Freakonomics Interview: How Inelastic Demand Can Boost Profits

Abstract

Part A There is inelastic demand for the firm's goods if the selling price does not change due to decreased labor costs. In other words, price adjustments do not affect demand for the product. On a graph, this would seem like a straight-up demand increase. When a company lowers its labor expenses, it may make the same product for less money. As can be seen in the graph, this creates a rightward shift in the supply curve. Where the supply curve meets the demand curve is the point of equilibrium. As the supply curve shifts to the right, the equilibrium price stays stable while the equilibrium quantity rises. Figure 1: Supply and Demand Curve Graph Since the demand curve is completely inelastic, the company may maintain the same production and price level while still realizing a profit—the company's bottom line benefits as a consequence. Overall, this scenario lends credence to Acemoglu's argument that businesses led by MBAs can cut labor costs without increasing investment in innovation or technology and instead use the savings to boost profits for shareholders in the event of perfectly inelastic demand. It's important to remember that inelastic demand curves are unusual in real-world markets. Thus cutting down on labor expenses usually means dropping the price and seeing a smaller bump in profit. Part B How would you make the distinction between allocative efficiency and productive efficiency in correcting Stephen Dubner? Different from one another, economics often utilize the ideas of allocative and productive efficiency. When resources are allocated effectively, the marginal benefit should equal the marginal cost, a condition known as "allocative efficiency." As a result, society is reaping the most possible benefits from the allotted resources. Productive efficiency is the process through which products and services are created with the least resources and are technically feasible. When products and services are produced efficiently, as few resources as feasible are used. Differentiating between these two ideas and using them properly would be key to refuting Stephen Dubner's claims. Allocative efficiency seems to be what Dubner has in mind whenever he uses the word "efficiency" about distributing scarce resources. To be sure, he probably means productive efficiency if he uses the word "efficiency" in the context of production. Does the Freidman doctrine imply that firms will be efficient both allocatively and productively? Firms are not guaranteed to be allocative and productively efficient if the Friedman theory is adhered to. This philosophy asserts that a company's only social obligation is to maximize profits for its owners. The pursuit of profit by businesses does not always result in the most effective use of resources or the creation of quality products. To add insult to injury, companies may pollute the environment or abuse their employees to increase profits. How do Daron Acemoglu's findings suggest that Business School managers are creating some type of deadweight loss? By cutting down on personnel expenses but not on innovation and technological advancement, Business School administrators may be causing a deadweight loss, according to research by Daron Acemoglu. Deadweight loss is the reduction in economic well-being from inefficient resource allocation. While a decrease in labor expenses might boost earnings for shareholders, if that money is not re-invested in research and development, the company could lose out on ways to become more productive and competitive. And if pay and benefits are cut to minimize labor expenses, it might mean less productive employees and less prosperity for the economy as a whole. Part C What price do you recommend for the online e-book? Pricing has to be adjusted such that serious readers go for the hardcover book and casual readers go for the online e-book to be incentive compatible. It has been determined that academics are prepared to spend $165 for the hardcover printed edition and $115 for the online e-book. At the same time, casual readers are ready to pay $125 for the hardcover printed version and $100 for the online e-book. If the publisher decides to sell the e-book online for $115, academics will choose the more expensive...