Price Elasticity of Demand (Practical Applications)

The following points highlight the nine main practical applications of the concept of price elasticity of demand. The uses are: 1. Effects of changes in price upon demand 2. Effects of changes in price on revenue 3. Monopoly pricing 4. Price discrimination 5. Wage bargaining by trade unions 6. Importance in taxation 7. Importance in determining the incidence of taxation and few others.

Practical Application # 1. Effects of Changes in Price Upon Demand:

The concept is very useful to study the reactions of the demand for a commodity to the changes in its price. If the demand is elastic, a small change in the price brings about a considerable change in the quantity demanded, but in the case of inelastic demand this consequential change in demand is relatively small. So, the concept is relevant to the decisions relating to business pricing and profits.

Thus, the fixing of price of a commodity is crucially based on the elasticity of demand of the commodity. As Bates and Parkinson put it: “When costs are rising, it is tempting to pass on the cost increases by increasing price to the consumer, and if demand for the product is relatively inelastic, this measure may well succeed; and when, as for example in the case of rail transport, there are many substitutes and the demand is relatively elastic, increasing prices may well lead to a reduction of total revenue rather than an increase.”

Practical Application # 2. Effects of Changes in Price on Revenue:

The concept enables us to determine the condition of equilibrium of a firm. And a profit-maximising firm reaches equilibrium when revenue = marginal cost.

And, the value assumed by MR depends on price elasticity of demand:

MR = P (1 – 1/E_p) where E_p is coefficient of price elasticity.

Thus, we could easily assert from this relationship that

(i) When E_p = 1 (unit elasticity of demand),

MR = AR x (1 -1) = 0. It means that a change in price will not affect total revenue.

(ii) When E_p → α (perfectly elastic demand),

MR = AR x (1 – 0) = AR, as under perfect competition.

So, a firm may raise the price of its product(s) if demand is inelastic, in which case sales and profits would not be affected. In case of a commodity with elastic demand, a reduction in price alone can raise the sales volume and, consequently, profit.

Practical Application # 3. Monopoly Pricing:

The concept is useful in monopoly price- decisions. The monopolist, being the sole supplier of a particular commodity, can raise price but cannot affect demand pattern of consumers. So, in fixing the price the monopolist will have, of necessity, to take note of the elasticity of demand for his product. He will fix the price at a low level when the demand is elastic and at a high level when it is inelastic.

Moreover, a profit-maximis­ing monopolist will always operate on the elastic part of his demand curve or his average revenue curve. Neither too high nor too low a price may enable him to realise his objective: profit maximisation. What will be the profit- maximising price will be dictated by elasticity of demand; and it will enable the monopolist to know exactly at what price sales proceeds or total revenue will be the highest.

Practical Application # 4. Price Discrimination:

In perfect competition, the same price is charged from all the buyers. But, the downward slope of the demand curve of the monopolist gives scope for price discrimination. Price discrimination refers to the practice of charging different prices for the same product from different buyers at the same time. It can be profitably practised only when price elasticity of demand differs from market to market or from one segment of the market to another.

Practical Application # 5. Wage Bargaining by Trade Unions:

The bargaining power of the trade unions in raising the wages of a group of labour in a particular industry also depends, among other things, on the elasticity of demand for their services to the employer. A trade union usually succeeds in raising wages when the demand for the services of labour to the employer is inelastic: because, in such a case the employer cannot easily dispense with their services. On the other hand, it may not succeed when demand for labour is elastic.

Practical Application # 6. Importance in Taxation:

Furthermore, the concept is a useful tool in taxation. A finance minister is to consider the elasticity of demand of the different commodities for the purpose of taxation. If he pushes commodity tax (excise duty) rates up too much the consequent increase in price may make the total tax yield even lower than before. On the other hand, a small tax reduction may result in an increase in the tax yield.

Firstly, the total expenditure by the consumers will determine the size of the tax yield. And, the total expenditure is the measure of elasticity of demand. If, however, the government simply wishes to discourage the consumption of a commodity which happens to have a highly inelastic demand—e.g., in case of cigarettes — the imposition of a tax may have very little effect on demand and tax collections may rise.

So, before imposing a tax or raising the existing rate of a tax, the government will have to consider the elasticity of demand of the commodity concerned. It can get more revenue from the taxes imposed on commodities with inelastic demand (like sugar, clothes, kerosene oil, etc.) than what is possible from the taxation of those with elastic demand (like refrigerators, motor cars, steel furniture’s, etc.). It so happens because in the former case taxes may raise their prices but their demand and sales will not fall very much; but, in the latter case taxes, by raising the prices, reduce the demand and sales considerably.

Practical Application # 7. Importance in Determining the Incidence of Taxation:

The concept of the elasticity of demand, along with that of supply, is used to determine the shifting and incidence of a tax. When a tax is imposed on a commodity of inelastic demand, the seller can generally transfer the burden of the tax upon the consumers by raising the price, and so the incidence of tax falls upon the buyers.

But, in the case of a tax on a commodity with elastic demand, such a shifting of tax is not an easy task. Similarly, in the case of import and export duties on commodities the inelasticity of demand can be used to determine the incidence of such duties.

Practical Application # 8. Price Determination of Joint-cost Products:

Again, in the case of the joint-cost products (e.g., cotton fibre and cotton seeds) where the cost of each cannot be separately determined, the criterion of demand elasticity is ap­plied in determining their individual prices.

Practical Application # 9. Economic Policy:

The knowledge of elasticity is also valuable in the formation of economic policies, too. This point may now be illustrated. A country suffering from balance of payments problems may try to tackle the imbalance by devaluing its currency.

But, whether devaluation will be successful or not crucially depends upon other countries, i.e., the rest of the world’s demand for the devaluing country’s products. If the demand for its products is inelastic there will be no increase in volume sold after devalu­ation, and consequently export earnings will fail due to lower unit price of its product (sales remaining constant).