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Importance of the Concept of Price Elasticity of Demand

Here we understand in detailed the concept of price elasticity of demand in theory and practice.

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Importance of the Concept of Price Elasticity of Demand:
The concept of price elasticity is considered to be one of the most important contributions in economic theory. The law of demand indicates only the direction of change in quantity demanded when there is a change in price. It does not quantify the change in price and consequent change in quantity demanded. This deficiency of the law of demand is removed by introducing the concept of price elasticity of demand.
Now we will discuss the Practical Significance as follows:
  1. To the Producer: The consumer aims at utility maximisation. But producer's goal is profit maximisation. Price setting is perhaps the prime factor affecting profit. While deciding the price of his product the producer has to take into consideration about the elasticity of demand for this product. He will charge high price if the demand for his product is inelastic as that will not lead to any significant fall in demand. Same way, if the demand for his product is elastic he will reduce price as the loss on account of reduction in price will be much less than overall gain due to expansion of demand and increase in his total revenue. Here Price strategy of the producer is thus guided by price elasticity of demand.
  2. To Decide Public Utilities: The government decision to declare certain industries as public utilities depends on the elasticity of demand for the products. Only those industries are taken over as public utilities by the state, the demand for whose products is inelastic, e.g. electricity and water supply.
  3. Encourages Producers to Incur Selling Costs: It encourages producers to spend more on advertising. They try thereby to make demand for their product less elastic, so that it may be possible to increase price without losing sales much.
  4. Determination of Prices of Public Utilities: Price elasticity of demand helps in fixing prices for the services rendered by public utilities. Where demand is inelastic, high price is charged, for eg, electricity used by the factories. Where demand is elastic, lower price is charged, for eg, electricity used by domestic consumers.
  5. Deciding Devaluation: In deciding on devaluation of local currency and foreign currency, the government will seriously consider the elasticity of demand for both exports and imports. Devaluation can be a wise choice only if the demand for exports and imports is elastic. In a such a situation devaluation would promote exports and cut down some imports and it will improve the country's balance of payments position.
  6. Determination of Gains from International Trade: The gains from international trade depend on the elasticity of demand for exports and imports. We will gain from international trade if demand for export goods in foreign markets is inelastic and demand for import goods in the local market is elastic. It demand for our goods in foreign markets is inelastic, we will be able to charge high prices for them. If demand for foreign goods in local market is elastic, we will be able to obtain these goods at lower prices. Thus, we shall gain both ways.
  7. To Explain the Paradox of Poverty in the Midst of Plenty: Sometimes it is seen and observed that rich harvest ruins the farmers and vice versa. This is known as the paradox of poverty in the midst of plenty. This paradox can be explained in terms of the concept of elasticity. Demand for agricultural products especially foodgrains is inelastic, a bumper crop is followed by a large fall in their prices, and therefore total revenue of the farmers goes down. Thus, bumper crops may be a curse for the farmers.
  8. In the Determination of the Prices of Joint Products: In the pricing of joint products like cotton and cotton seeds or wheat and straw etc, the concept of price elasticity of demand is of much use because in such cases, separate cost of production of each commodity is not known exact. Hence, price of each commodity is fixed on the basis of its price elasticity of demand in the market. Products like cotton and wheat having an inelastic demand are priced high, while by-products like cotton seeds and straw having elastic demand are priced low.
  9. To the Finance Minister: The Finance Minister too is aided by the concept of elasticity of demand. His function is to raise maximum possible revenue for his government with minimum opposition. He succeed in raising more revenue if he imposes or raises taxes on articles of mass consumption, having inelastic demand. The demand being inelastic in nature, even if higher taxes raise prices, the demand would not contract very much. If he were to raise tax rates on luxury goods without which people can easily pull on, he will fail to raise more income for this government. All the same, articles having very low elasticity are mostly necessaries of life. Hence, in democracy, the government will not dare impose taxes on these articles.
  10. To the Trade Union: One of the important functions of trade union leaders is to use weapon of collective bargaining to raise wages, D.A.s etc. for their members. These leaders knowingly or unknowingly make the use of the concept of elasticity of demand for labour pressuring the management for wage rise. If they are convinced that the employer firm cannot do without labour, that is, if demand for labour is inelastic, they will press the button strongly. If the demand for labour is elastic, the trade unionist would not be successful in their efforts to press for higher wages.
  11. To the Monopolist: Monopolist cannot afford to neglect the price of elasticity of demand for his product. The demand curve of the monopolists is sloping downwards. He has therefore to reduce price to sell more. He will weigh the loss in sales and the gain in revenue due to price rise. If the higher price is likely to demand, he would opt for profit maximisation only through price cut. Monopolist will practise price discrimination only if the elasticity of demand for his product in different markets is different. If it is same, it would not be profitable to him to charge different prices for the same product in different markets.
Importance of the Concept of Price elasticity of demand
To the producer
To the Monopolist
In the Determination of the Prices of Joint products
To the Trade Union
To the Finance Minister
To decide public utilities
Deciding Devaluation
Elasticity of Demand - Importance of the Concept of Price Elasticity of Demand.
Tech writer at NewsandStory