How is elasticity useful to business firms and government?

Expert Answers

An illustration of the letter 'A' in a speech bubbles

Elasticity is the degree of responsiveness of a product’s demand to a change in its price. A product can have either elastic or inelastic demand. An item with an elastic demand is more responsive to changes in price; a small decrease in price can lead to a large increase in...

Unlock
This Answer Now

Start your 48-hour free trial to unlock this answer and thousands more. Enjoy eNotes ad-free and cancel anytime.

Start your 48-Hour Free Trial

Elasticity is the degree of responsiveness of a product’s demand to a change in its price. A product can have either elastic or inelastic demand. An item with an elastic demand is more responsive to changes in price; a small decrease in price can lead to a large increase in the quantity demanded, and vice versa. On the other hand, a product with inelastic demand is less responsive to price changes.

Elasticity helps businesses determine the prices for goods. As long as the product is less responsive to changes in price, the firm can increase its cost to maximize revenues and profits. On the other hand, the company will want to set a lower price for goods with elastic demand.

Elasticity also helps the government create policies. If the government wants to get more revenues from tax, it will look at the goods’ elasticity. In most cases, the government will increase the levy on products with inelastic demand. The government does this because they know the buyers aren’t going to stop buying that product because of an increase in price.

The government also uses the elasticity of demand to protect consumers from predatory pricing. If a few firms are producing a good with inelastic demand, they can come together to fix the pricing at the point that helps them maximize profits. To protect the consumer, the government can limit how much those firms charge for the product by setting price controls.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

Elasticity is the manner in which prices effect supply and demand. If something is inelastic, its supply and demand do not respond much to changes in price, and if something is elastic, its supply and demand do. This is an extremely useful principle for businesses and the government to be aware of and use for their benefit.

For businesses, if a product they are selling is extremely inelastic, they can typically increase the price, either to improve margins or because of rising costs of production, and still maintain a significant demand. However, if one of their inputs is very elastic, and the price drops drastically, the supply may decrease as people purchase it in larger quantities.

The government also uses this to their advantage when setting taxes or fees on certain goods. If a product is inelastic, they can levy larger taxes on it and still see high demand.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

Elasticity is the degree to which demand for a product is responsive to changes in price. For the government, the most obvious reason to know this is taxation. For instance, alcohol and tobacco do not respond very strongly to changes in price, so levying heavy taxes on them is relatively easy. On the other hand, luxury goods have typically tended to be very elastic. This can help the government avoid taxing goods and services where the taxes will produce a high deadweight loss (for luxury goods, the sharp decrease in demand that the taxes create ensures that the loss of revenue for their producers is far larger than the revenue gained by the government).

On a deeper level, knowing that some goods are inelastic in price can help policymakers pay closer attention to those goods. Goods that are price-inelastic are those that people cannot do without and that thus merit more attention. For instance, healthcare is inelastic—people will willingly go into bankruptcy rather than forego chemotherapy. On the other hand, the supply of high-end SUVs is very elastic.

For businesses, knowing a good's elasticity is often the same thing as knowing what pricing strategy should be taken. Luxury goods that are very elastic are also, ironically, often those where producers tend not to compete on price.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

In economics, elasticity is a measure of how the demand or supply varies as the price of the product changes. Mathematically, elasticity is given as the ratio of % change in demand or supply to % change in the price of the commodity. If it is greater than 1, it is termed elastic and means that change in price will change the demand or supply significantly. Similarly an elasticity of less than 1 is termed inelastic and means that supply or demand does not vary much with changes in price of commodity.

A knowledge if elasticity is very important for both the government and the businesses. Government needs capital to work and it is generated from taxes. By knowing the elasticity of various products, government can decide the level of taxes that can be charged without harming the interests of the people. For example, heavy taxes can be levied on tobacco products such as cigarettes rather than milk or medicine. Such differential taxation can help government generate taxes without undue burden in people. A country's foreign exchange reserve is dependent on its imports and exports. Prices and taxes can be levied in such a way so as to keep such transactions favorable. To a business, the bottom line is of primary importance. It can decide on a commodity's price using the elasticity data and determine the price that will generate a certain demand and help the company meet their revenue targets. 

Approved by eNotes Editorial Team