Explain why an understanding of elasticity of demand is important to both business firms and the government.
Elasticity of demand is the measure of responsiveness of quantity demanded of a product in relation to a change in price. The knowledge of price elasticity of demand is integral to business firms and to the government. Business firms require an understanding about price elasticity of demand for the goods or services they produce to establish an optimal pricing strategy in order to increase sales. Similarly, the government applies the concept of price elasticity of demand to price goods and services it provides to the community. Additionally, the government derives the responsiveness of demand to predict the level of impact indirect taxes has on elastic, unit elastic and inelastic goods regarding revenue. Ultimately, the concept of elasticity of demand is both crucial to business firms in delegating the best price for the output and the government to assess the degree of impact indirect taxation has on revenue.
Business firms require an understanding about the price elasticity of demand for the goods it sells to determine the optimal price of a product. The optimal price is dependent on the responsiveness of elasticity of demand which can be categorised as elastic or inelastic demand. Elastic demand refers to a strong response to a change where an increase in the price of a good will cause the revenue of a business to decrease. In contrast, inelastic demand refers to a weak response to a price change of a good which is seen through an increase in price prompting an increase in revenue.
Business firms will deduce the elasticity and inelasticity of certain goods to determine an optimal price. If demand for a product is relatively elastic, the firm is more inclined to lower their prices to expand the volume of sales and project an increased total revenue. As elastic goods exhibit an inverse relationship between price and revenue which highlights a strong responsiveness. Luxury goods such as cars, have an elastic demand because they take up a large proportion of an individual’s income. Responsively, consumers tend to purchase less of luxury items when the prices are high because they are less willing and able to purchase at the higher price. As a result, this causes the revenue of business firms to drop when prices of elastic goods are high. But through the concept of price elasticity firms would know that lowering the price of elastic goods would augment the volume of sales, and hence increase revenue.
In contrast, if the demand of a product is inelastic the responsiveness of consumers to a price change is low. As the price of an inelastic product increases revenue would follow to increase. Inelastic goods tend to be necessities of daily life such as milk where an increase in price would not prompt the quantity demanded to plummet a great extent. Through this, a firm will raise the price of inelastic goods because a reduction in total sales would equate less to the price increase.