Elasticity of demand in pricing decisions

 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 or depreciation of a currency on its export earnings.

It has also a great use in fiscal policy because the Finance Minister has to keep in view the price 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.

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, 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 revenu

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 its total revenue. Therefore, for fixing a profit-maximising price, the firm cannot ignore the price elasticity of demand for its product.

Use in International Trade:

The price elasticity of demand is also crucially important in the field of international econom­ics. The Governments of the various countries have to decide about whether to devalue their curren­cies or not when their exports are stagnant and imports are mounting and as a result their balance of payments position is worsening.

The effect of the devaluation is to raise the price of the imported goods and to lower the prices of the exports. If the demand for a country’s exports is inelastic, the fall in the prices of exports as a result of depreciation will lower their foreign exchange earnings rather than increasing them.

This is because, demand being inelastic, as a result of the fall in prices quantity demanded of the exported products will increase very little and the country would suffer because of the lower prices.

On the other hand, if the demand for a country’s exports is elastic, then the fall in the prices of these exports due to depreciation will bring about a large increase in their quantity demanded which will increase the foreign exchange earnings of the country and will thus help in solving the balance of payments problem. Thus, the decision to devalue or not, depends upon the coefficient of the demand elasticity of exports.

Likewise, if the objective of depreciation or devaluation is to reduce the imports of a country, then this will be realised only when the demand for the imports is elastic. With elastic demand for imports, the imports will decline very much as a result of rise in their prices brought about by devaluation and the country will save a good amount of foreign exchange.

On the other hand, if the demand for imports is inelastic, the increase in prices as a result of devaluation will adversely affect the balance of payments, because at higher prices of the imports and almost the same quantity of imports, the country would have to spend more on the imports than before.

Importance in Fiscal Policy:

The elasticity of demand is also of great significance in the field of fiscal policy. The Finance Minister has to take into account price elasticity of demand of the product on which he proposes to impose the excise duty or sales tax if the revenue for the Government is to be increased.

The imposition of an indirect tax, such as excise duty or sales tax, raises the price of a commodity. Now, if the demand for the commodity is elastic, the rise in price caused by the tax will bring about a large decline in the quantity demanded and as a result the Government revenue will decline rather than increase. The Government can succeed in increasing its revenue by the imposition a of commodity tax only if the demand for the commodity is inelastic.

The elasticity of demand also determines to what extent a tax on a commodity can be shifted to the consumer. Thus, the incidence of a commodity tax on the consumers depends on their price elasticity of demand for the commodity.

A commodity tax, excise duty or sales tax drives a wedge between the price paid by the buyers and the price received by the sellers. Consider Figure 13.14(c) where the demand curve DD is inelastic and supply curve SS is elastic.

Suppose now sales tax equal to CB per unit is imposed. The producers or sellers will be willing to sell a given quantity of a commodity, if they receive the same net price as before. That is, the producers or sellers will treat the sales tax CB per unit as an extra cost of production and, therefore, they would add it to the cost per unit.

As a result of the imposition of a sales tax per unit of the commodity, supply curve will shift upward to S2and will be parallel to the supply curve S, without a tax. Demand curve DD will remain unaffected as a result of the imposition of sales tax.

It will be seen from Fig. 13.14(c) that the new supply curve intersects the demand curve DD at point B and determines higher equilibrium price OP1 and the quantity sold falls to OQ1. It will be seen from Fig. 13.14(c) that in this present case when demand is inelastic and supply elastic, the burden of the tax falls more on the buyers and less on the sellers. The buyers have to pay EB more price than before and sellers receive EC less price than before. And EB > EC.

Now consider Fig. 13.14(d) where demand curve DD is elastic and supply curve S1S1 is relatively inelastic. Before the imposition of tax P1 is the price at which quantity Q1 is being bought and sold consequent to imposition of tax equal to CB, supply curve shifts to S2S2. Price rises from P1 to P2 and equilibrium quantity sold and bought falls to Q2. In this case when demand is elastic and supply relatively inelastic, burden of tax EB per unit borne by the buyers is much less than CE borne by the sellers.

It follows from above that the burden or the incidence of taxes borne by the producer and the consumer will depend upon the elasticity of demand as well as elasticity of supply. The lower the elasticity of demand, the greater will be the incidence of tax borne by the consumer.

If the demand for a commodity is perfectly inelastic, the whole of the burden of the commodity tax will fall on the consumers as is seen from Fig. 13.14(e). When a tax is imposed on a commodity, its price will rise. As in the case of perfectly inelastic demand, the quantity demanded for the commodity remains the same, whatever the price, the price will rise to the extent of the tax per unit.