Explain the importance of elasticity of demand.
The elasticity of demand refers to the degree of responsiveness of quantity demanded of a commodity to a change in its price (or any other factor).
The concept of elasticity of demand is of great importance to producers, farmers, workers, and the Government. Lord Keynes considered this concept to be the most important contribution of Alfred Marshall.
The importance of elasticity of demand can be explained with the help of the following points:
- Importance to a Producer: Every producer has to decide the price of his product at which he has to sell it. The concept of elasticity of demand becomes important for this purpose. If the producer is producing a commodity whose demand is relatively inelastic, then he can set a high price for it. Similarly, if the producer is producing a commodity whose demand is relatively elastic, then he will set a low price for it. The concept of elasticity of demand is also useful to a monopolist to practice price discrimination.
- Importance to Government: The taxation policy of the Government is based on the concept of elasticity of demand. Those commodities whose demand is relatively inelastic will be taxed more because it will not affect their demand much and vice-versa.
- Important in Factor Pricing: The concept of elasticity of demand is useful in the determination of factor prices. The factor of production for which demand is relatively inelastic can command a higher price as compared to those having elastic demand. For example, workers can ask for higher wages, if the demand for the product produced by them is relatively inelastic.
- Importance in Foreign Trade: The concept of elasticity of demand is useful to determine terms and conditions in foreign trade. The countries exporting commodities for which demand is relatively inelastic can raise their prices. For example, the Organization of Petroleum Exporting Countries (OPEC) has increased the price of oil several times. The concept is also useful in formulating the export and import policy of a country.
- Public Utilities: In the case of public utilities like railways which have inelastic demand, the Government can either subsidize or nationalize them to avoid consumer exploitation.
- Proportion of expenditure: If the proportion of expenditure in a person's income is small, then demand for the product is relatively inelastic. For example, newspapers. If the proportion of expenditure is large, then demand for the product is relatively elastic.