Elasticity of demand (and for that
purpose, even elasticity of supply) plays an indispensable role in
economic decisions of the community. This is because whether an economic
decision is beneficial or not to the decision-maker unit depends, to a
large extent, upon the elasticity of demand of the good concerned. As a
result, all economic decisions (by the government, business firms,
investors, and consumers, etc.) take into account the elasticity of
demand of the relevant good. This fact is elaborated below with the help
of some leading areas in which elasticity of demand is used.
1. The Government:
The concept of elasticity demand is of
great use to the government in formulating its revenue-collecting and
welfare policies. The government needs resources for financing its own
activities and for providing several goods and services, which are
collectively needed by the society. It raises most of its finance
through taxation and supplements it, where the need be, by borrowings.
However, while levying and collecting
taxes, the government has to keep in mind the response of the market.
For example, basic necessities of life have a very low elasticity of
demand and the government, by taxing them, can collect a large amount of
tax revenue without reducing their demand by the consumers. However,
while taxing such goods, it has also to think of the fact that this may
lead to an undue burden upon the consumers. They may reduce their
consumption of some other (non-taxed or taxed at lower rates) goods
which happen to be health giving and nutritious, such as milk, cereals
and vegetables. However, if the good in question is considered a harmful
one and has an elastic demand, then the government can deliberately
levy a huge tax on it with the objective of reducing its consumption.
2. Business Sector:
It may be assumed that a business firm
pursues the objective of profit maximization. Its profit is the excess
of its revenue receipts over its total cost. The former, in turn, is
determined by the product of per unit price of the good (Px) and the
quantity of its demand (Dx).
When a firm changes Px, its total
revenue changes both on account of the change in Px and the resultant
change in Dx. Therefore, a firm finds that while determining the price
of its product, it should take into account its elasticity of demand as
well. This point may be further elaborated by noting that elasticity of
demand itself differs from one market structure to another.
Thus in perfect competition, the firm is
a price taker. Its product has perfect elasticity of demand, and it
cannot increase its price.
Business firms also realize that they
can charge higher prices with a limited reduction in demand only in the
short run. If faced with persistent high price, the consumers shift
their demand to lower priced substitutes in the long run,
3. Input Prices:
Distribution of national income between
individual members and households of the society is an important matter
for the economists and social thinkers. It is commonly believed that it
has an important role to play in the total welfare of the society. In a
modern economy, the income of a household is determined by two factors,
namely,
(i) The productive resources supplied by it to the market
(ii) The rates at which they are paid
for. And the latter, in turn, depends, to a large extent, upon the
respective elasticities of demand for the productive resources.
4. Rate of Exchange and Balance of Payments:
Elasticity of Demand .also plays a
central role in determining a country's rate of exchange and its balance
of payments. Rate of exchange is determined by the demand for and
supply of domestic currency in the international markets. And these
factors are intimately connected with the exports and imports of the
country in which elasticities play a central role. If a country's export
goods have a high elasticity of demand in international markets, it
finds it easier to increase its exports by reducing their prices. In
this case, it can improve its balance of trade without unduly weakening
its rate of exchange. But it will be risky for it to raise the export
prices if its exports have a low elasticity of demand in the
international markets.
