GT

 Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 

Cross-­‐Elasticity  
Definition  
We   now   apply   the   concept   of   elasticity   to   multiple   markets.   In   its   application  
to  a  single  good,  elasticity  measures  demand  or  supply  responsiveness  to  changes  in  
price.   Applied   to   two   goods,   it   measures   demand   or   supply   responsiveness   of   one  
good   to   changes   in   price   of   the   other   good.   We   will   see   that   it   affords   new   insight  
about  how  the  two  goods  are  related.  
We   will   first   focus   on   the   demand   side   of   this   measure,   called   the   cross-­
elasticity   of   demand.   The   definition   of   the   cross-­‐elasticity   of   demand   for   goods   A  
and  B  is  
%ΔDA
CrossDAB =  
%ΔPB
where     is   the   percentage   change   in   demand   for   good   A,   and     is   the  
percentage   change   in   price   for   good   B.   Note   that   we   use   the   percentage   change   in  
demand  for  good  A,  instead  of  using  the  percentage  change  in  quantity  demanded,  as  
we  did  in  the  formula  for  elasticity  of  demand.  
From  this  definition,  we  form  the  following  categorization:  
-­‐ If   CrossDAB > 0 ,  goods  A  and  B  are  substitutes  (in  consumption).  
-­‐ If   CrossDAB < 0 ,  goods  A  and  B  are  complements  (in  consumption).  
We   will   see   that   by   taking   this   as   the   definition   of   substitutes   and   complements,   we  
will  obtain  results  that  closely  align  with  our  intuition.  Let’s  look  at  an  example.  
 

Example:  Cross-­Elasticity  of  Demand  

Are  tires  and  gasoline  substitutes  or  complements?  
Solution:  
We   need   to   see   how   an   increase   in   price   of   one   good   affects   the   demand   for   the  
other.  We  could  use  either  combination;  let’s  suppose  the  price  of  gasoline  rises,  as  a  
result  of  a  supply  shock.  
How   does   this   impact   tires?   First,   tires   and   gasoline   are   related   through  
automobiles.   If   the   price   of   gasoline   rises,   it   will   decrease   the   demand   for  
automobiles,   as   consumers   will   use   other   means   for   travel   (bus,   bike,   etc.).   Since  
tires   are   an   input   used   in   producing   automobiles,   suppliers’   demand   for   tires   will  
decrease.  
Thus,   the   percentage   change   in   demand   for   tires   is   negative,   given   a   positive  
percentage  change  in  the  price  of  gas.  The  cross-­‐elasticity  is  
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ECO2013  -­‐  Spring  2010  
 
 

which,  by  definition,  means  tires  and  gasoline  are  complements.  

   
 
The  definition  of  cross-­‐elasticity  of  supply  is  similar.    The  cross-­elasticity  of  
supply  is  the  percentage  change  in  the  supply  of  B  divided  by  the  percentage  change  
in  the  price  of  A,  or  
%ΔSA
  CrossSAB =  
%ΔPB
If   an   increase   in   the   price   of   good   A   reduces   the   supply   of   good   B,   then   the   cross-­‐
elasticity  of  supply  is  positive  and  goods  A  and  B  are  substitutes  in  production.    If  an  
increase   in   the   price   of   good   A   increases   the   supply   of   good   B,   then   the   cross  
elasticity   of   supply   is   positive   and   goods   A   and   B   are   complements   in   production.   In  
short,  
-­‐ If   CrossSAB < 0 ,  goods  A  and  B  are  substitutes  (in  production).  
-­‐ If   CrossSAB > 0 ,  goods  A  and  B  are  complements  (in  production).  
Consider  the  following  example.  
 

Example:  Cross  Elasticity  of  Supply  

Suppose   leather   is   used   to   produce   both   footballs   and   belts,   and   the   demand   for  
footballs  goes  up.  Are  these  goods  substitutes  or  complements  in  production?  
Solution:  
We   need   to   answer   how   an   increase   in   the   demand   for   footballs   will   impact   the  
price   of   leather,   an   input   used   to   make   footballs.   An   increase   in   the   demand   for  
footballs   will   raise   the   price   of   footballs.   This   will   cause   producers   of   footballs   to  
want   to   make   more,   which   means   they   will   increase   their   demand   for   leather;   so,  
the  price  of  leather  will  rise.  
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ECO2013  -­‐  Spring  2010  
 
Since   leather   is   also   used   to   produce   belts,   and   it’s   now   more   expensive   to   buy  
leather,  the  supply  of  belts  will  shift  left.    
So,   the   percentage   change   in   price   for   footballs   is   positive,   and   the   percentage  
change   in   the   supply   of   belts   is   negative.   Thus   the   cross-­‐elasticity   of   supply   is  
negative.  By  definition,  then,  footballs  and  belts  are  substitutes.  
 

   
 
As  another  example,  consider  orange  juice  and  cattle  feed  made  from  orange  peels.    
If   the   demand   for   orange   juice   increases,   then   the   price   of   orange   juice   rises.    
Growers  plant  more  orange  trees,  increasing  the  supply  of  oranges  to  the  processing  
plants   making   orange   juice.     As   a   by-­‐product,   the   processing   plants   produce   more  
cattle   feed   from   orange   peels.     Thus   the   percentage   change   in   the   supply   of   feed  
divided  by  the  percentage  change  in  the  price  of  OJ  is  positive,  and  cattle  feed  and  OJ  
are  complements  in  production.      

Income  Elasticity  of  Demand  

Definition  
Finally,  we  apply  the  concept  of  elasticity  to  changes  in  income.  Our  results  
reveal  how  demand  responds  to  changes  in  income.  
Formally,  we  examine  the  income  elasticity  of  demand  for  good  A,  which  is  
defined  as  
%ΔDA
E − IncomeA =  
%ΔI
where     is   the   percentage   change   in   demand   for   good   A,   and     is   the  
percentage  change  income.  We  form  the  following  categorization:  
-­‐ If   E − IncomeA > 1 ,  good  A  is  a  luxury  good.  
-­‐ If   E − IncomeA > 0 ,  good  A  is  a  normal  good.  
-­‐ If   E − IncomeA < 0 ,  good  A  is  an  inferior  good.  
 GT  Concept  Note  ®  
ECO2013  -­‐  Spring  2010  
 
Informally,  a  normal  good  is  one  we  consume  more  of  as  our  income  increases,  while  
an  inferior  good  is  one  we  consume  less  of  as  our  income  increases.  A  luxury  good  is  
one   on   which   we   spend   a   greater   percentage   of   our   income   as   our   income   increases  
(like  jewelry).  Let’s  look  at  an  example.  
 

Example:  Income  Elasticity  of  Demand  

A   consumer   likes   to   eat   McDonald’s   and   Outback.   McDonald’s   is   cheaper,   but   he  
likes  Outback  more.  Is  McDonald’s  a  normal  good  or  an  inferior  good?  
Solution:  
Suppose   the   consumer’s   income   increases.   What   will   happen   to   his   demand   for  
McDonald’s?   Since   he   has   more   money   to   spend,   and   he   likes   Outback   more   than  
McDonald’s,  he  will  buy  less  McDonald’s.  
So,   the   percentage   change   in   demand   for   McDonald’s   is   negative   as   a   result   of   a  
positive  percentage  change  in  income.  This  means  his  income  elasticity  of  demand  
for  McDonald’s  is  

   

which,  by  definition,  means  McDonald’s  is  an  inferior  good.