The Price Elasticity of Demand for goods indirectly dictates the function of today’s economy, it does this by using the wants and needs of the consumer and in-turn governs the prices for individual goods. Below, scenarios in which government or firm have to look at the PED are presented and how they react to create the best possible outcome they can achieve.
Firms need to consider the elasticity of demand and, using this, determine the prices of a good; this is seen as a policy in firm’s cases. The firm needs to consider whether lowering the price will stimulate demand for the product, if so to what extent and whether the firm’s profits will also increase as a result. This can take either one of two outcomes: One, if the increase in sales is more than the reduction in price in proportion, the firm’s total revenue will increase and profits may be higher. Or two, if the increase in demand for the good is less than the fall in price in proportion then revenue will decrease and profits would most certainly decrease. In this scenario, the knowledge of PED as it can move the firm towards increasing the price of an inelastic good, which shifts the burden of any additional cost of production onto the consumers, or decreasing the price of an elastic good to increase demand, and if this is done to the right degree of accuracy, can increase a firm’s revenue greatly.
The burden of tax can also be shifted by the firm onto the consumer to compensate for maybe an increased cost of producing a good. The knowledge of PED here is so important to the firm as if their good can be seen as a highly inelastic good, they can impose large taxation because they know that people need the good irrespective of price, maybe due to addiction. This extra increase in price just makes the cost of producing the good so much cheaper for the firm, therefore revenue and profits will increase greatly. This is also apparent in the Government’s economic objective; they impose heavy taxation of addictive goods; e.g. tobacco and alcohol, two highly inelastic goods.
What the government do is ‘internalize the negative externality’ which means that they impose taxes on a good for the damage the good does to the people; i.e. the government raise cigarette prices by %20 in taxes, this %20 goes to the NHS to fund the treatment of liver failures and lung cancer for alcohol and cigarettes respectively. In relation to this, the ‘paradox of poverty amidst plenty’ highlights how the elasticity of agricultural goods affects farmers and farming communities; A ‘bumper’ crop (particularly productive harvest yielded) bring poverty to farmers; the increase in supply shifts the curve right, causing a massive decrease in the price consumers pay. The government intervenes here and subsides the farmers for doing their job; they buy up the surplus crop and store it for forthcoming years, a bad crop may come next year, which allows this surplus crop to be used up, showing fluctuation in the production of the good.
The Price Elasticity of Demand justifies the nationalization of public utility services, e.g. bus or train services, electricity, water supply and mail services. These services, by nature, are generally inelastic; if these services were to be run by private firms, the country would see large exploitation of the somewhat already extortionate prices – especially Northern Rail, grinds my gears!! – This is because private firms want to monopolize, or control, the market. Therefore, in the government’s interest of the general public, they own and control said services.