Role and Significance of Elasticity of Demand

Role and Significance of Elasticity of Demand

The concept of Elasticity of demand has significant role to play in economic theory and practice and we shall study the importance of this concept.

1. Elasticity of demand in production

In a free capitalistic economy, production mainly depends on consumer demand and care should be taken to adjust it to the extent of demand. Hence elasticity is a concept which enables all producers to take correct decision regarding the quantum of output based on the demand.

2. Elasticity of demand in Price Fixation

Every seller under imperfect competition and monopoly has to consider the elasticity of demand for his product when he fixes the price or contemplates to change the price. The seller has to take into consideration the extent of response in demand due to change in price as the revenue realized by him depends on the quantity demanded in the market.

In price fixation, this concept is made use of not only in imperfect competition, but also in monopoly. A monopolist can fix the price only on the basis of elasticity of demand.

If the commodity enjoys inelastic demand, the monopolist can increase the price without losing the quantity demanded. This will not in anyway affect the net monopoly revenue for him. In the case of price discrimination, the markets are divided mainly on the basis of difference in elasticities of demand for the same product in different markets.

In the case of perfect competition this may be an exception as the producer can expect perfectly elastic curve for his product.

3. Elasticity of demand in Distribution

The concept of elasticity of demand has an important role to play in the determination of the rewards for factors of production in a price-enterprise economy.

For example if the demand for labour is very elastic, the efforts of Trade Unions to increase the wages will not meet with success.

On the other hand if the demand for labour is inelastic, as there may be little scope for automation; Trade Unions can succeed well in getting the wages raised. Rewards for other factors of production also depends on their elasticity of demand.

4. Elasticity of demand in International Trade

The concept of elasticity of demand forms the basis of international trade, particularly the terms of trade which implies the rate at which the domestic commodity is exchanged for foreign commodities. So, while calculating terms of trade, the intensities of demand of the two countries requiring the product of the other country should be considered.

The terms of trade depends upon the mutual elasticities of demand of the two countries for each other’s goods.

5. Elasticity of demand in foreign Exchange

In the field of foreign exchange, fixation of appropriate rate of exchange between two currencies of the two countries mainly depends on the elasticities of demand for imports and exports.

In deciding devaluation or revaluation of the domestic currency, the authorities should make a careful study of the elasticity of demand for the country’s exports and imports and accordingly fix the exchange rate to correct the disequilibrium in the balance of payments.

6. Elasticity of demand in nationalizing an Industry

This concept of elasticity of demand is used to enable the government to decide whether an Industry can be declared as public utility to be nationalized. If the demand is inelastic for the product of a monopolistic concern, it is a clear case of declaring as public utility and the government can nationalize the concern and operate it.

7. Elasticity of demand in Public Finance

Elasticity of demand is of immense use to Finance Ministers to formulate taxation and economic policies. In imposing a tax on a commodity, the elasticity of demand of the commodity should be carefully studied to find out the effect of taxation.

The tax burden should be equally borne by all and at the same time the government should realize adequate revenue from that commodity.

The problem of Incidence of taxation (bearing the burden of taxation) depends upon the elasticities of demand and supply of the commodities taxed.

Further, in imposing statutory price — control for a commodity, the elasticity of demand for that commodity has to be taken into consideration. In framing the budget, the concept of elasticity of demand has a significant role in all matters relating to taxes and revenue.

In framing economic policies, the knowledge of elasticity of demand is required. For stabilizing agricultural prices, the government may adopt either output control or purchase surpluses and other similar operations.

In all cases, without knowing the trends of demand and elasticities of commodities and farm products, the government cannot stabilize the prices properly. Thus Elasticity of demand is of great significance in theory and practice.