Significance of Price Elasticity of Demand

Price Elasticity of Demand is useful in the following ways:

1. Useful for Business:

It enables the business in general and the monopolists in particular to fix the price.

Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and lower prices for goods which have elastic demand. In this way, this helps him to maximize his profit.

2. Fixation of Prices:

It is very useful to fix the price of jointly supplied goods. In the case of joint products like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and inelastic demand.

3. Helpful to Finance Minister:

It helps the Finance Minister to levy tax on goods. After levying taxes more and more on goods which have inelastic demand, the Government collects more revenue from the people without causing inconvenience to the people. Moreover, it is also useful for the planning.

4. Fixation of Wages:

It guides the producers to fix wages for labourers. They fix high or low wages according to the elastic or inelastic demand for the labour.

5. In the Sphere of International Trade:

It is of greater significance in the sphere of international trade. It helps to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is inelastic, the terms of trade will be profitable to the home country.

6. Paradox of Poverty:

It explains the paradox of poverty in the midst of plenty. A bumper crop instead of bringing prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the products are perishable and not storable.

7. Effect on Employment:

The effect of machines on employment opportunities depends on elasticity of demand for the goods produced by such machines. In the initial stage, use of such machines cause unemployment and prices will also fall. But when demand for such commodities is more elastic, then fall in prices will generate more increase in its demand.

As a result, demand will stimulate greater production and hence more employment. If demand for commodities produced by these machines is inelastic, then even fall in price will not increase demand as well as employment.

8. Significant for Government Economic Policies:

The knowledge of elasticity of demand is very important for the government in such matters as controlling of business cycles, removing inflationary and deflationary gaps in the economy. Similarly, for price stabilization and the purchase and sale of stocks, information about elasticity of demand is most useful.

9. Incidence of Taxation:

Incidence of tax lies on the person who ultimately pays the tax. The incidence is on the buyer, if demand is perfectly inelastic. He will go on buying as much as before despite the price rise. Thus, the government has to keep the watch on the ultimate burden of the tax, which depends on the elasticity of demand of the commodity taxed. If necessaries, which have less elastic demand are taxed the burden will fall more on the poor sections of society. Therefore, principle of justice in taxation is based on elasticity of demand.

10. Changes in Rate of Exchange:

Rate of exchange between two currencies can be changed through devaluation or overvaluation of one currency in relation to other currencies. A country while deciding for such a course of action will take into consideration the elasticity of demand for its exports and imports. If the government devalues the currency without considering the elasticity of demand for its exports and imports it may not be able to correct unfavorable balance of payments. Under these circumstances the demand both for its exports and imports turns out to be inelastic.

11. Joint Products:

The concept of elasticity of demand plays an important role in determining the price of joint products. In case of joint products like skin and meat of goat, separate costs are not known. The producer will be guided mostly by demand and its nature while fixing his price. For instance, when goat is bought, it is not kept in mind the separate costs of skin and meat.

When the seller sells the skin and meat, the seller keeps in mind the elasticity of demand of skin and meat. If elasticity of demand for meat is less elastic, in that case the price of meat will be higher. On the other hand if elasticity of demand for skin is more elastic, in that case the price of the skin will be low and vice versa.

12. International Trade:

The concept of elasticity of demand also plays a significant role in the international trade or the terms of trade. It is the nature of demand which is helpful in determining the amount of gain being enjoyed by different countries. The terms of trade would be favourable in case of those countries, whose exports are of the nature of more elastic demand. On the other hand, the terms of trade would be un-favourable if the exports of a country are of the nature of less elastic demand.

13. Market forms:

The concept of elasticity of demand is also useful is knowing the different market forms. If cross elasticity of demand is infinite, in that case there is perfect competition in the market. If cross elasticity is zero (or Ec = 0) it is a case of absolute or pure monopoly. If cross elasticity of demand is less than one (or Ec < 1), in that case there is relative monopoly. And if cross elasticity of demand is greater than one (or Ec >1), in that case, there is monopolistic competition or imperfect competition.

14. Determination of Price of Public Utilities:

This concept is significant in the determination of the prices of public utility services. Economic welfare of the society largely depends upon the cheap availability of the essential products like water, electricity, cooking gas, transportation etc. For such commodities, demand is inelastic and these should be controlled by the government.

The government will distribute these products at fair price. Therefore. Government helps to fix the prices of necessities of life. Thus, elasticity of demand is a very important tool of analysis and it plays an important role in economic analysis.