Effect of price changes on sales

Allocation of Resources – Price Changes (IGCSE Economics 0455)

Learning Objective

To understand why market prices move, how a change in price affects the quantity sold and the total revenue of a firm, and how the concepts of price‑elasticity of demand (PED) and price‑elasticity of supply (PES) help businesses, workers and governments make informed decisions.

1. Why do prices change? (Syllabus 2.5.1)

A change in market price occurs when either the demand curve or the supply curve shifts. The main causes are shown below.

Side of the marketFactor that can shift the curveDirection of the shift
Demand‑sideChange in consumer income (normal vs. inferior goods)↑ income for normal goods → demand ↑
↓ income for inferior goods → demand ↓
Changes in tastes and preferencesMore favourable → demand ↑
Less favourable → demand ↓
Price of related goodsSubstitutes ↑ → demand ↑
Complements ↑ → demand ↓
Expectations of future price or income (demand side)Expect price to rise → demand ↑ now (buy early)
Expect price to fall → demand ↓ now (wait)
Population / number of buyersMore buyers → demand ↑
Fewer buyers → demand ↓
Government policy (taxes, subsidies, regulations)Tax on a good → demand ↓ (price rises for buyers)
Subsidy → demand ↑ (effective price falls)
Supply‑sideInput (factor) pricesHigher input costs → supply ↓
Lower input costs → supply ↑
TechnologyImproved technology → supply ↑
Out‑dated technology → supply ↓
Number of sellersMore firms → supply ↑
Fewer firms → supply ↓
Expectations of future price (supply side)Expect price to rise → supply ↓ now (hold stock)
Expect price to fall → supply ↑ now (sell before price falls)
Taxes, subsidies & regulationsTax on a good → supply ↓ (costs rise)
Subsidy → supply ↑ (costs fall)
Availability of inputs & storage possibilitiesReadily available inputs or easy storage → supply ↑
Scarce inputs or difficult storage → supply ↓

2. The demand side of a price change

2.1 Law of demand & the demand curve

  • All else equal, a fall in price causes a movement down the demand curve – the quantity demanded rises. A rise in price causes a movement up the curve – the quantity demanded falls.

  • The demand curve is therefore downward‑sloping.

2.2 Price Elasticity of Demand (PED) – Syllabus 2.5.2

The responsiveness of quantity demanded to a change in price is measured by the price elasticity of demand.

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

Interpretation of PED values

Elasticity rangeInterpretationImplication for total revenue (TR)
|PED| > 1 (elastic)Quantity demanded changes proportionally more than price.Price ↓ → TR ↑   |   Price ↑ → TR ↓
|PED| = 1 (unit‑elastic)Quantity changes exactly in proportion to price.Price change does not affect TR.
|PED| < 1 (inelastic)Quantity demanded changes proportionally less than price.Price ↑ → TR ↑   |   Price ↓ → TR ↓
PED = 0 (perfectly inelastic)Quantity demanded does not change when price changes.TR moves in the same direction as price.
PED = –∞ (perfectly elastic)Any price above a certain level drives quantity demanded to zero.TR is zero at any price above the choke‑price; maximum TR occurs at the choke‑price.

2.3 Factors that affect PED (Cambridge 2.5.3)

FactorEffect on elasticity
Availability of close substitutesMore substitutes → more elastic demand
Proportion of income spent on the goodHigher proportion → more elastic demand
Time period consideredLonger time → more elastic (consumers can adjust)
Nature of the good (luxury vs. necessity)Luxuries → more elastic; necessities → more inelastic
Definition of the market (broad vs. narrow)Narrowly defined markets (e.g., “Coca‑Cola”) are more elastic than broadly defined ones (e.g., “soft drinks”).

2.4 Effect of a price change on sales (quantity sold) and total revenue

Sales (or total revenue) is calculated as:

\$\text{TR}=P \times Q\$

Because a price change causes a movement along the demand curve, the change in TR depends on the elasticity of demand as shown in the table above.

2.5 Consumer expenditure and PED (Syllabus 2.5.4)

  • Consumer expenditure = price × quantity demanded.

  • When demand is elastic, a price fall reduces expenditure per unit but the large rise in quantity more than offsets it, so total consumer expenditure increases. The opposite occurs with a price rise.

  • When demand is inelastic, a price rise raises expenditure per unit and the small fall in quantity cannot offset it, so total consumer expenditure increases. A price fall reduces total expenditure.

2.6 Numerical examples

Example 1 – Price decrease (elastic demand)

Initial: 1,000 units at \$10 → TR = \$10,000.

New price = \$8, quantity demanded rises to 1,500 units → TR = \$12,000.

Calculate PED:

\$\%\Delta P = \frac{8-10}{10}\times100 = -20\%\$

\$\%\Delta Q = \frac{1,500-1,000}{1,000}\times100 = 50\%\$

\$\text{PED}= \frac{50\%}{-20\%}= -2.5\;(\text{elastic})\$

Because demand is elastic, the $2 price cut increases total revenue.

Example 2 – Price increase (inelastic demand)

Initial: 1,000 units at \$10 → TR = \$10,000.

New price = \$12, quantity falls to 900 units → TR = \$10,800.

\$\%\Delta P = \frac{12-10}{10}\times100 = 20\%\$

\$\%\Delta Q = \frac{900-1,000}{1,000}\times100 = -10\%\$

\$\text{PED}= \frac{-10\%}{20\%}= -0.5\;(\text{inelastic})\$

With inelastic demand, the price rise raises total revenue.

3. The supply side of a price change (Syllabus 2.7)

3.1 Law of supply & the supply curve

  • A higher price motivates producers to supply more; a lower price reduces the quantity supplied.

  • The supply curve is upward‑sloping, representing a movement along the curve when price changes.

3.2 Price Elasticity of Supply (PES)

\$\text{PES}= \frac{\%\;\text{change in quantity supplied}}{\%\;\text{change in price}}\$

Interpretation of PES values

Elasticity rangeInterpretation
PES > 1 (elastic)Producers can increase output quickly when price rises.
PES = 1 (unit‑elastic)Output changes in the same proportion as price.
PES < 1 (inelastic)Output cannot be increased much in the short‑run (e.g., agricultural products).
PES = 0 (perfectly inelastic)Quantity supplied does not change regardless of price (e.g., a fixed‑supply artwork).
PES = ∞ (perfectly elastic)Producers are willing to supply any quantity at a given price but none at a higher price (e.g., a perfectly competitive market with a fixed market price).

3.3 Factors influencing PES (Cambridge 2.7.2)

FactorEffect on elasticity
Availability of inputsReadily available inputs → more elastic supply
Time periodLong‑run → more elastic (firms can adjust plant size, hire labour)
Complexity of productionSimple, fast‑turnaround production → more elastic; complex processes → more inelastic
Spare capacityUnused capacity → elastic; operating at full capacity → inelastic
Storage possibilitiesGoods that can be stored (e.g., wheat) → more elastic in the long‑run.

3.4 Consequences of a price change for producers

  • If PES is elastic, a price rise leads to a large increase in output and a proportionally larger rise in total revenue.

  • If PES is inelastic, output can only rise a little; total revenue still rises because the price increase outweighs the small quantity increase.

  • In the short‑run many agricultural products have inelastic supply, so price spikes translate into higher revenue with little change in output.

4. Significance of elasticity for decision‑making (Cambridge 2.5‑2.7 applications)

4.1 Firms

  • Choose a price that maximises total revenue:

    • Elastic demand → lower price to increase quantity sold.

    • Inelastic demand → higher price to increase revenue with little loss of sales.

  • Consider PES when planning capacity:

    • Elastic supply → easy to expand output when market price rises.

    • Inelastic supply → may need to invest in new technology or additional inputs before a price rise can be fully exploited.

4.2 Workers (labour market)

  • Demand for labour can be elastic or inelastic:

    • Elastic labour demand → a small fall in wages can cause a large fall in employment; a small rise in wages can cause large job losses.

    • Inelastic labour demand → firms can raise wages with little effect on the number of workers employed (e.g., specialised skilled workers).

  • Supply of labour is also subject to elasticity (e.g., short‑run vs. long‑run willingness to work at different wage rates).

4.3 Government

  • Taxation: Tax goods with inelastic demand (e.g., tobacco, alcohol). Quantity falls only slightly, so tax revenue is high and the welfare loss (deadweight loss) is relatively small.

  • Subsidies: Subsidise goods with elastic supply to increase output quickly (e.g., renewable‑energy technologies).

  • Price controls:

    • Price ceiling on a good with elastic demand → large excess demand (shortages).

    • Price floor on a good with elastic supply → large excess supply (surpluses).

  • Import duties & quotas: Apply where the imported good has inelastic demand to raise revenue without a large fall in import volumes.

5. Suggested diagrams

  1. Demand curve showing an elastic segment (flatter) and an inelastic segment (steeper). Mark two price points (P₁ and P₂) and the corresponding quantities (Q₁ and Q₂). Shade the rectangles under each point to illustrate total revenue before and after the price change.

  2. Supply curve with an elastic portion (steeper) and an inelastic portion (shallower). Use the same price‑change illustration to show how quantity supplied responds.

  3. Combined demand‑supply diagram where a shift in either curve creates a new equilibrium (P* → P′, Q* → Q′). Label the movement as “demand‑driven” or “supply‑driven” and note the likely effect on total revenue.

Key Points to Remember

  • Prices move because either the demand curve or the supply curve shifts.

  • A change in price causes a movement along the relevant curve, altering the quantity sold (or supplied).

  • Law of demand: price ↓ → quantity demanded ↑ (downward‑sloping demand curve).

  • Law of supply: price ↑ → quantity supplied ↑ (upward‑sloping supply curve).

  • PED measures buyer sensitivity; PES measures producer sensitivity.

  • Elastic demand → price cut raises total revenue; inelastic demand → price rise raises total revenue.

  • Elastic supply means producers can quickly increase output when price rises; inelastic supply limits output change, especially in the short‑run.

  • Understanding elasticity helps firms set optimal prices, workers assess wage changes, and governments design taxes, subsidies and price controls.

  • Elasticities are not fixed – they vary with time, market definition, availability of substitutes, and the proportion of income spent on the good.