In a capitalist economy, the entire volume of output is directed and controlled by consumer demand. If production is to be profitable the volume of output of goods and services produced must be adjusted in terms of the available demand for them. Consumer demand exercises a major influence upon producers demand for factors of production, and this affects the distribution of factors in various lines of production. The concept of elasticity of demand plays a significant role in economic theory and practice.
- Helpful to the Government in formulating taxation policies. The concept of elasticity of demand also proves helpful to the Government in the formulation of its economic and taxation policies. The Finance Minister has to consider the nature of the elasticity of demand for a commodity before applying an excess tax on it.
- Helpful to a monopolist in fixing price. The individual producer under imperfect competition has to consider the demand for his product when he fixes its price. He has to take into account the response of his customers in formulating his price policy. Likewise the monopolist has to study the elasticity of demand of his product before he fixes its price. If his product happens to have inelastic demand, the monopolist is in a position other thing 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.
- Helpful in 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. If the demand for labor on a particular industry is relatively inelastic (there being little or no scope for automation in that industry), it will be easier for the Trade Union to get their wages raised. The same remarks apply to other factors of production whose demands are relatively inelastic.
- Helpful in declaring 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 which is controlled by a private monopolist and the demand for whose product is inelastic has a greater case for being declared as ‘Public utility’ and being consequently owned and operated by state.
- Helpful in determination of terms of trade. It is possible to calculate the terms of trade between two countries only by taking into account the mutual elasticity’s 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 other units of a commodity of a foreign country. In calculating the terms of trade we have take into account the mutual intensity of demand for the products of the two countries.
Helpful in determining the rate of 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. Before deciding to devalue or revalue domestic currency in relation to foreign currencies the Government has to study carefully the elasticity’s of demand for its imports and exports.