Question

Consider firms selling three goods: Firm A sells a good with an income elasticity of demand less than zero; Firm B sells a good with an income elasticity of demand greater than zero but less than one; and Firm \(C\) sells a good with an income elasticity of demand greater than one. In a recession when incomes fall, which firm is likely to see its sales decline the most? Which firm is likely to see its sales increase the most? Briefly explain.

Short answer

Firm \(A\) is expected to see an increase in sales due to it selling inferior goods, the demand for which rises as income falls. Firm \(B\)'s sales might mildly lower given that it sells necessary goods. Firm \(C\) would likely face the most prominent sales decline due to it selling luxury goods, the demand for which highly shrinks when incomes drop.

Step-by-step solution

Norm Analysis

Firstly, catalog each firm on the grounds of elasticity of demand. Firm \(A\) has an income elasticity of demand less than zero indicating it sells an inferior good. Firm \(B\) has elasticity greater than zero but less than one, implying it sells a normal but necessary good. Firm \(C\) also sells a normal good but it is interpreted as a luxury because an elasticity greater than one denotes that.

Recession Impact on Firm \(A\)

During a recession, people's incomes fall. For inferior goods, as income decreases, the demand increases. Hence, Firm \(A\) is likely to see an increase in its sales.

Recession Impact on Firm \(B\)

As for Firm \(B\), it sells a necessary good, the demand of which mildly depends on income changes. But since in a recession income decreases, the sales could see a slight decrease as well.

Recession Impact on Firm \(C\)

Firm \(C\) sells luxuries that have high income elasticity of demand. In a recession, as income falls, the demand for these goods falls sharply. Therefore, Firm \(C\) is expected to witness the greatest decline in sales.

Key concepts

Inferior Goods

Inferior goods are unique because their demand actually increases when incomes fall. This may seem counterintuitive at first, but it makes sense when you think of the context. These goods are typically more affordable or considered substitutes for more expensive products.
For example, think about public transportation. When people's incomes aren't high, they might choose to use public transport instead of owning a car. Therefore, demand for such alternatives rises in tough times, like recessions. This is why the income elasticity of demand for inferior goods is less than zero, as represented by Firm A in the original exercise. So, while other goods may suffer declining sales when the economy contracts, sellers of inferior goods often find their sales increasing.
In summary, inferior goods provide an economic cushion during downturns as people switch to these less costly options when their incomes dip.

• Income elasticity of demand: less than zero
• Examples: Public transport, second-hand clothing
• Impact in recession: Increase in sales

Normal Goods

Normal goods are what most of us use daily and whose demand is directly related to changes in income. When incomes rise, people buy more, and vice versa. The elasticity of demand for these goods is positive but less than one.
This means that while demand does increase with rising incomes, it's not as dramatic as with luxury goods. During a recession, when incomes fall, the demand for normal goods tends to decrease, albeit only slightly. Firm B from the exercise represents such products, where sales are mildly affected by income changes.
This mild dependency means they aren't as vulnerable to economic downturns as luxury goods, but they are also not as resilient as inferior goods.

• Income elasticity of demand: greater than zero, less than one
• Examples: Groceries, household essentials
• Impact in recession: Slight decrease in sales

Luxury Goods

Luxury goods are at the high end of the income elasticity of demand spectrum. These are items people buy more of only when they have extra money to spend. As a result, their elasticity is greater than one.
Think of luxury cars, designer clothes, or high-end electronics. These items are not necessary for survival, and thus, their demand is highly sensitive to changes in income.
During economic downturns, people prioritize necessities over luxuries, leading to a sharp decline in the demand for these goods. As illustrated by Firm C in the exercise, these products are most vulnerable during a recession, witnessing the greatest drop in sales.

• Income elasticity of demand: greater than one
• Examples: Luxury cars, designer brands
• Impact in recession: Significant decrease in sales