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Elasticity of Demand 89

factors held constant.For example, the income elasticity of demand for spend-

ing on groceries is about.25; that is, a 10 percent increase in income results

in only about a 2.5 percent increase in spending in this category. In other

words, a household’s consumption of groceries is relatively insensitive to

changes in income. In contrast, restaurant expenditures are highly sensitive

to income changes. The income elasticity for this type of spending is

about 3.0.

A main impact on the sales outlook for an industry, a firm, or a particular

good or service is the overall strength of the economy. When the economy

grows strongly, so do personal income, business profits, and government

income. Gains in these income categories generate increased spending on a

wide variety of goods and services. Conversely, when income falls during a

recession, so do sales across the economy. Income elasticity thus provides an

important measure of the sensitivity of sales for a given product to swings in the

economy. For instance, if EY1, sales move exactly in step with changes in

income. If EY 1, sales are highly cyclical,that is, sensitive to income. For an

inferior good, sales are countercyclical,that is, move in the opposite direction of

income and EY0.

CROSS-PRICE ELASTICITIES A final, commonly used elasticity links changes

in a good’s sales to changes in the prices of related goods. Cross-price elasticity

is defined as

where Pdenotes the price of a related good or service. If the goods in ques-

tion are substitutes, the cross-elasticity will be positive. For instance, if a 5 per-

cent cut in a competitor’s intercity fare is expected to reduce the airline’s ticket

sales by 2 percent, we find EP(2%)/(5%)  .4. The magnitude of EP

provides a useful measure of the substitutability of the two goods.^10 For exam-

ple, if EP .05, sales of the two goods are almost unrelated. If EPis very large,

however, the two goods are nearly perfect substitutes. Finally, if a pair of goods

are complements, the cross-elasticity is negative. An increase in the comple-

mentary good’s price will adversely affect sales.

Table 3.1 provides estimated price and income elasticities for selected

goods and services.

EP

¢Q/Q

¢P/P

(^10) We could also examine the effect of a change in the airline’s fare on the competitor’s ticket sales.
Note that the two cross-price elasticities may be very different in magnitude. For instance, in our
example the airline flies only half as many flights as its competitor. Given its smaller market share
and presence, one would predict that changes in the airline’s price would have a much smaller
impact on the sales of its larger rival than vice versa.
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