Role of Elasticity of Demand in Economic Theory and Practice:
(1) Price-Fixation under Imperfect Competition and Monopoly- The individual producer under imperfect competition has to consider the elasticity of the demand for his product when he fixes its price or contemplates a change in the existing price. He has to take into account the reaction or response of his customers in formulating his price policy. Likewise, the monopolist too, has to study the elasticity of demand of his commodity before he fixes its price. If his product happens to have an inelastic demand, the monopolist is in a position, other things remaining the same, to fix a high price for it. The concept of elasticity of demand also helps the monopolist to practice price discrimination in the market. He must carefully study the elasticity of demand for his product in different markets before he can practice price discrimination. He can resort to price discrimination only if the elasticity of demand for his product is different in different markets.
(2) Economic and Taxation Policies of Government- The concept of elasticity of demand also proves helpful to the government of a country in the formulation of its economic and taxation policies. For example, the government has to take into account the elasticity of demand for a product before imposing statutory price control on it. Likewise, the Finance Minister has to consider the nature of the elasticity of demand for a commodity before levying an excise tax on it.
(3) Determination of Rewards for Factors of Production- The concept of elasticity of demand also influences the determination of the rewards for factors of production in a private enterprise economy. For example, if the demand for labor in a particular industry is relatively inelastic (there being little or no scope for automation in that industry), it will be easier for the Trade Unions to get their wages raised. The same remarks apply to other factors of production whose demands are relatively inelastic.
(4) Determination of Terms of Trade- It is possible to calculate the terms of trade between two countries only by taking into account the mutual elasticities of demand for each other’s products. The term “Terms of Trade” implies the rate at which one unit of a domestic commodity will exchange for units of a commodity of a foreign country. In calculating the terms of trade, we have to take into account the mutual intensities of demand for the product of the two countries.
(5) Determination of the Rate of Foreign Exchange- The concept of elasticity of demand also helps the government in fixing an appropriate foreign rate of exchange for its domestic currency in relation to the currencies of other countries. For example, before deciding to devalue or revalue domestic currency in relation to foreign currencies, the government has to study carefully the elasticities of demand for its imports and exports. It is only through such a study that the government can have an idea of the likely effects of devaluation or reevaluation of its currency on its balance of payments.
(6) Declaration of Certain Industries as “Public Utilities”- The concept of elasticity of demand also enables the government to decide as to what particular industries should be declared as “public utilities” to be taken over and operated by state organs. Thus, an industry that is controlled by a private monopolist and the demand for whose products is inelastic is a clear case for being declared as a “public utility” and being consequently owned and operated by the state.
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