The concept and theory of elasticity of demand play a vital role in the solution of economic problems and the determination of various economic policies. Mainly there are four types of elasticity of demand (price, income, cross, and advertisement). Here we will talk about the importance or uses of price elasticity of demand. The concept of all the types of elasticity of demand plays a vital role in the understanding of different economic activities, the relationship between different economic activities, and they provide guidelines for the analysis and formulation of different economic policies.
Importance of Price Elasticity
Price elasticity is a tool to analyze various economic problems, issues, policies, and programs of different sectors of an economy. Most of the applications of the concept of the price elasticity of demand have to do with pricing decisions of business firms, government agencies that directly or indirectly regulate price. The businessman must know the effect of the price change on quantity demand of the product and factor in the market with the help of the concept of price elasticity of demand. The following table shows the major importance or use of price elasticity of demand.
|Product Pricing||By using the concept of price elasticity of demand, the business firms can determine whether a decline in price is better or a rise in price is better to increase sales, total revenue, and the profitability of the business. Generally, the lower price is fixed for the elastic product and the higher price is for the inelastic product.|
|Price Discrimination||It is the act of charging different prices to different buyers in different markets for identical products. It is one of the major attributes of a monopolist seller. Low price is charged in the market where there is elastic demand and the higher price is charged in the market in which price elasticity is relatively low.|
|Pricing and nationalization of Public Utilities||Public utilities are very important for the daily life of all the people living in the country and generally, their demand is inelastic. If they are left at the hand of the private sector, they might be charged a very high price and there will reduction in the people’s welfare. Therefore, the elasticity of demand is used while deciding which economic undertaking should be controlled by public authority and which is left on the hand of the private sector. Similarly, the pricing problem of public utility is also solved by price elasticity.|
|Pricing of Joint Product||In the case of a joint product like wool and mutton, paddy and straw, chicken and eggs, etc. their pricing issue is solved with the help of price elasticity. The separate pricing is very difficult in such cases or the separate cost of predication is not known in such type of joint product. Thus, the concept of price elasticity of demand is used to determine their separate price.|
|Demand Forecasting||The value or coefficient of price elasticity of demand is useful to forecast the future demand of a commodity. The determination of elasticity will let know a business firm about the percentage change in demand with one percentage change in price. So given the value of elasticity of demand, future demand forecasting would become easy.|
|Shifting Tax Burden||The shift of the burden of tax is also based on the degree of price elasticity of the product. If the value of price elasticity of demand is relatively lower, then the businessman will shift more burden of tax on the hand of buyers and vice versa.|
|International Trade||The pricing of goods to be import or export is also based on these goods’ elasticity of demand. If the elasticity is higher in the foreign market then the lower price is fixed for exporting products and if the value of elasticity is lower than a higher price is charged for exporting goods by the domestic firms or government.|
|Formulation of Tax Policies||The taxation policy of the government is also based on the elasticity of the products. Generally, higher taxes are charged on the products having less elasticity and vice-versa. Similarly, the government may decide their protection or subsidy policy for those goods or products whose elasticity is comparatively high. It is because they may not be able to face competition until the prices of these products are supported by subsidies.|
|Factor Pricing||The elasticity of demand concept is also useful to determine the price of factor inputs. If the demand for input is elastic, the entrepreneurs are prepared to pay a low price and vice versa.|
Use of Income Elasticity
Income elasticity of demand helps a business firm to know the income elasticity for its products and to select target markets and make forecasts. It is the fact that the income of the consumer is not a controllable factor for the business firm, but a firm can get selective control by selecting a target market and target group of the consumers. From the business viewpoint, the concept of income elasticity of demand has the following important uses.
|Demand Forecasting||If the income elasticity of the particular product, the rate of increase in the income of the target market is known then the firm can easily forecast the demand for its products. Thus the knowledge of income elasticity of demand gives an idea of how much to produce at a different level of income. In the long-run, the demand for luxurious products may become income elastic. Thus the business firms may formulate their business strategies accordingly.|
|Classification of Goods||The income elasticity of demand helps to classify the commodities. Whether the product is a normal good, luxurious normal good, essential good, inferior good, or neutral good, we can easily classify with the help of the coefficient of income elasticity of demand. If the coefficient of income elasticity of demand is positive, the commodity is normal, if greater than one, the commodity is luxurious, the coefficient is positive but less than one then the commodity is essential, if it is negative then the good is inferior and when it is zero then the commodity is neutral good.|
|Helpful in Strategic Decisions||The business can classify all the people into different classes based on the measurement of income elasticity of demand. They can then produce their product accordingly. The firm produces high-quality expensive products if its strategy is to target the richer class of society. In contrast, they focus to produce normal and low priced goods if they have the strategy to cover the comfort and common type of market and class of people. Thus, the business firm can classify the entire market into different classes based on income elasticity of demand and accordingly formulate business policies and strategies.|
|Helpful to Government for Policy Formulation||The governmental organs also use the concept of income elasticity of demand in the formulation of different types of policies. For example, for the imposition of taxation, the government can use the concept of income elasticity of demand. The income elasticity of demand is highly elastic for luxurious goods and it is less elastic for normal goods. Thus which good is to be taxed can be seen from the point of income elasticity also.|
|Helpful in Designing Marketing Activities||Marketing activities deal with promotional activities of the business forms. Generally, businesses apply different types of promotional tools and activities to increase their sales volume and profitability. If there is high-income elasticity of a product then extensive marketing strategies can be applied to attract more consumers and increasing the possibility of business expansion in the future while an increase in income of the consumers.|
Importance of Cross Elasticity of Demand
Business firms want to know the cross elasticity for their product to see their main competitors, their strategies, and the formulation of their own firm’s business policy according to their observation. Thus, cross elasticity is a useful tool to formulate business and pricing decisions. The following are the major uses of cross elasticity of demand.
|Categorization of Goods||The concept of cross elasticity of demand is useful for the categorization of goods. If the cross elasticity is positive then two goods are substitutes and in the case of negative two goods are complementary. Similarly, if cross elasticity is zero then goods are independent. After knowing the commodities the firms can formulate their policies accordingly.|
|Pricing Policy Related to Other’s Product||The products produced by anyone company are in many ways related to the output of other company’s products. Thus their demand is directly affected by the pricing policies of other producing firms. By knowing the cross elasticity the business firm can get information regarding the pricing policies of other competitors and they can formulate the best price for their products.|
|Establishment of Interrelation between Industries||Based on the measurement of cross elasticity of demand different industries got to know their relation as to whether they are related to each other complementarily or they are substitutable. In case they are substitutable they cannot raise their prices without making consideration and coordinating with other industries. Similarly, if they are related complementarily, they also cannot directly alter their strategies without negotiating their complement industries. So it establishes a king of interdependence between industries of the economy.|
|Classification of Market||The market can be classified based on cross elasticity of demand. The higher the value of cross elasticity of demand between goods, the higher will be the competition in the market and vice-versa. If the cross elasticity is infinite, the market structure is perfectly competitive. If it is zero, the market is a monopoly.|
|Pricing Policy Related to Own Goods||Different firms produce a different line of products. They may be substitutes (a cream company produces varieties of creams) and complementary (a company may produce toothpaste and toothbrush). Thus the pricing of such products can be done with the help of the concept of cross elasticity of demand.|
Importance of Advertisement Elasticity of Demand
Advertisement plays a key role in modern businesses. It conveys oral and visual messages that have designed for informing customers about the availability of the product and influencing and persuading them to purchase the products. Thus, advertisement constitutes a key place in business decision making. The major uses of advertisement elasticity of demand are as below.
|Advertisement Decision||A firm incurs promotional spending for its products intending to increase sales volume and profitability. Whether the firm has to increase it or decrease it may be based on its elasticity of demand. If the advertisement elasticity of demand during a particular time then the promotional spending could be increased and vice versa.|
|Effectiveness of Promotion||Higher advertisement elasticity of demand signifies the greater effectiveness of the firm’s advertisement expenditure and vice-versa.|
|Effectiveness of Media||The study of the concept of advertisement elasticity of demand helps to evaluate the effectiveness of advertising media. The firm can decide which media the promotional expenditure has to be done and in which it has to be stopped.|
|Marketing Strategies||In the case of a competitive market, the advertisement elasticity of demand also helps to formulate the advertisement and promotional packages for the marketing department. If there are high competition and higher elasticity of advertisement then the firm can massively be involved in the promotional campaigns.|