The term “price elasticity of demand” might
not be very common but it is frequent used by firms, organizations and
government in decision making. Knowledge of the basic law of demand is not
enough to decide about final price of the product or service. It has to be
measured how change of the price will affect the final outcome.
Public policy making uses elasticity to impose
tax on goods like cigarettes, alcohol or petrol.
Those products are inelastic, they have not many
substitutes, are essential or addictive. When the price goes up, the quantity
demanded does not fall significantly. Those goods are not responsive to a price
change, which means demand will still be high regardless raised price.
the examples of the use of the Elasticity of demand can be Price Reticulation
and Crop Restriction of Farm Products used by governments of many countries. In
United States of America the Government encourages farmers to limit agriculture
production by offering them grants. The demand of the farm products is
inelastic and big supply of those products causes fall of the price which
lowers farmers’ incomes. The government enacted policy restricting farm
production and provides subsidy to those who keep their land not cultivated.
This policy reduces supply in the market which causes the price of those
products rise. Agricultural products are inelastic and the fall in production
leads to increase of the revenue and farmers’ incomes.
The graph above illustrates how farmers revenue
equals to the OP1, E1,Q. After implementation of the Governments rules, supply
shifts to the left. (Supply curve is assumed to be perfectly elastic to
simplify the case). When agricultural products price increases to P2 and
quantity demanded decreases to Q2 the new revenue is OP2,E2,Q2 and it is higher
than what it was before governments regulations which increased farmers’
Elasticity of Demand allows calculate responsiveness to price change of the
good or service. It predicts how consumer will react to those changes and how
will it affect the revenue.
The reason why Government uses Price Elasticity
of Demand is not only to increase revenue but also environmental or public
health or safety (crime and drugs) etc. It is important tool to measure
sensitivity of the price change in national and international scale.