What is demand elasticity? Briefly explain the importance of price elastto elasticity of demand?
Answers
Area # 1. In the Determination of Output Level:
For making production profitable, it is essential that the quantity of goods and services should be produced corresponding to the demand for that product. Since the changes in demand is due to the change in price, the knowledge of elasticity of demand is necessary for determining the output level.
Area # 2. In the Determination of Price:
The elasticity of demand for a product is the basis of its price determination. The ratio in which the demand for a product will fall with the rise in its price and vice versa can be known with the knowledge of elasticity of demand.If the demand for a product is inelastic, the producer can charge high price for it, whereas for an elastic demand product he will charge low price. Thus, the knowledge of elasticity of demand is essential for management in order to earn maximum profit.
Area # 3. In Price Discrimination by Monopolist:
Under monopoly discrimination the problem of pricing the same commodity in two different markets also depends on the elasticity of demand in each market. In the market with elastic demand for his commodity, the discriminating monopolist fixes a low price and in the market with less elastic demand, he charges a high price.
Area # 4. In Price Determination of Factors of Production:
The concept of elasticity for demand is of great importance for determining prices of various factors of production. Factors of production are paid according to their elasticity of demand. In other words, if the demand of a factor is inelastic, its price will be high and if it is elastic, its price will be low.
Area # 5. In Demand Forecasting:
The elasticity of demand is the basis of demand forecasting. The knowledge of income elasticity is essential for demand forecasting of producible goods in future. Long- term production planning and management depend more on the income elasticity because management can know the effect of changing income levels on the demand for his product.
Area # 6. In Dumping:
A firm enters foreign markets for dumping his product on the basis of elasticity of demand to face foreign competition.
Area # 7. In the Determination of Prices of Joint Products:
The concept of the elasticity of demand is of much use in the pricing of joint products, like wool and mutton, wheat and straw, cotton and cotton seeds, etc. In such cases, separate cost of production of each product is not known.
Therefore, the price of each is fixed on the basis of its elasticity of demand. That is why products like wool, wheat and cotton having an inelastic demand are priced very high as compared to their byproducts like mutton, straw and cotton seeds which have an elastic demand.
Area # 8. In the Determination of Government Policies:
The knowledge of elasticity of demand is also helpful for the government in determining its policies. Before imposing statutory price control on a product, the government must consider the elasticity of demand for that product.The government decision to declare public utilities those industries whose products have inelastic demand and are in danger of being controlled by monopolist interests depends upon the elasticity of demand for their products.
Area # 9. Helpful in Adopting the Policy of Protection:
The government considers the elasticity of demand of the products of those industries which apply for the grant of a subsidy or protection. Subsidy or protection is given to only those industries whose products have an elastic demand. As a consequence, they are unable to face foreign competition unless their prices are lowered through subsidy or by raising the prices of imported goods by imposing heavy duties on them.
Area # 10. In the Determination of Gains from International Trade:
The gains from international trade depend, among others, on the elasticity of demand. A country will gain from international trade if it exports goods with less elasticity of demand and import those goods for which its demand is elastic.
In the first case, it will be in a position to charge a high price for its products and in the latter case it will be paying less for the goods obtained from the other country. Thus, it gains both ways and shall be able to increase the volume of its exports and imports.