Factors Affecting and Importance of the Price Elasticity of Demand

Determinants of Price Elasticity of Demand:

Price elasticity of demand is different for different commodities. It is important to know why demand for some goods is more elastic while for others it is less elastic. There are many factors which determine the elasticity of demand. Which are as follows:

Availability of Substitute
Nature of Commodity
Proportion of the income Spent
The Number of uses of a commodity
Possibility of postponement of consumption
Price Range
Habits of the consumers
Income of the consumer

1. Availability of Substitutes :

The most important determinant of elasticity of demand is the number and kind of Substitutes available for a commodity.

A commodity with more and close substitute tends to have an elastic demand and one with a few and weak substitute has an Inelastic demand.

Example : Tea and coffee –

Both are close Substitutes, when the price of coffee falls, given the price of tea, many people will buy more of coffee and less of tea since coffee has become relatively cheaper.

On the other hand, demand would be Inelastic if there is no or less substitute of commodity. Example – milk, if the price of milk increases, the quantity demanded will not decreases much, since there is no substitute of milk.

2. Nature of the commodity:

Price elasticity of demand is greatly affected by the nature of the commodity i.e. , whether it is a ‘necessity’ or a ‘luxury’ or a commodity of ‘comfort’.

Demand for the goods of necessity is inelastic since they are essential for existence, they will be purchased in more or less fixed quantities, whether the price is low or high.

The commodities of luxuries and comfort are not essential and their consumption can be postponed. Thus their demand is elastic.

The demand for luxuries changes by large amount due to small change in their price. Example TV , air conditioner etc.

3. Proportion of the Income Spent :

Elasticity of demand is also affected by the proportion of the income which the consumer spent on it.

The smaller the proportion of the income spent on a commodity, the smaller will be the elasticity of demand and vice versa.

Example, Soap, salt matches tooth paste etc. Since the consumer used to spend very small proportion of his income on them, their demand is highly inelastic.

Since the rise in their price will not cause much effect on his budget, he will continue to buy the same quantity thus their demand is inelastic.

On the other hand, the demand for clothes, furniture etc. Is elastic, since the consumer spends a large proportion of his income on these goods. A change in their price will have considerable effect on his budget. This will affect their demand to a great extent. Hence their demand is highly elastic.

4. The number of uses of a commodity:

The greater the number of uses to which a commodity can be put to, the greater will be its price elasticity of demand.

Example, electricity – if electricity is very expensive it might be used for lighting only. As the price of electricity falls, it might be used for less important uses like cooking and heating. Thus, the demand for electricity is greatly affected by its price.

5. Possibility of Postponement of consumption :

Demand for a commodity is elastic if its consumption can be postponed.

The consumption of clothing, air conditioner etc. can be postponed and therefore a rise in their price will cause a fall in quantity demanded, hence their demand is elastic.

Consumption of the food item can not be postponed.

6. Price Range :

Demand for a commodity tends to be inelastic at very high and very low prices and elastic with in a moderate range of prices.

At a very high price of the commodity, the demand for it will come from rich consumer only. The rise or fall in its price will not affect its demand much as it would still be out of reach of most of the people. So their demand is inelastic.

At very low price of the commodity, all those who want to buy it would have bought this commodity. Further fall in price will not lead to much increase in the demand for the commodity, so the demand is inelastic.

The demand for the commodity is elastic within the moderate range of price as the commodity will be within the reach of a large number of consumers.

7. Habits of the consumer:

If consumers are habitual of consuming some commodity like cigarettes, coffee etc. they will continue to consume these even at higher prices.

Demand for these commodities will be usually inelastic.

8. Income of the consumer:

For high income consumer – rich consumer, rise and fall of price of the commodity will not affect their budget. Hence demand will be inelastic.

For middle income or poor consumer, a slight change in price will affect the demand of the commodity, so the demand is elastic.

Question : What is meant by price elasticity of demand ? Explain the importance of price elasticity of demand .

Answer:

Price Elasticity of Demand :

Price elasticity of demand refers to the degree of responsiveness of quantity demanded of a commodity to a change in its price.

It also refers to the ratio of percentage change in quantity demanded of a commodity to a given percentage change in its price.

Thus,

ep =( percentage change in quantity demanded) / (percentage change in Price)

ep = (∆Q/ ∆P ) × (P / Q)

Where ep = price elasticity of demand

∆Q = change in quantity demanded

∆P = change in Price

Q = initial quantity

P = initial Price

Importance of Price Elasticity of Demand:

1. Important for taking business decisions

2. In Price Discrimination Policy of Monopolist

3. Determining Factor Price

4. Importance in the Formulation of Government Policies

5. Importance in the International Trade

6. Change in the Rate of Exchange

7. Incidence of Taxes

8. Explanation of the ‘Paradox of Plenty’

1. Important for Taking Business Decisions :

Price elasticity of demand plays an important role in taking decisions regarding increase in price or not and decisions over output.

If the demand for a commodity is Inelastic then price can be raised to increase total revenue.

Moreover, raising price will be advisable if the elasticity of demand for its Substitutes is low otherwise consumer will shift to the consumption of these Substitutes as the firm raises the price of its product.

2. In price discrimination policy of Monopolist :

In the policy of price discrimination a Monopolist charges different prices from different consumers.

An idea of price elasticity of demand can help him to charge different prices for his product.

A Monopolist will charge higher price from those consumers who have Inelastic demand for his product.

The Monopolist will charge lower price from those consumers who have elastic demand for the product sold by him.

3. Determination of Factor Prices :

Price elasticity of demand plays an important role in determining the factor price like wages.

Example: The bargaining power of trade union will depend upon the elasticity of demand for labour.

If trade union wants to set wages for labour, she should know the elasticity of demand for the labour and the product which the labour is producing.

If the demand for labour and the product which that labour is producing happen to be elastic, an attempt by the trade union to increase wages will not be succeed.

The rise in wages will increase the price of product thus the demand will be decrease and consequently large decease in demand for the labour.

But if the demand of the product is Inelastic, the trade union can bargain for higher wages.

4. Importance in the Formulation of Government Policies:

Price elasticity of demand is useful formulation of government policies like taxation policy, the policy of granting subsidy to the industries etc.

By having the idea of price elasticity of demand government can increase its revenue by imposing taxes on those products which have an Inelastic demand.

If the government imposes higher taxes on commodities with elastic demand, this policy will bring about a decline in the revenue of the government.

5. Importance in the International Trade:

The concept of elasticity of demand is also important in the field of international trade. It is of great importance in determining the terms of trade ( the rate at which exports and imports are exchanged) and consequently gains from international trade, in determining the effect of export and import duties on exports and imports and thereby on the balance of payment.

6. Change in the Rate of Exchange:

Rate of exchange means the rate at which a unit of one country’s currency is exchanged for currencies of other countries.

The rate of exchange between two countries can be changed through devaluation or revaluation of one currency in relation to other currencies.

The policy of devaluation and revaluation can be used to correct unfavourable balance of payments.

While deciding whether the government should devaluate its currency or not, it need to consider the elasticity of demand for its exports and imports.

For instance, the policy of devaluation will be successful only if the demand for country’s exports and imports is elastic.

7. Incidence of Taxation:

Incidence of taxes refers to the persons who ultimately bear the burden of taxes, i.e., the persons who ultimately pay the taxes.

Whether the incidence of taxes is on the buyers or on the sellers depends on the elasticity of demand .

The higher the elasticity of demand, the more is the incidence of taxes on sellers.

On the other hand, the more inelastic the demand, the more is the burden of taxes on the buyers of the commodities.

Therefore, while taking decision with regard to imposition of indirect taxes like GST and excise duties, the government is required to have some idea of elasticity of demand of the commodity to be taxed.

8. Explanation of the ‘Paradox of Plenty’:

The concept of elasticity of demand also helps in explaining “paradox of plenty” in agriculture, i.e., a bumper crop brings in smaller income to the farmers.

A bumper crop instead of raising the income of the farmers, reduces it because of inelastic demand for agricultural products.

A bumper crop reduces the prices of agricultural products drastically in view of the inelastic demand for these products and thereby reduces the income of the farmers. It is because of this that the government fixes the minimum prices of agricultural products.

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