Applying PED — Supply Shifts and Total Revenue

Idea

When supply shifts, price and quantity move in opposite directions, so the effect on total revenue is indeterminate until the price elasticity of demand is known. PED fixes how far quantity demanded responds to the price change, and therefore which of price or quantity dominates the revenue outcome.

Diagram

Mechanism

A rise in supply lowers price and raises quantity demanded. With

$PED = \frac{\%\,\text{change in quantity demanded}}{\%\,\text{change in own price}}$

• Price elastic demand ($|PED| > 1$): quantity demanded rises more than proportionately than price falls, so the quantity effect dominates and total revenue rises ($P_eQ_e > P_0Q_0$).

• Price inelastic demand ($|PED| < 1$): quantity demanded rises less than proportionately, so the price effect dominates and total revenue falls ($P_iQ_i < P_0Q_0$).

A flatter demand curve through the equilibrium is the more elastic one; a steeper curve is the more inelastic. Note that PED measures a movement along demand (a change in quantity demanded), not a shift.

Considerations

The determinants of PED are remembered as SNIT:

• Substitutes — the more numerous and closer the substitutes, the more elastic, since buyers can switch away when price rises.

• Necessity — the greater the degree of necessity (a basic good, or an addictive one), the more inelastic, since buyers are unwilling or unable to cut back.

• Proportion of income — the larger the share of income a good absorbs, the more elastic, since a price rise is felt more keenly.

• Time period — demand is more inelastic in the short run and more elastic in the long run, as buyers need time to find alternatives.

These are a menu for evaluation: whether a tax, a price change or a supply shock raises or erodes a firm’s or a government’s target turns on which determinants dominate for the good in question.