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Price Elasticity- Factors & Importance

Price Elasticity- Factors & Importance

Factors Determining Price Elasticity

For some goods, elasticity of demand is high and for some demand is inelastic or less elastic. The degree of elasticity depends upon a number of factors. These are:

  1. Availability of Substitutes:

    One of the most important determinants of elasticity of demand for a commodity is the availability of its close substitute. The higher the degree of the closeness of the substitute, the greater is the elasticity of demand for the commodity. For instance, coffee and tea may be considered as close substitutes for each other. If the price of coffee rises, we may curtail its purchase and take to tea and vice versa.

  2. Nature of the Commodity:

    The demand for necessities is generally inelastic because the consumption of a necessary article (e.g., salt or wheat) does not change much with a change in prices. Demand for comforts and luxuries like fans, tape recorders, T.V. sets, etc., is relatively more elastic. If the price of a T.V. set rises, its purchase can be dispensed with because it is not necessary or urgent goods. If the price of a tape recorder falls, many people will purchase tape recorders.

  3. Share in Total Expenditure:

    A commodity on which the amount spent constitutes a small fraction of the total expenditure is apt to be inelastic. Coat buttons are an example, a lower price of coat buttons will not stimulate demand for coat buttons.

  4. Number of Uses:

    If a commodity can be put to several uses its demand tends to be elastic. Every fall in its price induces people to put it to less urgent uses.

  5. Distribution of Income:

    According to Prof. Taussig when the distribution of wealth in a country is even, the demand for most of the goods is elastic, because the equality of incomes will increase the number of the middle class people having nearly the same purchasing power.

  6. Consumer’s Behaviour:

    Above all the most important factor is the consumer’s tastes and preference. A smoker of Wills Flake Cigarettes or a consumer of Ponds cosmetics shall not give up the consumption of these commodities because of a small rise, in their prices. Demand for such products can said to be inelastic in nature.

  7. Durability of the Commodity:

    If the commodity is durable or repairable, a rise in price is likely to be followed by the use of same commodity already purchased after due repairs for longer period. Thus, such commodities are likely to have elastic demand.

  8. Income Level:

    People with high incomes are less affected by price changes than people with low incomes. A rich man will not curtail his consumption of fruit or milk even if its price rises significantly and will continue to purchase the same quantity as before. But a poor man can not do so. Hence, the demand for fruit or milk is inelastic for the rich but elastic for the poor.

  9. Price Level:

    Elasticity of demand tends to be great at high prices. In other words, demand is elastic at higher prices, unitary elastic at medium prices and inelastic at lower prices.

  10. Joint Demand:

    Jointly demanded goods have less elastic demand. For example, if the price of fountain pen falls it does not necessarily lead to an increase in the demand of ink.

  11. Postponement:

    When goods is such that its consumption can be postponed, demand for it is more elastic. For example, in the rainy season the demand of an umbrella cannot be deferred and accordingly it is inelastic. However, during winter, when the demand can be postponed, it is rather elastic.

  12. Future Expectations about Price Changes :

    It also effects the nature of the elasticity of demand. If we expect a fall in price the demand will be elastic, and if we expect a rise in price the demand will assume the character of inelasticity.

Importance of the Study of Elasticity of Demand

We can study the importance of elasticity of demand under following headings:

  1. For the Businessman:

    Knowledge of the nature of the elasticity of demand for his products will help a businessman to decide whether he should cut his prices in a particular case. In general, for items where the demand is elastic, it will pay him to charge relatively low prices, while on those whose demand is inelastic, he would be better off with a higher price.

  2. For Monopolist:

    The price elasticity concept is of much significance, particularly to a monopolist who fixes his own prices for his goods. If demand for his goods is inelastic, it will be profitable for him to charge a higher price and sell a smaller output. If demand is elastic, it will be profitable to change a lower price and increase the sales.

  3. For Finance Minister:

    Whenever the Finance Minister contemplates the introduction of a fresh levy upon certain commodities or the raising of the tax-rates on existing tax objects with a view to getting more of revenue for the state, he makes an intensive study of the elasticity of demand for the commodities in question. The Finance Minister often taxes those commodities whose demand is price-inelastic. This increases taxation revenue. Similarly, in levying indirect taxes, the Finance Minister taxes those commodities which are having inelastic demand from the rich class and thereby the burden of taxation is on the richer class.

  4. For Determination of Prices of Joint Products:

    The concept of the elasticity of demand is of much use in the pricing of joint products, like cotton and cotton seeds, wool and mutton, wheat and straw, etc. Here it is not possible to ascertain separate marginal cost of joint products. The producer while fixing the price is guided mostly by elasticity of demand. But his total receipts must cover the total cost. The transport authorities fix their rates according to the principle ‘charge what the traffic will bear’.

  5. For Explaining the Paradox of Poverty in the Midst of Plenty:

    The concept of elasticity of demand explains the paradox of poverty in the midst of plenty. For example, if there is a bumper crop of wheat it may spell disaster to farmers, instead of causing prosperity, if the demand for wheat is inelastic. A fall in price of wheat of due to an increase in supply will reduce the incomes of farmers.

  6. For Determining Reward of Factors of Production:

    Elasticity of demand is equally important in determining the rewards of the various factors of production in the country. For instance, if the demand for workers is elastic, efforts of trade unions to raise the wages of the workers will meet with failure. On the contrary, if the demand for labour in a particular field is inelastic, trade unions can extract higher wages from employers. The same is true of other factors of production. Factors of production which have a more elastic demand have to accept a smaller reward; and factors which have an inelastic demand can command a bigger reward.

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