The U.S. economy is challenged by high energy costs, rising interest rates and the eventual effects of prolonged federal budget deficits. People naturally wonder how businesses they own — or that employ them — will fare in these rougher economic seas. The answer may depend highly on elasticities of demand for the product a business produces.
“Elasticity of demand” may sound like jargon, but the idea is pretty simple. When prices rise or when peoples’ incomes drop, they don’t reduce purchases of all products by equal proportions. Purchases of some items stay constant. Others drop precipitously.
Two recent news stories provide good examples. Minnesota ATV manufacturer Polaris reportedly sees reduced sales from higher gas prices and interest rates. But an executive for outdoor retailer Cabela’s argued consumers are “still going to hunt and fish” even when gas prices are high.
In the face of rising fuel prices and interest rates, these two Midwestern companies perceive different prospects. Both may be better off than the manufacturer of Hummers. Both are on thin ice, however, compared to businesses producing toothpicks, table salt, toilet paper and or even home heating fuels.
First, a short economics lesson. The simplest elasticity, “price elasticity of demand,” relates changes in quantities sold to changes in the price of the good itself. For example, if the price of gasoline goes up 20 percent, by what percentage does the number of gallons sold decline?
“Cross-price elasticity of demand” is slightly more complicated. It relates changes in quantities sold for one product with changes in the price of a related one. The two goods may be substitutes. If the price of ground beef increases 10 percent, by what percentage do sales of chicken increase? They can also be complements — goods that are used together. One example is oil filters and gas prices. When the price of gasoline goes up, people drive somewhat less and change their oil less frequently. Oil filter sales drop.
A third type, “income elasticity of demand” is the relevant category for manufacturers like Polaris or for specialty retailers like Cabela’s. If your income goes up 15 percent, how much more — or less — oatmeal do you buy? What about gasoline, T-bone steaks, DVDs or Caribbean cruises? If your take-home drops 15 percent, what do you cut back on and how much?
For example, as incomes rise, people buy less oatmeal or packaged macaroni and cheese. They buy more steaks and gourmet foods. They go bowling less and frequent vacation resorts more. The reverse happens when incomes fall.
Purchases of some types change little with income. Table salt, toothpicks and Preparation H fall in this category.
What is important right now is that price increases for important items like gasoline or home heating fuels act like cuts in income. If your natural gas bill goes from $200 to $300, it acts like a $100 cut in your monthly paycheck. With $100 less to buy all other things, how will your purchases of different categories change?
As gasoline and heating costs eat into family budgets, people don’t stop eating. They eat less-expensive foods and they may go out to eat less often. Nor do they go naked. They do buy less expensive clothing and make it last longer. They probably don’t reduce consumption of toilet paper or cholesterol-reducing medications at all. But Cancun vacations, cruises, jewelry and big-ticket toys get the ax.
The Cabela’s representative’s optimism probably is justified. As energy costs crimp recreation budgets, sales of bread-and-butter camping, fishing and hunting supplies may hold steady or even increase because these activities are low-cost substitutes for more expensive options like a cruise or a long driving trip to the Grand Canyon.
But outdoor retailers probably won’t sell as many fine shotguns imported from Italy or top-of-the-line fishing rods and reels.
Polaris is more vulnerable, partly because its product is not finely divisible. When money is tight, you can cut one movie a month or eat at home one more Friday night. You don’t have to give up movies or restaurant meals entirely.
An ATV or new ski boat is different. Either you buy one or you don’t. But you cannot move from buying one boat to getting only three-fourths of a boat.
Energy costs are not the only relevant factor. Rising interest rates boost the monthly purchase costs of any big-ticket items like cars, boats, ATVs or even televisions that people borrow money for. The response here is a simple price-elasticity one. If monthly payments on a car increase from $350 a month to $375, fewer cars get sold. The same is true for ATVs and big-screen TVs.
A rising economic tide may lift most boats, even if not equally. When the economic tide goes out, however, some boats get hung up on the rocks well before others.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.