Cambridge O Level2281

Price changes

Economics 2281 Chapter Notes

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Price changes - Causes of price changesPrice changes - Consequences of price changes
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In this chapter

  1. 1Calculating Price Elasticity of Demand (PED)
  2. 2PED and Total Revenue
  3. 3Factors Influencing Pricing Decisions
  4. 4Demand-Based Pricing Strategies
  5. 5Government Influence on Prices

1. Calculating Price Elasticity of Demand (PED)

Price Elasticity of Demand (PED) measures how much the quantity demanded of a product changes in response to a change in its price. It's a crucial concept for firms when they make pricing decisions. A high PED means consumers are very responsive to price changes (elastic demand), while a low PED means they are not very responsive (inelastic demand). The value is always negative because price and quantity demanded move in opposite directions, but we usually ignore the minus sign and focus on the number's size.

PED = (% Change in Quantity Demanded) / (% Change in Price)

% Change in Quantity Demanded = (Change in Quantity / Original Quantity) × 100

% Change in Price = (Change in Price / Original Price) × 100

Key term

Price Elasticity of Demand (PED): A measure of the responsiveness of the quantity demanded of a good to a change in its price.

Examiner insight

Examiners award marks for showing the full calculation, including the percentage change formulas, not just the final PED value.

Common pitfall

Confusing the numerator and denominator in the PED formula. Always remember it's 'quantity over price' (%ΔQd / %ΔP).

Worked example 14 marks

The price of a smartphone rises from $500 to $550. As a result, weekly demand falls from 10,000 units to 8,500 units. Calculate the PED for this smartphone.

  1. 1

    Step 1: Calculate the percentage change in quantity demanded.

  2. 2

    % Change in Quantity Demanded = [(8,500 - 10,000) / 10,000] × 100 = (-1,500 / 10,000) × 100 = -15%

  3. 3

    Step 2: Calculate the percentage change in price.

  4. 4

    % Change in Price = [($550 - $500) / $500] × 100 = ($50 / $500) × 100 = 10%

  5. 5

    Step 3: Calculate PED.

  6. 6

    PED = % Change in Quantity Demanded / % Change in Price = -15% / 10% = -1.5

  7. 7

    Step 4: State the result. The PED is 1.5 (ignoring the negative sign). Since 1.5 > 1, demand is price elastic.

Recap

  • PED measures the responsiveness of demand to a price change.
  • The formula for PED is (% change in quantity demanded) / (% change in price).
  • If PED > 1, demand is price elastic.
  • If PED < 1, demand is price inelastic.
  • If PED = 1, demand is unit elastic.

Quick check

  1. If a 20% rise in price causes a 5% fall in quantity demanded, what is the PED?2 marks
  2. Is the demand in the previous question price elastic or price inelastic?1 mark

2. PED and Total Revenue

The relationship between PED and total revenue (TR) is fundamental for any business. Total revenue is the total amount of money a firm receives from its sales (TR = Price × Quantity). How TR changes when price changes depends entirely on whether demand is elastic or inelastic. Understanding this allows a firm to predict the impact of a price change on its income.

Total Revenue (TR) = Price (P) × Quantity Demanded (Qd)

Key term

Total Revenue: The total income a firm receives from selling a given quantity of output, calculated as price multiplied by quantity sold.

Examiner insight

Clear, logical links are essential. State the PED value, identify it as elastic or inelastic, and then correctly deduce the effect on total revenue.

Common pitfall

Incorrectly assuming that a price increase always leads to an increase in total revenue. This is only true if demand is price inelastic.

Fun fact

During sales, retailers rely on elastic demand. They believe the percentage increase in sales will be greater than the percentage discount, leading to higher overall revenue.

Worked example 15 marks

A cinema sells 1,000 tickets per week at a price of $10 each. It is considering cutting the price to $9. It estimates the PED for tickets is 2.0. Advise the cinema whether it should cut the price.

  1. 1

    Step 1: Calculate the initial total revenue.

  2. 2

    Initial TR = Price × Quantity = $10 × 1,000 = $10,000.

  3. 3

    Step 2: Calculate the percentage change in price.

  4. 4

    % Change in Price = [($9 - $10) / $10] × 100 = -10%.

  5. 5

    Step 3: Use PED to find the percentage change in quantity demanded.

  6. 6

    PED = %ΔQd / %ΔP => 2.0 = %ΔQd / -10% => %ΔQd = 2.0 × 10% = 20%. (Note: we use the positive 10% for calculation ease, knowing quantity moves opposite).

  7. 7

    Step 4: Calculate the new quantity demanded.

  8. 8

    New Quantity = 1,000 + (20% of 1,000) = 1,000 + 200 = 1,200 tickets.

  9. 9

    Step 5: Calculate the new total revenue.

  10. 10

    New TR = New Price × New Quantity = $9 × 1,200 = $10,800.

  11. 11

    Step 6: Advise the cinema. Since the new total revenue ($10,800) is higher than the initial total revenue ($10,000), the cinema should cut its price. This is because demand is price elastic.

Recap

  • If demand is price elastic (PED > 1), a price fall increases total revenue.
  • If demand is price elastic (PED > 1), a price rise decreases total revenue.
  • If demand is price inelastic (PED < 1), a price fall decreases total revenue.
  • If demand is price inelastic (PED < 1), a price rise increases total revenue.
  • If demand is unit elastic (PED = 1), a price change leaves total revenue unchanged.

Quick check

  1. A firm raises its price and its total revenue increases. Is demand for its product price elastic or inelastic?1 mark

3. Factors Influencing Pricing Decisions

Setting the right price is a complex decision for a firm. While understanding customer demand (PED) is vital, it's only one piece of the puzzle. Firms must also consider their own costs of production, the actions of their competitors, and their overall business objectives. A successful pricing strategy balances these different factors to achieve the firm's goals.

Key term

Market Structure: The organisational and other characteristics of a market, especially the nature of competition and pricing.

Examiner insight

Good answers go beyond just listing factors and explain *how* each factor influences the pricing decision, showing a clear cause-and-effect relationship.

Fun fact

Some restaurants deliberately have one extremely expensive item on the menu, not to sell it, but to make the other items seem more reasonably priced by comparison. This is called 'anchoring'.

Worked example 14 marks

A new coffee shop is opening in a busy high street with several existing competitors. Explain two factors, other than the costs of its coffee beans and milk, that the new shop should consider when setting its prices.

  1. 1

    Factor 1: Competition. The firm must consider the prices charged by rival coffee shops on the same high street. If it sets its prices significantly higher than competitors for a similar quality product, it will struggle to attract customers, as consumers have many alternative options. It might need to price competitively, perhaps slightly lower, to gain initial market share.

  2. 2

    Factor 2: Business Objectives. The firm's objective will influence price. If the main objective is to maximise sales and build a customer base quickly, it might adopt a low pricing strategy (penetration pricing). However, if the objective is to create a premium brand image and maximise profit per cup, it might set a higher price, focusing on quality, atmosphere, and service to justify it.

Recap

  • Pricing decisions are influenced by demand, costs, competition, and business objectives.
  • Production costs (fixed and variable) set a 'floor' for the price in the long run.
  • The level of competition in the market heavily influences pricing power.
  • A firm's objective, whether profit maximisation or sales maximisation, will guide its pricing strategy.
  • Advertising can be used to build a brand image, making demand less elastic and allowing for higher prices.

Quick check

  1. State two different business objectives that might influence a firm's pricing strategy.2 marks

4. Demand-Based Pricing Strategies

Demand-based pricing strategies focus on setting prices according to 'what the market will bear', or how much consumers are willing to pay. This contrasts with cost-based pricing, which starts with production costs and adds a profit margin. These strategies are often used in markets where consumer perceptions and the level of competition are key drivers of sales.

Key term

Price Skimming: Setting a high initial price for a new product to maximise revenue from 'early adopters' before competitors enter the market.

Examiner insight

When discussing pricing strategies, examiners look for the use of real-world examples to demonstrate understanding, such as Apple for price skimming or a new chocolate bar for penetration pricing.

Common pitfall

Mixing up the definitions of price skimming and penetration pricing. Remember 'skimming' is taking the 'cream' off the top (high price), while 'penetrating' is getting deep into the market (low price).

Worked example 14 marks

Explain the difference between price skimming and penetration pricing.

  1. 1

    Price skimming involves launching a new product at a high price. This strategy targets consumers who are willing to pay more to be the first to own a product (e.g., a new games console or smartphone). The high price helps the firm recoup high research and development costs quickly. Over time, as competitors enter, the price is gradually lowered.

  2. 2

    Penetration pricing is the opposite. It involves launching a new product at a low price to attract a large number of customers quickly and gain market share. This strategy is common in markets with many competitors. The aim is to build brand loyalty and then potentially raise prices later once a customer base is established.

Recap

  • Demand-based pricing sets prices based on consumer willingness to pay.
  • Price skimming involves setting a high initial price for a new, unique product.
  • Price skimming is effective when there is little competition and demand from early adopters is inelastic.
  • Penetration pricing involves setting a low initial price to gain market share quickly.
  • Penetration pricing is often used in competitive markets to encourage brand switching.

Quick check

  1. Would a firm launching a revolutionary new drug with a patent be more likely to use price skimming or penetration pricing? Explain why.2 marks

5. Government Influence on Prices

Firms do not set prices in a vacuum; governments can significantly influence the final price consumers pay through taxes and subsidies. Indirect taxes, like Value Added Tax (VAT) or excise duties, increase production costs for firms, which are often passed on to consumers as higher prices. Conversely, subsidies are payments from the government to firms to reduce their costs and encourage production, often leading to lower prices for consumers.

Key term

Subsidy: A grant of money from the government to a producer to lower their costs of production and encourage an increase in output.

Examiner insight

For questions involving taxes or subsidies, drawing a clear, fully-labelled diagram is crucial and often carries half the marks. Ensure you show the shift in the correct curve (always supply) and clearly label the old and new equilibriums.

Worked example 16 marks

The government places a new $2 tax on every packet of cigarettes sold. Using a demand and supply diagram, explain the likely effect on the market for cigarettes.

  1. 1

    Step 1: Draw a standard demand and supply diagram, showing the initial equilibrium price (P1) and quantity (Q1). Label axes 'Price' and 'Quantity'.

  2. 2

    Step 2: Explain that the tax is a cost to the producer. This causes the supply curve to shift vertically upwards by the amount of the tax ($2), from S1 to S2. This is because firms now require a higher price to supply any given quantity.

  3. 3

    Step 3: Show the new equilibrium on the diagram where the new supply curve (S2) intersects the original demand curve (D1). This results in a higher equilibrium price (P2) and a lower equilibrium quantity (Q2).

  4. 4

    Step 4: Conclude by stating that the tax leads to a higher price for consumers and a reduction in the quantity of cigarettes bought and sold. Note that the price for consumers does not typically rise by the full amount of the tax; the burden is shared between consumers (paying a higher price) and producers (receiving a lower effective price).

Recap

  • Indirect taxes (e.g., VAT, excise duties) are taxes on goods and services that increase a firm's costs.
  • An indirect tax shifts the supply curve to the left (or upwards), leading to a higher market price and lower quantity.
  • Subsidies are government payments to firms that reduce their costs.
  • A subsidy shifts the supply curve to the right (or downwards), leading to a lower market price and higher quantity.
  • Governments use taxes to discourage consumption of demerit goods and raise revenue, and subsidies to encourage consumption of merit goods.

Quick check

  1. What is the name for a tax placed on an imported good?1 mark
  2. If the government wants to make solar panels cheaper for consumers, should it use a tax or a subsidy?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define 'price elasticity of demand' and give the formula used to calculate it.3 marks
  2. Explain, using the concept of PED, why a farmer with a poor harvest of a staple food crop might see their total revenue increase.4 marks
  3. A business reduces the price of its product from $20 to $18 and its weekly sales increase from 500 to 600 units. Calculate the PED for the product and state whether demand is price elastic or inelastic.4 marks
  4. Discuss two factors, other than consumer demand, that a car manufacturer must consider when setting the price of a new electric car.6 marks
  5. Analyse the difference between the pricing strategies of price skimming and penetration pricing, giving an example of a product for which each strategy might be suitable.6 marks
  6. Explain how a government subsidy on children's shoes would affect the market price and quantity sold.4 marks
  7. A firm sells a product with a PED of 0.5. Advise the firm on the likely impact on its total revenue if it decides to hold a '20% off' sale.5 marks
  8. Why might a business spend millions on advertising to make the demand for its product more price inelastic?4 marks
  9. With the help of a demand and supply diagram, analyse the impact of a new indirect tax on the market for sugary drinks.6 marks
  10. Discuss whether knowledge of price elasticity of demand is the most important factor for a firm when deciding how to change its prices.8 marks

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