Applications of the Price Elasticity of Demand
The concept of elasticity of demand plays a crucial role in the pricingdecisions 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 infiscal policy because the Finance Minister has to keep in view the elasticity of demand when it considers to impose taxes on various commodities. We shallexplain below the various uses, applications and importance of the elasticityof demand.Elasticity of demand is mainly useful in Pricing Decisions by Business Firms.The business firms take into account the price elasticity of demand whenthey take decisions regarding pricing of the goods. This is because change inthe price of a product will bring about a change in the quantity demandeddepending upon the coefficient of price elasticity. This change in quantitydemanded as a result of, say a rise in price by a firm, will affect the totalconsumer’s expenditure and will therefore, and affect the revenue of thefirm. If the demand for a product of the firm happens to be elastic, then anyattempt on the part of the firm to raise the price of its product will bringabout a fall in its total revenue. Thus, instead of gaining from the increase inprice, it will lose if the demand for its product happens to be elastic. On theother 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 aprofit maximizing price, the firm cannot ignore the price elasticity of demandfor 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 itsproduct, say by 5 percent?2.
How large a reduction in price of a product is required to increasesales, say by 25 percent.It has been found by some empirical studies that business firms often fail totake elasticity into account while taking decisions regarding prices, or theygive insufficient attention to the coefficient of price elasticity. No doubt, the