Should a firm which produces a product with a positive income elasticity of demand and positive cross elasticity of demand lower the price of the product?

 

1.

Income elasticity of demand assesses the degree to which a change in income will affect the demand for a good. Positive income elasticity of demand suggests that a rise in income will result in a rise in demand, and a fall in income in a fall in demand.

If a firm is a price-maker rather than a price taker (that is, if it is not operating under conditions of perfect competition) then it might choose to reduce price to make its product affordable. This suggests that the good would have a positive price elasticity of demand too, because otherwise, a fall in price could result in a loss of revenue.

A positive cross elasticity of demand indicates that a good has substitutes which could experience a fall in demand if the good is reduced in price. This implies, but does not prove, that the good itself would attract customers from the substitute. This would allow for a rise in revenue, the capture of greater market share, and, possibly, the development of economies of scale as long run average costs would decline with greater output. In these circumstances, cutting prices would be justified.

If the firm were operating or monopolistic competition, however, starting a price war with other firms or even making customers price-aware could collapse the whole market, and shift firms towards normal profit, so the decision would have to be weighted carefully. Firms in an oligopoly would also have to consider the response of other firms before acting. This is because the demand curve, equivalent to the average revenue curve, is kinked in oligopolistic markets, with price inelastic consumers below the kink. If a firm cut prices and people did not change their activity, large falls in revenue could result; if consumers became price-aware and changed habit, inertial behaviour, or tastes, the increase in their price elasticity could be disastrous.

The nature of the good could be a factor. A good with a positive income elasticity of demand is not an inferior good, but it could be a Veblen good (that is, one in conspicuous consumption.) Consumers who buy goods for reasons of quality rather than simply price, or because price is high, might not react well when confronted with advertising or marketing simply based on low prices, as the activities of Sainsbury’s food stores in the 2000s, and those of Marks and Spencers stores in the 2010s, show. Both companies were retail giants who launched a ‘value to shout about’ campaign in one instance, and a line of cheap clothing in another, which damaged their brand, drove away traditional customers, and failed to gain new ones.

The objectives of the firm might also matter. Firms which seek to revenue maximise or sales maximise are not seeking to produce at maximum profit and might consider the expansion of revenue or sales as a success. Many newspapers and television shows earn more money from advertising based on the number of readers or viewers they have rather than from the quality of their product or the revenue from customers paying directly, for instance. 

Firms generally consider the direction of the wider economy before making decisions. In an economy in which credit is restricted or unemployment is rising, some firms may choose to cut prices to increase revenue or simply to sell goods which might soon become unaffordable. If on the other hand, firms were confident about the future they would not act like this, choosing instead to leave price rises to inflation or below and to rely on the expansion of the market through rising incomes.

Sometimes a firm will not have the capacity to increase output to meet new demand at a lower price, and in these circumstances a fall in price will result, unless the firm has large amounts of product in storage ready to be released, in a fall in revenue. Raising production might raise costs, which, at a time when revenue is falling, simply means a move towards a normal profit or a loss, either of which would have to be explained to owners, shareholders, or creditors.  Firms therefore might have no incentive to lower prices.

Therefore, firms with positive income elasticity of demand and positive cross-elasticity of demand should first identify the price elasticity of demand of their consumers; note the market structure in which they operate and consider how rivals will act before deciding to change prices. They will also have to consider if their activity will result in temporary or permanent falls in revenue, what their capacity is, and how stakeholders will react before acting.