Elasticity of demand (and for that purpose, even elasticity of supply) plays an indispensable role in economic decisions of the community. This is because whether an economic decision is beneficial or not to the decision-maker unit depends, to a large extent, upon the elasticity of demand of the good concerned. As a result, all economic decisions (by the government, business firms, investors, and consumers, etc.) take into account the elasticity of demand of the relevant good. This fact is elaborated below with the help of some leading areas in which elasticity of demand is used.
1. The Government:
The concept of elasticity demand is of great use to the government in formulating its revenue-collecting and welfare policies. The government needs resources for financing its own activities and for providing several goods and services, which are collectively needed by the society. It raises most of its finance through taxation and supplements it, where the need be, by borrowings.
However, while levying and collecting taxes, the government has to keep in mind the response of the market. For example, basic necessities of life have a very low elasticity of demand and the government, by taxing them, can collect a large amount of tax revenue without reducing their demand by the consumers. However, while taxing such goods, it has also to think of the fact that this may lead to an undue burden upon the consumers. They may reduce their consumption of some other (non-taxed or taxed at lower rates) goods which happen to be health giving and nutritious, such as milk, cereals and vegetables. However, if the good in question is considered a harmful one and has an elastic demand, then the government can deliberately levy a huge tax on it with the objective of reducing its consumption.
2. Business Sector:
It may be assumed that a business firm pursues the objective of profit maximization. Its profit is the excess of its revenue receipts over its total cost. The former, in turn, is determined by the product of per unit price of the good (Px) and the quantity of its demand (Dx).
When a firm changes Px, its total revenue changes both on account of the change in Px and the resultant change in Dx. Therefore, a firm finds that while determining the price of its product, it should take into account its elasticity of demand as well. This point may be further elaborated by noting that elasticity of demand itself differs from one market structure to another.
Thus in perfect competition, the firm is a price taker. Its product has perfect elasticity of demand, and it cannot increase its price.
Business firms also realize that they can charge higher prices with a limited reduction in demand only in the short run. If faced with persistent high price, the consumers shift their demand to lower priced substitutes in the long run,
3. Input Prices:
Distribution of national income between individual members and households of the society is an important matter for the economists and social thinkers. It is commonly believed that it has an important role to play in the total welfare of the society. In a modern economy, the income of a household is determined by two factors, namely,
(i) The productive resources supplied by it to the market
(ii) The rates at which they are paid for. And the latter, in turn, depends, to a large extent, upon the respective elasticities of demand for the productive resources.
4. Rate of Exchange and Balance of Payments:
Elasticity of Demand .also plays a central role in determining a country's rate of exchange and its balance of payments. Rate of exchange is determined by the demand for and supply of domestic currency in the international markets. And these factors are intimately connected with the exports and imports of the country in which elasticities play a central role. If a country's export goods have a high elasticity of demand in international markets, it finds it easier to increase its exports by reducing their prices. In this case, it can improve its balance of trade without unduly weakening its rate of exchange. But it will be risky for it to raise the export prices if its exports have a low elasticity of demand in the international markets.