The Relevance of the Concept of Elasticity of Demand in Volatile Economies

Question

Explain the relevance of the concept of elasticity of demand in volatile economies

Answer

The concept of elasticity of demand is central to understanding the market place, it is of particularly relevant to understanding the way demand may manifest in volatile market. To appreciate this the concept of elasticity of demand will be reviewed, and then applied within the context of a volatile economy.

For most goods there is a negative relationship between demand and price; as prices increase demand usually decreases (Pindyck and Rubinfeld, 2009). However, this does not indicate the proportional changes which may be expected, this can determined be assessing the elasticity; using historical data from past price changes, the calculation is the percentage change in quantity demanded divided by the percentage change in price (Nellis and Parker, 2006). If the result is zero, then the good is perfectly inelastic, meaning that there is no change in demand, when prices change (Nellis and Parker, 2006). Results between 0 and less than 1 indicates an inelastic good/service; where demand decreases are proportionately less than the proportionally price increase. These are usually essential goods. Elasticities above 1 are elastic goods/services, where the decrease in demand will be disproportionately greater than the increase in price (Baye, 2007).

In a stable economy the elasticity level may be used to forecast the impact on changes. In a volatile economy this helps to determine which goods/service are most likely to have sustained demand; those with their elasticity closest to 0, and which are most likely to be negativity effected (Pindyck and Rubinfeld, 2009). As volatility impacts across many different goods or services, as the volatility increases, uncertainty will be exacerbated for the non-essential elastic goods. Therefore, knowing elasticity can be used to help assess areas for government price controls, as well as risks and opportunities for businesses, in terms of production and price management. 

References

Baye, M., 2007. Managerial Economics and Business Strategy. New York: McGraw-Hill/Irwin. Nellis, J.G., and Parker, D., 2006. Principles of the Business Economics. Harlow: Prentice Hall. Pindyck, R.S., and Rubinfeld, D.L., 2009. Microeconomics. Seventh ed. Upper Saddle River, NJ: Pearson Education Inc.