Answer to Question #188711 in Microeconomics for pragya paliwal

Question

examine the significance of price elasticity of demand for the decision making of firms and government.(15 marks)

Answer 1

In making decisions such as fixing prices for the typical firm, the determination of pice elasticity of demand is quite significant in that:

1. To obtain a higher profit, a firm needs to understand the relativity of response to it's product in the market. A product which is very elastic will be watched more closely by the firm so as not to reduce it's profit when prices are increased.
2. Since wage is known to be the price of labour, and for an industry whose demand for labor is relatively elastic ( inelastic), an increase in the wage rate leads to massive unemployment as firms are unable to meet up with the wage set by workers and unions. Government try to set a price floor which goes a long way in re-establishing a more normal wage rate for the firms and helping to fix a more viable price for their products.
3. One way government generates revenue is by levying certain goods and services through taxes. The more elastic the product or service is , the more tax the firm bear because consumers are responsive to price change and thereby move to a substitute with a lesser price. On the other hand, goods that are less elastic tend to be taxed more heavily with majority of the tax being shifted to the consumer because if there very little response to price change in the product.
4. Price elasticity of demand also helps in determining whether a product would be subsidized or not.