5 Steps to a 5 AP Microeconomics, 2014-2015 Edition

consumption of fast-food meals is quite income elastic. A relatively small percentage

increase in income causes a large—in fact, twofold—percentage increase in fast-food meals.

Some refer to these goods as luxuries.

Example:

Jen’s income rises 5 percent, and we observe her consumption of bread rises 1 percent.

EI=1%/5% = .2

Once again, this measure would indicate that bread is a normal good, as more income

prompts more bread consumption. However, the relatively small increase in consumption

compared to the increase in income tells us that bread demand is relatively income inelas-

tic. This makes sense; after all, how much more bread does one really wish to consume as

his or her income rises? If Jen’s income doubled, would she double, or more than double,

her consumption of bread? These goods are often referred to as necessities.

Example:

Consumer income increases by 5 percent, and we observe consumption of pack-

aged bologna decreases by 2 percent.

EI=–2%/5% =–.4

Again, there are two important observations that can be made here. First, because con-

sumption of bologna decreased with an increase in income, we can conclude that bologna,

in this example, is an inferior good. Second, there is a relatively inelastic response in

bologna consumption to a change in income.

Elasticity, Microeconomic Policy, and Consumer Theory ‹ 81

TIP

KEY IDEA

•If EI> 1, the good is normal and income elastic (a luxury).

• If 1 > EI> 0, the good is normal but income inelastic (a necessity).
  •If EI< 0, the good is inferior.

Cross-Price Elasticity of Demand

Consumers also change their consumption of good X when the price of a related good,

good Y changes. The sensitivity of consumption of good X to a change in the price of good

Y is called the cross-price elasticity of demand.

Ex,y =(%DQdgood X )/(% DPrice good Y)

Example:

The price of eggs increases by 1 percent, and the consumption of bacon falls

2 percent. The fact that bacon consumption fell when eggs became more

expensive tells us that these goods are complementary goods.

Ex,y=(%DQdbacon)/(% DPrice eggs) =–2%/1% =–2

Example:

The price of Honda cars increases 2 percent and consumption of Ford cars

increases 4 percent. Because Ford cars saw increased consumption when Honda

cars got more expensive, the two goods are substitutes.

Ex,y=(%DQdFord)/(% DPrice Honda) =2%/1% =+ 2