Different producers should adopt a different business strategy during economic growth, and a different business strategy during economic recession.
As the economy is passing through different stages of The Business Cycle, the business strategy will mainly depend on the income elasticity of demand. The formula is as follows:
Income Elasticity of Demand (YED) = Change (%) in Demand ÷ Change (%) in Income
Income elasticity of demand measures how demand for a product changes when people’s income change – the responsiveness of demand to the change in income. It can be expressed in three different ways. It can either be:
1. Negative Income Elasticity of Demand (YED<0)
2. Income Elasticity of Demand equals zero (YED=0)
3. Positive Income Elasticity of Demand (0<YED):
a.) Low positive (0-1)
b.) Equals one (YED=1)
c.) High positive (1<YED)
1. Producers of inferior goods and services
Inferior products are those inferior to normal goods and services. They are of low quality and purchased mainly by most of the poor people with the lowest incomes.
Examples of inferior goods and services include: instant noodles, frozen meals, clothes of low quality, basic cellphones, cheapest cars, public transportation, instant coffee, margarine instead of butter, cheap bread, etc.
Inferior goods and services have negative income elasticity of demand (YED<0).
It means that an increase in consumer’s income will decrease demand. A decrease in consumer’s income will increase demand.
Example 1: A 10% increase in income might lead to a 5% decrease in the demand for instant noodles. A 10% decrease in income might lead to 5% increase in demand for inferior products such as bus transportation.
During the period of economic growth, the demand for inferior goods and services will decrease – people have higher income, so they want to buy normal goods and services instead of inferior. While during the period of recession, the demand for inferior goods and services will increase as people have lower income, so they cannot afford normal goods and services.
Strategy for economic growth:
- Attempt to move as many products upmarket as possible from inferior goods to selling more normal goods.
- Add extra value to the product, e.g. better ingredients, convenient distribution, improved packaging, etc., so the products are not perceived as low quality by customers.
- Extend the product range to include more exclusive products, and products with higher overall quality, so you have more luxury products for sale in your portfolio.
Strategy for recession:
- Promote good value for money, even for the most inferior products.
- Increase range of distribution outlets to offer as many inferior products as possible to the customers with lower incomes.
- Offer free consumer tests to stimulate consumption.
2. Producers of ‘must-have’ goods and services
Quantity demanded by customers is independent from income. It means that income has no effect on demand whatsoever.
Examples of goods with perfectly inelastic demand include: insulin and other lifesaving medications to treat chronic medical conditions, highly addictive substances, butane gas, electricity, running water, salt, cooking oil, etc.
‘Must-have’ goods and services have zero income elasticity of demand (YED=0).
It means that consumers will purchase a fixed amount of those goods and services irrespective of their income or the price. Usually, the products that are closer to fulfilling basic human needs without which human being are not able survive will have that kind of elasticity.
Example 2: A 10% decrease in income will lead to a 0% decrease in the demand for a ‘must-have’ medication. A 10% increase in income will also lead to 0% increase in demand for butane gas to heat the house in winter. The person will need that drug or gas in order to survive no matter what.
Neither during the period of economic growth nor during the period of recession, the demand for ‘must-have’ goods and services will change at all.
3. Producers of normal necessity goods and services
Normal necessity products are those used by people in everyday life. They are purchased on daily basis by almost everybody in the society.
Examples of normal necessity goods and services include food staples such as fresh meat, fresh fruits, fresh vegetables, decent quality clothing, fruit juice, household appliances, furniture, medium-priced cars, etc.
Normal necessity goods and services have a positive correlation between income and demand.
Normal necessity goods have low positive income elasticity of demand (0<YED<1).
It means that an increase in consumers’ income will slightly increase demand, but no more than that rise in consumers’ income. A decrease in consumer’s income will slightly decrease demand, but no more than that decrease in consumer’s income. Consumers buy nearly the same number of products as the price increases or decreases.
Example 3: If income rises by 5%, the demand quantity for food and clothes also increases as well – but is smaller than 5% and higher than 0%. If income decreases by 5%, the demand quantity for meat or home furniture also decreases as well – but is smaller than 5% and higher than 0%.
At the end of the day, we all need to eat and drink, move around, get dressed and communicate, so we all need to buy normal goods and services.
During the period of economic growth, the demand for normal goods and services will slightly increase as people will buy less inferior good and services, and buy more normal goods and services instead. While during the period of recession, the demand for normal goods and services will slightly decrease because people will switch to buying more inferior products.
Strategy for economic growth:
- Add extra value to the product, e.g. higher overall quality, better ingredients, convenient distribution, improved packaging, etc.
- Brand image may attract exclusive tag; therefore, customers will perceive the products as luxury.
- You can do completely nothing because sales will not be affected much anyway.
Strategy for recession:
- Lower prices because customers with lower incomes are now looking forward to buying cheaper goods and using cheaper services.
- Offer various discounts and promotions, so the prices look cheaper.
- You can do completely nothing because sales will not be affected much anyway.
4. Producers of goods and services with unitary elasticity
In this case, income elasticity of demand equals unity. The percentage change in quantity demanded for a good or service is equal to percentage change in the customers’ income.
These goods and services have unitary income elasticity of demand (YED=1).
It means that a rise in consumers’ income will increase demand proportionally. If consumer income rises by 10%, the demand for products with unitary elasticity will increase demand exactly by 10%.
I came up with the following example by myself. And while it is not ideal, in my opinion, it is by far the best example that applies the concept of unitary income elasticity of demand to a real-life situation.
Example 4: Let’s think about an investor who buys shares of companies on the stock exchange. He wishes to earn income from dividends paid by those companies. Let’s say, he buys 1 share of XYZ Company for USD$100. This company pays 5% annual dividend. So, the income for the investor will be USD$5. Now, if the investor wants to double his income to $USD10, he will need to purchase 2 shares of XYZ Company for USD$200. The demand for the shares increased by 100%, in order to increase the income by 100%.
In the example above, the investor’s income increased by 100%, from USD$5 to USD$10 in dividend income. It led to a rise in quantity demanded by 100%, from buying 1 share to buying 2 shares.
5. Producers of normal luxury goods and services
Normal luxury products are bought mainly by rich people. They are produced only for a very small portion of the whole population with the highest income.
Examples of normal luxury goods and services include: sports cars, expensive jewelry, diamonds, dining at high-end restaurants, expensive smartphones, overseas holidays, fine wines, luxury chocolates, antique furniture, designer clothes, etc.
Normal luxury goods and services have high positive income elasticity of demand (1<YED).
It means that a rise in consumers’ income will increase demand more than proportionally. If consumer income rises by 5%, the demand for them increases by more than 5%. They are very sensitive to price changes.
Example 5: A 5% increase in income might lead to a 10% rise in the demand for luxury goods such as expensive wine or sophisticated chocolate. A 5% decrease in income might lead to a 10% decrease in the demand for luxury goods such as overseas holidays.
During the period of economic growth, the demand for luxury goods and services will increase a lot. While during the period of recession, the demand for luxury goods and services will decrease a lot.
Strategy for economic growth:
- Increase the range of luxury goods and services as there is strong demand from customers who are now looking to buy more luxury products.
- Raise prices to increase profit margins. Customers have higher income; therefore, they will be less price sensitive.
- Promote exclusivity, uniqueness and style to stimulate consumption.
- Increase output produced and distribution network to meet the market demand.
Strategy for recession:
- Offer promotions as customers with declining incomes are more price sensitive.
- Offer promotions in order to prevent delayed consumption.
- Widen product range with lower-priced models as more reasonable customers are looking now to buy normal goods instead of ‘overpaying’ for unnecessary luxury.
- Offer credit terms to improve affordability, e.g. longer trader credit, or purchasing in 12-months installments.
- Do not reduce prices at all to prevent damaging long-term brand image.
In conclusions, the producers and retailers of inferior products gain during the recession and lose when the economy is growing. The producers and retailers of normal products neither lose nor gain during the recession or when the economy is growing. While the producers and retailers of luxury products lose during the recession and gain when the economy is growing.
