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Importance of PED for firms and government decision-making
We will now consider the relevance of PED in real life. When economists estimate the price elasticity of demand, how can firms and governments use this information?
Importance of PED for firms: the optimal pricing decision
Before we start this section, review the table summarising the relationship between price elasticity of demand and total revenue on the previous page. In the light of this relationship between the two important variables, what pricing strategy would you recommend to profit-maximising firms that sell:
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Milk
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A specific brand of shower gel such as Dove
Remember profit is the difference between total revenue and total cost. Other things being equal, higher total revenues result in higher profits.
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You might have guessed that a firm's pricing decision depends on the price elasticity of demand for the good. The demand for milk is likely to be relatively inelastic as it may be an important part of the diet in many cultures and is regarded as a good source of nutrition, particularly for children. Thus, there are not as many substitutes for milk. It can also be regarded as a necessity especially for families with small children. For a lot of consumers, the proportion of income spent on milk is not likely to be very high. Due to all these reasons, we expect the demand for milk to be relatively inelastic.
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Having established that the demand for milk is relatively inelastic, let us see what might happen if the firm was to lower the price of milk. As a result of this price change, the increase in quantity demanded would be proportionally lower. The total revenue will, therefore, fall. Clearly, this is not a profit maximizing strategy. What happens if the firm raises the price of milk? In this scenario, not many families will significantly reduce the consumption of milk. The percentage change in quantity demanded is lower than the percentage change in price, and total revenue will therefore increase. The optimal pricing strategy for a firm with inelastic demand is to increase the price of the good. In fact, governments in some countries intervene in the market for milk to ensure that price increases by firms, to maximise revenue, do not make necessities, like milk ,unaffordable by the people.
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Let us now consider the case of shower gels. There are many different varieties of shower gel available on the market, from a wide range of producers. Other substitutes include various kinds of soaps. The availability of a wide range of substitutes makes the demand for shower gels highly elastic. If the price of Dove shower gel was lowered, quantity demanded will increase more than proportionately resulting in an increase in revenue. The opposite strategy of raising the price would result in a significant reduction in quantity demanded due to the prevalence of many substitutes. As a result, total revenue will fall. Firms selling goods with an elastic demand should therefore lower the price to increase revenue and profit, ceteris paribus. The table below is an extension of the table we saw on the previous page with a column added for the relevant pricing strategy to use in each case.
The price elasticity of demand, therefore, enables firms to decide the optimal pricing strategy for their product. According to this article published in the Harvard Business Review,
"Setting the right price for your product or service is hard. In fact, determining price is one of the toughest things a marketer has to do, in large part because it has such a big impact on the company’s bottom line. One of the critical elements of pricing is understanding what economists call price elasticity."
PED is commonly used by managers to inform the price-setting decision although it is not easy to estimate PED values. It also plays an important role in the overall marketing strategy including advertising. The purpose of advertising is two-fold:
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To increase the demand for the good or service (shift the demand curve to the right) and thereby increase sales
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To make the demand for the good or service more inelastic (make the demand curve more steep) so that price can be increased in order to maximise revenue.
Firms employ various strategies to make their product more attractive for their customers. They also try to "differentiate" their product and make it appear more unique in the eyes of the consumer. This is expected to reduce the substitutability of the good and to make demand more inelastic. The same article continues:
"When, through branding or other marketing initiatives, a company increases consumers’ desire for the product and their willingness to pay regardless of price, it’s improving the company’s standing compared with competitors."
We have established that firms, in real life, regard PED as an important data point in their decision-making with regard to:
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The pricing decision using lower prices when demand is elastic and relatively higher prices when it is inelastic
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Decisions about advertising, branding and marketing to make the demand for their product more inelastic
Governments: taxation to generate revenues
We have seen earlier that an indirect tax is a compulsory levy or payment that the government collects from the producers of a good or service. This income from tax collections is known as tax revenue (different from total revenue which firms receive from selling their goods).
Tax revenue = tax per unit * post-tax quantity sold
The tax revenue is then used to fund all the operations of the government such as the provision of roads, national defence, external relations, hospitals and schools, and the benefits to the unemployed and the elderly. The collection of taxes is not without its administrative costs. One of the 'common sense' principles of taxation is that tax revenues should be high relative to the costs of tax collection.
We also know that the 'burden' of an indirect tax results in increased prices either by the full amount of the tax or a part of it. In other words, if the tax on a litre of sweetened drinks is 24p (as in the UK currently), the price of a litre of the drink increases by 24p or a fraction of that. The point is that the price does increase and therefore consumption decreases.
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Consider the following values of PED:
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Tobacco products: 0.4 (source)
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Chevrolet cars: 4.0 (from the previous page)
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In the case of cigarettes, a 10% increase in the price of cigarettes (as a result of the imposition of an indirect tax) leads to a 4% fall in quantity demanded. Thus, the post-tax quantity is still high and therefore the tax revenue is also relatively high.
In the case of Chevrolet cars, a 10% increase in price, due to a tax, leads to a 40% decrease in quantity demanded. Thus, a large proportion of the quantity is lost. This fall in consumption means that the tax revenue is not very high.
Thus, purely from a revenue perspective, it makes sense to tax cigarettes. This is because the PED of cigarettes is low. Therefore, the percentage fall in quantity demanded is lower than the percentage increase in price (due to the tax). Tax revenue (= tax per unit* post-tax quantity) is therefore relatively high.
On the other hand, when PED is high, demand is highly responsive to a price increase on account of the tax and quantity demanded falls by proportionately more. Tax revenues (= tax per unit * post-tax quantity) will not be as high.
Governments all over the world use this principle to tax goods with inelastic demand such as cigarettes, alcohol and, more recently, sugar-based drinks. However, revenue maximisation is not the only reason for taxing these commodities at a high rate. As we will see later, these are all addictive goods that have a negative impact on both individual health and the productivity of society, as a whole. For this reason, taxes on these goods are sometimes called 'sin taxes'. According to Adam Smith as quoted here:
"Sugar, rum, and tobacco, are commodities which are no where necessaries of life, which are become objects of almost universal consumption, and which are therefore extremely proper subjects of taxation."
The study above reports the estimates of PED as shown below.
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Alcohol: PED range 0.51-0.77
Soft drinks: PED = 0.8
Tobacco products: PED range 0.2-0.8
Thus, real-life data supports the assumption of inelastic demand for these goods. Consequently, taxes are expected to yield relatively higher revenues. To quote the same source as above:
"In every country that has raised its tobacco tax by a nontrivial amount, consumption has fallen and revenues have increased."
It is therefore important for policymakers to take PEDs of the taxed products into account when estimating potential gains in tax revenue. This exercise will be helpful in choosing the right set of products to tax. Data shows that governments do have a tendency to resort to 'sin taxes' when trying to generate more revenue to make up a shortfall in their planned spending.