Sunday, January 16, 2011

An Economics 101 lesson

In the very first weeks of Principles of Microeconomics students learn the concept of price elasticity of demand-- how responsive quantity demanded is to a change in price, all else constant.

It is an "Economics 101" lesson that apparently isn't common sense to most people because every day one can find a myriad of examples of businesses and governments that scratch their heads over it. Usually what happens is a firm (or government) raises a price (or increases a tax) in order to increase revenue and instead sees revenue decrease. (I have a few local examples I like to use in class.) They improperly estimated elasticity, essentially facing a demand curve that looks like this:The magnitude of the price change is small relative to the magnitude of the change in quantity demanded and the firm (or government) loses revenue. Oops.

Last week a friend told me about a company whose economists were recommending they raise the price of their product. The economists had done some informal calculations and figured out that at the price they were charging for the product demand was relatively inelastic, meaning the demand curve they face looks like this:
The economists recommended increasing the price because it would generate more revenue-- inelasticity means that the revenue effects of an increase in price outweigh the revenue effects of losing customers due to the higher price. (The percentage change in price is greater than the percentage change in quantity demanded.)

The company exists in a monopolistically competitive environment where its survival hinges on differentiating itself from competitors. A couple of departments within the company were concerned that competitors were catching up and wanted more funding to improve operations, upgrade their inputs and quality, etc. An increase in price would generate more revenue (and profit) for the company and allow them to increase investment in making their product better.

It's a no-brainer for a company to maximize profit. A corporation owes that to its shareholders, or to people who have a stake in the company succeeding. (Studies have found that corporations don't maximize profits as we assume in Economics 101, but that's a different story.) In this case a simple increase in price would do the trick.

However, the board of directors of the company vetoed the proposal. They argued that an increase in price causes a loss of customers and that that is all that matters. Indeed, if you look at the second graph above the law of demand says that some customers will be lost. But revenue (and profit) will increase, which should be the goal of the management.

The management decided instead to improve its bottom line by cutting costs. So, areas in need of investment got funding cut, workers promised pay increases were told to wait a while, etc. It's "belt-tightening" time in a company that has already determined it has one of the tightest belts in the industry and in the face of an obvious solution on the revenue side.

In this company's case they will keep customers in the short-run but potentially lose them in the long run as they forego much-needed investment to make their product better. Management has sent the message that they are either shortsighted or have goals that don't make sense. If the goal is just to maximize customers, why not just lower the price (or offer it for free)? With an inelastic demand curve lowering price means, of course, losing revenue, but by refusing to increase price the management has made it clear they're not interested in revenue anyway. By forgoing an opportunity to improve their product, they're signaling they don't care much about the long-run for the firm. By "belt-tightening" in the face of an easy solution on the revenue side management puts its economists-- and indeed all of its employees-- in a very awkward position.

(The reasons why this story is blog worthy will have to wait until another day.)

1 comment:

Ken said...

Oh, I think I have an idea on why your post is blogworthy.