The main determinant of the price elasticity of supply is the amount of time a producer has to respond to its price
change. If a producer makes pencils and it raises its price, the amount of time it takes for the producer to translate that
price change into a quantity supply increase determines the goods’ elasticity.
Cross-Elasticity
While price elasticities measure the quantity demanded or supplied, cross-elasticitymeasures the consumer purchases
in one product when there is a price change in another product. The impact one product’s price makes on another prod-
uct’s demand is valuable information to a producer.
Cross-elasticity = Percentage change in
Quantity demanded for good 1
Percentage change in price
of product 2Substitute goods:If Pepsi increases its price and it causes consumers to buy more Coke, this results in a positive cross-
elasticity of demand, meaning that consumers have substituted Coke for Pepsi because of a price increase. If in the pre-
vious equation we get a positive number, it is safe to assume that the two goods are substitutes.
Complementary goods:If an increase in the price of a product leads to a decrease in demand for another product, then
the two goods must be complements. For example, an increase in the price of DVD players leads to a decrease in con-
sumption of DVD movies. If in the equation we get a negative number, it is safe to assume that the two goods are
complements.
Independent goods:If the answer to the equation is a zero or near zero answer, the two goods are independent or
unrelated.
You may be wondering why this cross-elasticity stuff is of any value to anyone. Let’s take Gatorade, for example: sup-
pose that Gatorade is considering whether it should lower the price of its flavored water product. Gatorade will want to
know if the price decrease will affect total revenue, and it will also want to know if the price decrease will influence the
sales of its energy fruit drinks (a related good). Will an increase in sales for Gatorade’s water product come at the expense
of its energy fruit drinks? How sensitive are the sales of one of its products to a change in the price of another product?
Gatorade doesn’t want to “chip away” at its success with energy drinks.
The government also uses this cross-elasticity to determine whether firms that propose a merger would be violating
antitrust laws. If companies are close substitutes for each other, then the government would be inclined to decline a
merger because it would lessen competition, thereby reducing efficiency.
The Income Elasticity of Demand
This type of elasticity measures how or if a change in income produces a change in consumption. When changes in income
occur, consumers may or may not react with an increase in consumption. Typically, consumers spend more as they make
more; however, how much more do they spend?
Income elasticity of demand = Percentage change in quantity demanded
Percentage change in incomeNormal goods:When you have a positive relationship between an increase in income and consumption (as one rises,
the other rises), you have what is called a normal good. A normal good is anything that increases in demand when
income increases. Typical normal goods are gourmet meals and luxury cars.
Inferior goods:A negative or inverse relationship (as one rises, the other falls) between income and consumption des-
ignates an inferior good. Inferior goods are products you buy less of when your income increases. Canned soup and
Spam are just two examples of inferior goods.
Part I: The Fundamentals