How and when the concept of elasticity is applied in economic policy decisions.

The concept of elasticity can be applied in economic policy decisions in the light of the following situations:

  • Business pricing decisions: revenue can be increased by increasing prices where demand is inelastic; where demand is elastic, revenue could be increased by lowering prices. At the same time, its important to a firm when seeking to estimate the effect of price changes of competing firms on its own – where demand is elastic, a rational firm will decide to keep its prices stable; This concept is also important when estimating or deciding on the nature and scope of promotional activities such as advertising; persuasive kind of advertising tends to make the demand for commodities relatively more price inelastic.
  • Consumer spending programmes: since resources are scarce, consumers will more often seek to allocate their income in such a way that the most pressing wants are satisfied first (scale of preference); preference in this case is given to necessities whose demand is necessarily inelastic.
  • Production decisions: To producers/suppliers, elasticity of demand is relevant when deciding on what price and amount of inputs to purchase. Such decisions will depend on the elasticity of demand of the final product(s) for which the inputs help produce. If, for instance, demand for the final product is inelastic, a firm may find it still viable/rational/reasonable to purchase such inputs at relatively higher prices since the additional cost could be covered by way of increasing the final product prices. In situations of elastic demand for the final product(s), firms should be more careful in making input purchases at least ensuring that the input prices are comparatively low because any attempt to recover such costs by increasing prices tends to reduce sales and thereby necessitating a price reduction in order to survive the competitive market – the decision becomes self-defeating.

Government policy orientation from the stand point of:

  • Tax policy: knowledge of elasticity assists the government when estimating its revenue from indirect taxes. Those commodities which are highly price inelastic in demand should be taxed more (eg. alcohol, cigarettes). The government should however take into account the need not to tax (or tax
    less) necessities such as food products/services whose demand is equally inelastic – tax on such basic and most essential goods/services tends to have negative welfare implications.
  • Discouraging consumption: the government as a matter of policy can impose higher taxes on those commodities whose demand is price elastic such as the self actualization car models and pornographic materials (any exceptions held constant). Tax, in this case, has an effect of increasing prices and thus a downward pressure on demand. Tax may also be used as a means of effecting environmental protection programmes eg. against pollution.
  • Protectionism: Its in the interest of most governments to protect their domestic industries against unfavourable external competition (largely because of the state of unequal footing between domestic and foreign industries producing virtually the same or close substitute products) by imposing tariffs on imports. This policy can only be effective where the domestic demand for both local and foreign substitutes is highly price elastic; this way, an increase in import prices by the amount of tariff should be sufficient to deter or discourage domestic demand for them, at least in favour of domestic substitutes (assuming that the quality and other buyer benefits or factors are held constant).
  • Price controls/minimum wage guidelines: Depending on the nature of an economy, minimum wage legislations can be effective only where the demand for labour (in the labour market) is highly inelastic; If elastic, any attempt to set a minimum wage will be met by a drastic fall in demand for labour hence unemployment, a situation which makes job seekers much more willing to accept lower wages, rendering the legislation ineffective.
  • Regulation of farmers’ income especially during bumper harvest – demand should be inelastic otherwise the government will be forced to buy and store or even dispose of the surplus to external markets (dumping). This depends on the nature of the commodity (perishable or durable) and the ability of the government to pay farmers promptly (eg 1994/1995 maize bumper harvest in Kenya)
  • Devaluation policy: reducing the relative value of a domestic currency i.e. making it cheaper in terms of another (foreign) currency. This has an effect of making exports cheaper and imports relatively expensive, the aim being to encourage (increase) exports and discourage (reduce) imports so as to improve the country’s balance of payments (BOP) position. This policy is effective only when demand for both imports and exports is highly price elastic.

Knowledge of elasticity is also relevant in the event of:

  • Price discrimination: market segmentation where more is supplied/sold in the price elastic than inelastic markets and charging lower and higher prices respectively.
  • Shifting the tax burden: It is possible to shift the indirect tax burden to the consumer where demand is price inelastic.
    Production of commodities whose income elasticity of demand is positive and high eg. TV’s, cars etc.

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