax Per Unit} \times \text{Quantity Demanded} $$
When governments apply indirect taxes on goods and services (2.7), they shift the supply curve upwards (similar to a leftward shift causing supply to fall) by the tax displayed in the graphs below.
NoteDon't worry if you don't understand how taxes shift the supply curve, we will discuss taxes in depth in subtopic 2.7. For now, understand the following idea:
The more inelastic the demand, the greater the tax revenue.
After studying subtopic 2.7, come back and the diagrams will make more sense!
The application of the tax and the government revenue (shaded region) can be observed from the figures above.
As the Tax Per Unit in the graph is fixed, the only factor that changes is the quantity demanded. Therefore:
- When demand is inelastic, the quantity demanded will fall by a smaller amount than if the demand is elastic.
- Hence, the tax revenue the government receives from inelastic demand would be higher than from elastic demand.
- This is observed with the shaded regions in the two diagrams provided above.
Case Study: Government Taxation on Elastic and Inelastic Goods
Context:
In recent years, governments worldwide have implemented taxes on goods with varying price elasticity of demand (PED) to achieve two main goals: generate revenue and influence consumer behaviour. For instance, goods like tobacco and sugary drinks are often targeted for taxation. The outcomes depend heavily on whether the goods have elastic (PED > 1) or inelastic (PED < 1) demand.
Effects of Taxation:
Tobacco Taxes: An Example of Inelastic Demand
- Policy Implementation:
- The Australian government has steadily increased tobacco taxes, including annual hikes of 12.5% since 2013.
- As of 2023, the price of a pack of cigarettes in Australia exceeds AUD 40 (USD 26), with taxes comprising over 70% of the price.
- Impact on Revenue:
- Tobacco demand is inelastic (PED ≈ 0.4–0.8), meaning a significant price increase results in only a small reduction in consumption.
- In 2020, tobacco taxes contributed approximately AUD 12 billion to government revenue.
- Public Health Outcomes:
- Smoking rates decreased from 19% in 2001 to 11% in 2020, though the reduction has slowed in recent years due to the inelastic nature of demand.
Sugary Drink Taxes: An Example of Elastic Demand
- Policy Implementation:
- In 2018, Mexico introduced a tax of 1 peso per liter on sugary drinks, equivalent to about 10% of the retail price.
- Similar taxes have been enacted in countries like Chile, the United Kingdom, and several U.S. cities, including Philadelphia.
- Impact on Consumption:
- Sugary drinks have elastic demand (PED ≈ 1.2–1.5), meaning price increases lead to a significant reduction in quantity demanded.
- In Mexico, sugary drink consumption dropped by 12% in the first year after the tax was introduced.
- Impact on Revenue:
- The tax generated $1.3 billion USD in revenue within the first two years, funding public health initiatives.
Challenges of Taxation:
- Equity Concerns:
- Taxes on inelastic goods like tobacco are often regressive, disproportionately affecting low-income households who spend a larger portion of their income on these goods.
- Elastic goods like sugary drinks also impact low-income groups but may offer health benefits by encouraging better dietary choices.
- Market Responses:
- Producers may adapt by offering cheaper alternatives or reducing product sizes to mitigate the impact of taxes.
- Illegal Markets:
- For heavily taxed inelastic goods like tobacco, smuggling and black markets can undermine government revenue and public health goals.
Outcomes:
- Tobacco Taxes:
- Australia’s tobacco tax policy highlights how governments can leverage inelastic demand to generate substantial revenue while modestly reducing consumption. However, the slowing decline in smoking rates raises questions about the effectiveness of further tax increases.
- Sugary Drink Taxes:
- In Mexico, the reduction in sugary drink consumption demonstrates the power of taxation on elastic goods to achieve behavioral changes. However, the tax's long-term health impact remains uncertain.
Questions for Discussion:
- How can governments strike a balance between revenue generation and minimising the regressive effects of taxes on inelastic goods?
Are firms and governments exploiting consumers with the knowledge of $PED?$
Self review- Self-Review: If demand for a product is price elastic, should a firm increase or decrease prices to increase revenue? Why?
- Challenge Question: How might an economic recession affect the elasticity of demand for luxury goods and necessities? What strategies should firms adopt in response?
