The concept of elasticity of demand is of considerable significance in various situations. The importance of elasticity of demand can be realised as follows:
(1) Business Decisions:
Change in price of a good brings about a change in the quantity demanded depending upon the value of elasticity of demand. Change in quantity demanded affects the total expenditure of the consumers and will, therefore, affect the profits of the business.
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If the price elasticity of demand is low, the business firm can fix up a higher price for the commodity (to raise his revenue and profits).
If elasticity of demand is less than one, a reduction in price will reduce the total revenue of the firm. However, he would not be able to charge a high price for a commodity with elastic demand. The concept of elasticity of demand is of special importance to a monopolist while fixing a profit maximizing price and output. A monopolist fixes a higher price in a less elastic market and a lower price in a more elastic market.
(2) Economic Policies of Government:
A knowledge of the elasticity of demand helps the Government and economic planners in formulating its economic policies. Government can stabilise the prices of agricultural goods by following a policy of price support programme in the event of increased production.
A bumper crop instead of being a cause of prosperity may spell disaster, if the commodity has inelastic demand, particularly, when the produce is perishable. This is called the paradox of poverty amidst plenty, as poor people get less prices with almost same demand due to excess supply. To overcome this situation, the Government has to be prepared to procure the excess supply of the commodity from the farmers at certain minimum price.
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This step is necessary to prevent a fall in food grains production and a fall in farmer’s income on account of bumper crops. In the absence of such Government policy, the farmers may resort to destroying already produced crops. This would be a national wastage, particularly, in developing countries which are already plagued with poverty, hunger and malnutrition.
Similarly, in case of shortages and high price, the Government can protect the interests of the consumers by fixing ‘ceiling price’, the highest price beyond which the farmers cannot charge. As the situations of shortages and surpluses arise occasionally in agriculture, the Government follows buffer stock operations, i.e., procuring stocks from surplus areas and disposing them in deficit areas. Government can alternatively import the commodity from other countries to dispose off in deficit areas.
(3) Determination of Public Utilities:
The concept of elasticity of demand enables the Government to decide as to which industry should be declared as public utility and consequently owned and controlled by the state. The products like electricity, gas, water, transportation, etc. have inelastic demand.
The industries of these products should be taken over by the Government and should be declared as public utilities to avoid high prices, restricted output and exploitation of consumer by the monopolist.
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Public utilities are vested with a public interest and raise the economic welfare of the community by facilitating cheap availability of the essential products like, electricity, gas, water, post, and telegraph, etc.
(4) Taxation Policy:
The Government interested in raising its revenue can impose higher indirect taxes (excise duty, sales tax, etc.) on the commodities with inelastic demand. The demand for such commodities does not much fall, even when prices rise after the imposition of taxes.
The burden of the tax is partly borne by the consumer and partly by the producer, depending upon the magnitude of the elasticity of demand, besides that of elasticity of supply. If the demand for commodity is perfectly inelastic, the entire burden of the tax will fall on to the consumer.
The reason is that, imposition of tax will raise the price of the commodity by an amount equal to the amount of tax, quantity demanded remaining the same. Further, taxes on commodities having elastic demand will not yield much revenue to the Government as the demand for such commodities will fall significantly with an increase in their prices. On the extreme, if the demand is perfectly elastic, the entire burden of the tax will be borne by the producer, as in this case, price of the commodity does not increase.
Thus, the knowledge of the elasticity of demand helps the Government to formulate suitable taxation policy, so that the burden of the tax is equitably distributed among different groups of tax payers. On considerations of social justice, the Government should levy higher taxes on goods not falling under the categories of necessities (having inelastic demand).
(5) Determination of Factor Pricing:
Elasticity of demand helps in the determination of wages and share of each factor of production in proportion to its demand in the product. A factor with an inelastic demand commands a higher price as compared to a factor with relatively elastic demand.
Further, any attempt by trade union to demand higher wages will be more successful, when the elasticity of demand for a product is low. Otherwise, it may cause unemployment among workers due to restricted production as a result of fall in demand at consequent high price of the product. The Government can determine minimum wage policy on the basis of elasticity of demand of labour input.
(6) International Trade:
The ‘terms of trade’ can be determined by measuring elasticity of demand in two countries for each other’s goods. In international trade, a country earns more profits by importing the commodities, which have elastic demand and exporting the ones, which have relatively less elasticities.
Here, the terms of trade are said to be in favour of the country and the country is in a position to export its goods at high prices, but, to import its requirements at low prices. Finally, at the time of taking decision to devalue or revaluethe currency, the Government should carefully see the nature and the value of elasticity of demand and supply of both exports and imports.
When the balance of payments is adverse and continues to be adverse for the country for some years, the Government can devalue its currency to correct this imbalance. Such devaluation will make exports cheaper and imports dearer.
This will help in increasing export earnings and cutting down import payments. If the exports have inelastic demand and imports have elastic demand, devaluation will be successful. Otherwise, the policy of devaluation will fail. Elasticity of demand also helps the Government to maintain a proper rate of foreign exchange for its currency in relation to other currencies that will keep balance of payment in equilibrium.
Besides the practical importance of the concept of elasticity of demand, it has theoretical importance also. It can be used as a tool of analysis to explain many economic theories and problems. Keynes considered price elasticity of demand to be the most important contribution of Marshall.
Price elasticity of demand is useful in the theory of price determination. Under perfect competition, no firm has control over the price of the product. It implies that price elasticity is infinity in this case. While under imperfect competition or monopoly, a firm can exercise control over the price.
The degree of control (monopoly power) is inversely related to the coefficient of price elasticity of demand. The lesser is the elasticity of demand for a product, the greater is the degree of monopoly power. In perfect competition, the monopoly element is completely absent, as the elasticity of demand is infinity.