Applications of Price Elasticiy of Demand
Firms give a lot of importance to PED while setting prices for their products. A firm will be more willing to increase the price of a product which has a more inelastic demand because it will lead to an overall increase in their revenue. With an increase in price of the product, the demand will not fall in the same proportion and this end up in more revenue for the firm. On the other hand a firm seeking to increase its revenue and having elastic demand for its product should not increase its prices because it will lead to a fall in their revenue. As the price increase there will be a more than proportionate fall in sales, thus pulling down the overall revenue of the firm.
The PED for primary commodities is relatively low due to the fact that they have very few substitutes whereas manufactured products have a relatively high PED because of the existence of many substitutes. For example, the PED for cow leather (primary commodity) is relatively lower than a genuine cow leather shoe (manufactured product). The reason being there is no or very few substitutes for leather as a raw material for producing shoes. However, leather shoe may have many substitutes in the form of sheep leather and other types of artificial leather shoes available in the market.
PED hold a lot of significance for government while deciding indirect taxes on goods and services. Government uses taxes to reduce the use of demerit goods in the economy. For example they might increase taxes on cigarettes. Cigarettes are habit forming or ‘addictive’ and have inelastic demand, thus, even a high increase in indirect taxes will not lead to a fall in the consumption of cigarette smoking. Thus overall revenue of government will increase without drastically harming the cigarette manufacturing industry and employment. Moreover, it might lead to some fall in cigarette consumption due to increased prices.