Demand is a variable that bears a direct influence on several aspects of a country’s macroeconomic environment. The two most prominent aspects are the performance of existing firms and government fiscal policy measures. Demand refers to the quantity of a good or service that consumers are willing and able to buy at a certain price. The concept of elasticity of demand is applied by both firms and governments in determining optimal prices and output levels. The concept of elasticity is described in economic theory as the measure of the responsiveness of a variable to changes in another variable that affects it. Elasticity of demand is, therefore, a measure that shows the responsiveness of quantity demanded to changes in factors that affect demand such as price, income, substitute, and complementary goods. The concept of elasticity of demand is essential to the performance of firms and governments since it enables them to leverage their costs and optimize their revenues by charging the best-suited prices.
Usefulness to Business and Government
The aforementioned definition of elasticity of demand gives rise to several types of elasticities of demand depending on the factor under consideration. Firstly, own-price elasticity of demand measures the responsiveness of quantity demanded to changes in the price of the commodity. The second kind of elasticity of demand, which measures the percentage change in quantity demanded following a change in the price of related products, is cross-price elasticity. The cross-price elasticity of demanded can be illustrated as shown in Figure 1 using close substitute goods.
Figure 1: Cross-price elasticity of close substitutes
Complementary goods portray a negative cross-price elasticity while substitute goods portray a positive cross-price elasticity. Lastly, income elasticity of demand measures the degree of responsiveness of quantity demanded of a good to changes in consumers’ income levels. The main objective of businesses is making profits. As such, they must continually ensure that their products are correctly priced in order to ward off competition. Moreover, they must ensure that they produce the ideal amount of output so as to avoid losses emanating from low sales turnover. Businesses must also ensure that they know the income levels of their consumers, the prices of substitute goods, and those of complementary goods. The price elasticity of demand is calculated by dividing the percentage change in quantity demanded, change in quantity demanded divided by original demand, and the percentage change in price, that is, change in price divided by original price, as shown in Figure 2.
Figure 2: Price Elasticity of Demand
The income elasticity of demand is calculated by dividing the percentage change in consumers’ quantity demanded, change in quantity demanded divided by original quantity demanded, and the percentage change in income, that is, change in income divided by original income, as shown in Figure 3.
Figure 3: Income Elasticity of Demand
Businesses utilize the knowledge about the elasticity of demand to achieve various outcomes. They include; determining their prices, monopolist’s discriminating price, and determining output level. The pricing decisions adopted by businesses have a direct impact on the quantity demanded, sales turnover, and the revenues earned. This relationship is well captured in the law of demand which stipulates that an increase in price leads to a decrease in the quantity demanded for a product, while a decrease in price leads to an increase in the quantity demanded ceteris paribus. An increase in the price for an elastic product will lead to a decrease in the quantity demanded and a reduction in the revenues of the business (Amlani 4). As such, the business should use the coefficient of own-price elasticity to determine the optimal level beyond which the business stands to make a loss instead of a profit by increasing prices. Products with elastic elasticities of demand have a coefficient of elasticity that is more than 1, and hence, they are highly responsive to any price changes:
Figure 4: Elastic Demand
Commodities whose coefficients of demand are less than 1 are inelastic, and hence, they have a low responsiveness to changes in price. The knowledge about a product’s type of elasticity informs the pricing decisions accordingly.
Figure 5: Inelastic Demand
Secondly, changes in demand may be caused by another reason other than the price of the product. Any changes in consumers’ income levels will have an effect on the quantity demanded. An increase in the general income level will result in an increase in demand, while a decrease in income level will cause a decrease in demand except for the case of highly-inelastic products of necessity such as medical care. The relationship between quantity demanded and income level is direct because an increase in income results in an increase in disposable income and consumption level. This relationship between income level and quantity demanded gives rise to the income elasticity of demand. Products will have different income elasticities depending on changes in their demand with income changes. A positive income elasticity will be portrayed by normal goods, while a negative income elasticity will be portrayed by inferior products. Firms thus have to calculate their products’ income elasticities so that they can know the ideal quantity to produce with an increase or decrease in consumers’ income levels.
Lastly, the elasticity of demand is used by monopolist firms to set their prices and to determine the ideal price for discrimination purposes. A monopoly firm is a single producer of a particular good or service, and as such, it controls the market due to an absence of competitors. The monopolist can, therefore, maximize profits from the market by determining the elasticity of demand for its product. An inelastic product such as fuel can provide the monopolist with multiple opportunities to increase profits since an increase in price will have less or completely no effect on the quantity demanded (Gallo). An elastic product, on the other hand, such as smartphones, must be carefully handled since an increase in price significantly reduces demand. Moreover, the knowledge of elasticities is useful to a monopolist seeking to pursue price discrimination policies. This is because a single commodity can be elastic in location A due to the presence of close substitutes, and inelastic in location B. The monopolist firm can only determine this difference by carefully calculating the elasticity of the commodity in the two different locations. The monopolist can, therefore, charge higher prices for this commodity in location B due to the absence of close substitutes. Also, it could charge low prices in location A to prevent consumers’ from opting for the substitute product.
Governments, like businesses, play the crucial role of providing goods and services to the public. Additionally, the government also sets the wage levels of public workers and influences decisions on international trade. These three functions of the government are highly influenced by the elasticity of demand. First, the government’s role of safeguarding the public against harmful products is undertaken with knowledge on elasticity of demand. Various governments’ across the world often serve the role of ensuring that only harmless foodstuffs and edibles are sold to the public. In the event that certain products are deemed harmful, even in small quantities, it is a government’s obligation to safeguard its citizens. The government may institute policies aimed at discouraging the consumption of such products, for instance, cigarettes and alcoholic drinks, by raising their prices indirectly through increasing taxes levied on these items. Determining the elasticities of such goods initially will inform the amount of taxes to be levied since the prices will rise with a similar degree. Further, the government can end up increasing its revenues from this activity. Secondly, governments have the responsibility of ensuring the growth of local producers and protecting them from foreign competition. The decision on whether or not to offer subsidies to local producers is pegged on the elasticity of demand. Subsidies will be considered for products with an elastic demand since lower imports significantly affect the local demand for the local output. The government will provide subsidies and protection to a level where the producers can compete fairly with the imported goods. Thirdly, a government also controls a country’s international trade activities. Government policies regarding international trade should align with the elasticity of demand to ensure that a country can have a positive net export. To achieve this, the government should import goods with elastic demand and export goods with less elasticity of demand. Notably, higher prices can be charged for less elastic and inelastic products, while elastic goods must be charged at the least possible price. Additionally, prior to exporting, the government should determine the nature and degree of the demand elasticity of the product in the importing country. If the elasticity of demand for the product is elastic due to many available local substitutes, the export prices should be maintained as low as possible. However, if the product is demand-inelastic, then higher export prices can be charged for them.
Elasticity of demand is a concept that measures the responsiveness of quantity demanded of a product to changes in price or/and income. Three types of elasticities of demand exist: own-price, cross-price, and income elasticity of demand. A proper understanding of this concept is required for the success of businesses and government policies. Businesses utilize knowledge on the elasticity of demand to determine their output levels, prices, prices of jointly-produced products, and the discriminating price of a monopolist. The government, on the other hand, uses the elasticity of demand to undertake protectionist policies such as provision of subsidies, discouraging the consumption of harmful products while earning revenue in the process, and ensuring gains from international trade.
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