Question

If a firm knows that they face a highly elastic demand curve, does this mean that it is necessarily a good business decision to lower prices?

Give an example of an inferior good. Do companies that produce inferior goods tend to perform better or worse during economic downturns? Explain why.

Answer 1

Elasticity of demand refers to the degree of responsiveness of quantity demanded of a commodity, to change in any of its factors, including own price of the commodity, income of the consumer and price of related commodities.

Here, it has been mentioned that a firm is aware that its demand curve is highly elastic. This means that the consumers have a liberty to change or shift their demands away from that good when its price increases and more in favour of that good when its price falls. Formula wise, the price elasticity of demand is given by:

ep= (%change in quantity demanded/ %change in price).

When demand is highly elastic and the absolute value of price elasticity is greater than 1, then the %change in quantity demanded is greater than the % change in price. In such cases, GENERALLY, it is wise for the firm to reduce the price of the commodity and attract more consumers towards it. This way, the total revenue of the firm increases. This is clear from the example given below:

                                                                    

Demand Schedule
Price (P in $)	Quantity (Q in units)	Total Revenue (TR = P*Q)
6	10	60
5	13	65

From the table above, it is clearly visible that with a decrease in price, the firm's total revenue rises. To prove that here elasticity of demand is greater than 1, the following calculations can be done :

%change in quantity demanded = {(10-13)/10}*100 = -30%

%change in price ={(6-5)/5}*100 = 20%

Therefore price elasticity of demand =|-30/20| = 1.5 which is greater than 1.

However, the most important thing to note here is the nature of the commodity that the firm is selling. It is only wise to reduce price if the firm is selling a normal good. In case the firm sells a Giffen good, lowering of the price is not a good idea, even if the demand curve is highly elastic. This is because, a Giffen good is an exception to the law of demand, where it is a special type of inferior good for which demand rises with rise in price and demand falls with fall in price. The highly elastic demand curve for a normal good is shown in figure 1 and that of a Giffen good is shown in figure 2. Since elasticity is high, the demand curves are flat. It is very clear that at price $6 and quantity 10 units in figure 2, the total revenue if $60. When price falls to $5, the demand also falls to 8 units and the total revenue REDUCES to $40. Thus, lowering the price here is not a good idea. It's only wise to lower the price when elasticity of demand is high and the good is normal.

An inferior good is a type of good whose demand falls with rise in income of the consumer. In other words, the income elasticity of demand for an inferior good is negative. The concept of an inferior good is very relative. A good that might be inferior for consumer A might be a luxury good for consumer B. For example, for a person who's income is very low, having a meal with his family at McDonald's is a luxury affair. Whereas having the same meal at McDonald's is an inferior good for a person who's income is high and who frequents a Michelin star restaurant. If income of the first poor person shoots up, then generally his tastes will also shift away from McDonald's to more costly restaurants and McDonald's will become an inferior good for him as well.

When there is an economic downturn, the economy contracts and the income of most of the agents in the economy falls. Having established this fact, a rational consumer will shift his consumption away from his usual bundle to more 'affordable' bundles. Continuing with the above example, if prices of meals at Michelin star restaurants and McDonald's remain unchanged, then a fall in the income will result in a fall in demand for the high end restaurant and a rise in demand for McDonald's. Thus, during economic downturns, the demand for inferior goods rises because the inferior goods become cheaper substitutes of other normal goods. If having a car is necessary and there is an economic downturn, consumers wouldn't mind buying a small car rather than spending on a Mercedes at that time. Therefore, companies that produce inferior goods tend to perform much better during economic downturns.