Eco 101 Income and Cross Elasticity

Here's a quick review of what we know.

Elasticity is basically the responsiveness of demand to changes in price.

There are three equations for elasticity. They all work.

Relative Change in Demand/Relative Change in Price

/\ Q / Avg Q
/\ P / Avg P

(Avg P / Avg Q) X (1 / Slope)

INCOME ELASTICITY OF DEMAND IS EXACTLY THE SAME, except instead of responding to changes in Price, demand is responding to changes in Income. As such, we use 'Y' instead of 'P' in the formula

Relative Change in Demand/Relative Change in Price

/\ Q / Avg Q
/\ Y / Avg Y

(Avg Y / Avg Q) X (1 / Slope)

There are two main kinds of goods which are affected by changes in income in different ways.

Normal goods are items which respond positively to changes in income. If your income increases, you buy more of them. As your income decreases, you buy less of them. These include items such as cars or food.

Inferior goods are abnormal goods (although not necessarily of lower quality) which repond negatively to income changes. You buy less of them as your income increases, and more of them as your income decreases. This includes things like Wal-Mart shoes and craft dinner, but it is also dependent on personal tastes. Some inferior goods may be consumed less as income increases, because education also increases as income increases, and these products are considered unhealthy.

LUXURY: Movies (3.5) Electricity (2.0) Autos (1.0) --------> Elasticity is greater than 1
NECESSITIES: Furniture (0.5) Clothing (0.5) Food (0.2)-----> Elasticity is less than 1, but still positive
INFERIOR: Whole Milk (-0.5) Pig Products (-0.2)---------> Elasticity is negative

There are two factors which determine the elasticity of income:
1: Characteristics of the good
2: Taste Preferences

The nature of the good itself will define elasticity, but often, preferences will determine the necessity level of a good. Often, as income increases, there is a move away from staple foods to produce and meats, to restaurant meals.

CROSS ELASTICITY OF DEMAND: The sensitivity of demand in one product to price changes of another product

Relative Change in Demand for Product X/Relative Change in Price for Product Y

/\ QX / Avg QX
/\ PY / Avg PY

(Avg PY / Avg QX) X (1 / Slope)

There are two different scenarios here:

COMPLIMENTARY GOODS: Eg, CDs and Walkman Players
THESE HAVE A NEGATIVE CORRELATION
In other words, the cross elasticity of demand for complimentary goods is negative.

SUBSTITUTE GOODS: EG, Pepsi and Coke
THESE HAVE A POSITIVE CORRELATION
In other words, the cross elasticity of demand for substitute goods is positive

Here is a case scenario which could make us think about the cross elasticity of substitute goods. Gateman was, at one point, down in Ottawa to study this case. Here, Fritto-Lay (a subsidiary of Pepsico) was essentially buying out Hostess Chips (through a multimillion dollar merger). The government saw that this was essentially the creation of a monopoly in the potato chip industry, and rushed in to prevent the merger. The company lawyers for Fritto-Lay, however, were able to conclusively prove that the merger would not, in effect, create a monopoly, because in real markets, other goods such as popcorn and cheese puffs serve as de facto substitute goods for potato chips. Potato chips have a higher cross elasticity of demand with these substitute snack foods, so as a result, Fritto-lay would not be able to create a real market monopoly. Frito-Lay naturally won the case and was allowed the merger..... Hooray!