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Business Administration QUESTION #9604
Question 1
During the business cycle, a company that manufactures luxury goods experiences a 40% revenue drop while a company selling basic food staples sees only a 3% decline. Which economic concept explains this difference, and what strategic implication does it carry for portfolio diversification?
  • Comparative advantage — luxury goods are more internationally traded and therefore more exposed to exchange rate fluctuations than food staples
  • Income elasticity of demand — luxury goods have high positive income elasticity (demand falls sharply when income falls) while necessities have low income elasticity (demand is relatively stable across income changes); a diversified firm should hold both cyclical and defensive businesses to smooth earnings through economic cycles✔️
  • Price elasticity of demand — luxury goods have more elastic demand because consumers can substitute them; food staples are inelastic because they have no substitutes
  • The Giffen goods paradox — as income falls, consumers paradoxically increase spending on inferior staples and reduce luxury consumption
Correct Answer Explanation
Income elasticity of demand (YED) measures how demand responds to income changes. Luxury goods have YED > 1 (income elastic — demand drops disproportionately in downturns); necessities have YED between 0 and 1 (income inelastic — demand is resilient). The strategic implication is portfolio theory applied to business units: combining cyclical (luxury) and defensive (staples) businesses reduces earnings volatility — the same logic institutional investors apply to equity portfolios.