Calculating PED is the easy half. The reason it sits in every syllabus is that a firm cannot price sensibly without it and a government cannot tax sensibly without it. Get this page right and you will find whole essay questions suddenly have an obvious plan.
📚 What you need to know
Total revenue = price × quantity sold. Change the price and both parts move, in opposite directions.
The total revenue rule: raise the price on inelastic goods, cut the price on elastic goods.
Total revenue is at its maximum where PED = 1.
Firms use PED for pricing decisions and for price discrimination.
Governments tax inelastic goods to raise steady revenue, and subsidise elastic goods to get a big rise in consumption.
The more inelastic demand is, the more of an indirect tax the consumer ends up paying. That is tax incidence.
The total revenue rule
Total revenue is price multiplied by quantity. When you cut the price, you lose money on every unit you were already selling, but you gain money from the extra units you now sell. Whether revenue rises or falls depends entirely on which effect is bigger — and PED is exactly the measure of that.
The rule in one line
Demand elastic → cut the price. Demand inelastic → raise the price.
The solid green block is revenue after the price change; the red dashed outline is revenue before. In both cases the new block has the larger area.
Do not memorise the rule as two sentences. Draw the two rectangles instead. Once you have seen the areas swap size, you will never get the direction the wrong way round in an exam.
Where revenue actually peaks
Put the two ideas together. Along a straight-line demand curve, PED starts high and falls as you move right. Revenue therefore rises while demand is elastic, peaks at the point where PED equals 1, and falls once demand becomes inelastic.
Both graphs share a quantity axis. Read straight down from any point on the demand curve to see what revenue is doing there.
The one-sentence version. A firm should keep cutting price while demand is elastic and keep raising it while demand is inelastic — which means it should stop exactly where PED = 1.
How firms use PED
Setting price. A firm with a strong brand and few substitutes faces inelastic demand and can raise price without losing many customers. A firm in a crowded market cannot.
Price discrimination. Charging different groups different prices for the same product, based on their elasticity. Business travellers book late and cannot easily change plans, so their demand is inelastic and they pay more; tourists booking six months out are flexible, so they pay less.
Planning a sale. A discount only raises revenue if demand is elastic. Cutting the price of something people buy out of habit just gives money away.
Judging a cost rise. If input costs rise, a firm facing inelastic demand can pass most of it on. A firm facing elastic demand has to absorb it and lose margin.
How governments use PED
Governments have two different goals, and PED tells them which goods suit which goal.
Goal
Pick goods with
Why it works
Raise tax revenue
Inelastic demand: fuel, tobacco, alcohol
Consumption barely falls when the tax pushes the price up, so revenue stays high and predictable
Cut consumption of a harmful good
More elastic demand, or a large tax
If demand is inelastic, a small tax changes behaviour very little — it mostly just collects money
Boost consumption with a subsidy
Elastic demand: public transport, electric vehicles
The price fall produces a proportionally larger rise in quantity demanded
Notice the awkward truth hiding in that table. The goods that raise the most tax revenue are the ones where the tax changes behaviour the least. A government cannot fully achieve both goals with the same tax, and saying so is a strong evaluation point.
Tax incidence: who actually pays?
An indirect tax is collected from the producer, but that is not the same as being paid by the producer. The producer raises the price to cover it, and how much of the tax ends up on the consumer depends on how inelastic demand is.
Demand is steep, so quantity falls only from Q1 to Q2. Almost the entire tax lands on the consumer, which is exactly why governments tax fuel and tobacco.
Worked examples
WORKED EXAMPLE 1
A cinema sells 800 tickets a week at $12. PED for its tickets is 1.5. It cuts the price to $10.80. Calculate the change in total revenue. [4]
Step 1: percentage change in price(10.80 − 12) ÷ 12 × 100 = −10%Step 2: percentage change in quantity1.5 × 10 = 15% rise, so 800 × 1.15 = 920 ticketsStep 3: revenue before and afterBefore: 12 × 800 = $9,600After: 10.80 × 920 = $9,936Revenue rises by $336Demand was elastic, so the price cut worked — exactly what the total revenue rule predicts.
WORKED EXAMPLE 2
A government puts a tax on cigarettes, where PED is 0.3. Explain the likely effect on tax revenue and on smoking rates. [4]
Step 1: what the PED value tells youPED = 0.3, so demand is strongly price inelastic because cigarettes are addictive and have few close substitutes.
Step 2: effect on tax revenue
Quantity falls by proportionally much less than the price rises, so the government collects tax on almost the same number of packets. Tax revenue rises significantly.Step 3: effect on smoking
Consumption falls, but only slightly. A 20% price rise cuts quantity by about 6%.
Strong revenue gain, weak health gainThe evaluation writes itself: the tax is efficient at raising money and inefficient at changing behaviour.
💡 Exam tip
Always calculate revenue both before and after. Showing both numbers is worth more than stating the direction.
Use the phrase “proportionally more/less than”. It is the exact language mark schemes reward.
For tax questions, say who bears the burden and why, not just that the price goes up.
Draw the two revenue rectangles if a question asks you to illustrate the total revenue rule.
Remember PED changes along the curve, so “cut the price” is only good advice while demand is still elastic.
Add a real limitation: firms often do not know their PED accurately, so decisions are made on estimates.
⚠️ Common mix-up
Confusing revenue with profit. Total revenue ignores costs completely. Maximum revenue is not maximum profit.
Saying a price rise always raises revenue. It only does so if demand is inelastic.
Thinking the producer pays the whole indirect tax because they hand it to the government. Incidence depends on elasticity.
Assuming a tax on an inelastic good cuts consumption a lot. It barely does — that is the point of choosing it.
Forgetting that price discrimination needs the groups kept apart. If cheap tickets can be resold to business travellers, it collapses.
Applying the total revenue rule to the whole demand curve at once. It applies at the point you are currently at.
Up next: Income Elasticity of Demand — price is not the only thing that moves demand. When incomes rise, some goods boom and others quietly shrink. YED tells you which is which.
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