Applications of the Price Elasticity of Demand

The concept of elasticity of demand plays a crucial role in the pricing  decisions of the business firms and the Government when it regulates prices.  The concept of price elasticity is also important in judging the effect of  devaluation of a currency on its export earnings. If has also a great use in  fiscal policy because the Finance Ministry has to keep in view the elasticity of  demand when it considers to impose taxes on various commodities. We shall  explain below the various uses, applications and importance of the elasticity  of demand.

Price elasticity of demand
Price elasticity of demand is the relative response of a change in quantity demanded to a change in price.

Elasticity of demand is mainly useful in Pricing Decisions by Business Firms.  The business firms take into account the price elasticity of demand when  they take decisions regarding pricing of the goods. This is because change in  the price of a product will bring about a change in the quantity demanded  depending upon the coefficient of price elasticity. This change in quantity  demanded as a result of, say a rise in price by a firm, will affect the total  consumer’s expenditure and will therefore, and affect the revenue of the  firm. If the demand for a product of the firm happens to be elastic, then any  attempt on the part of the firm to raise the price of its product will bring  about a fall in its total revenue. Thus, instead of gaining from the increase in  price, it will lose if the demand for its product happens to be elastic. On the  other hand, if the demand for the product of a firm happens to be inelastic,  then the increase in price by it will raise total revenue. Therefore, for fixing a  profit maximizing price, the firm cannot ignore the price elasticity of demand  for its product.

Price elasticity of demand can be used to answer the following types of  questions:

  1. What will be the effect on sales if a firm decides to raise the price of its  product, say by 5 percent?
  2. How large a reduction in price of a product is required to increase  sales, say by 25 percent?

It has been found by some empirical studies that business firms often fail to  take elasticity into account while taking decisions regarding prices, or they  give insufficient attention to the coefficient of price elasticity. No doubt, the  main reason for this is that they don’t have means to calculate price  elasticity for their product, since sufficient data regarding past prices and  quantity demanded at those prices are not available. Even if such data are  available, there are difficulties of interpretation of it because it is not clear  whether the changes in quantity demanded were the result of changes in  price alone or changes in some other factors determining the demand.

However, recently big corporate business firms have established their  research departments which estimate the coefficient of price elasticity from  the data concerning past prices and quantities demanded. Further, they are  also using statistical techniques to isolate the price effect of the quantity  demanded from the effects of other factors.

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