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3.

Consumer theory and elasticity


by Xavier Duran, course workshop director.
The consumer is one of the most important units of study in Economics. The analysis
of the consumer supports the study of why goods are demanded. One useful starting
point in the study of the consumer is the analysis of the demand function outlined in
Unit 2 in this course on Foundations of Economics. Utility theory constitutes one of
the building blocks upon which the demand curve is constructed. Thus, if one defines
utility as the level of satisfaction or well-being obtained from the consumption of a
particular product, the objective of the consumer must be the optimisation of utility.
In this process of optimising utility, nevertheless, the consumer is constrained by her
income and the prices of the products she wishes to buy. The analysis of the consumer
thus focuses on a problem of utility optimisation subject to a budget constraint. By
analysing the effects on consumption as a result of changes in prices through the use
of utility functions and budget constraints we can subsequently define a demand
curve. The analysis of utility, furthermore, also supports the analysis of a large
number of situations involving trade-offs. These are crucial in Managerial Economics.
In a situation where there is a separation of ownership from control which permits
managers to pursue their own objectives, for example, there could be a trade off
between profits and sales. Utility theory supports the analysis of such situations by
ascribing a utility function to management.
Another important issue concerns the analysis of the response of the demand to
changes in its determinants which is known as elasticity. Its application in decisionmaking resides in the analysis managers can make of the likely reactions of
consumers to the implementation of strategy. Thus, for instance, the price elasticity of
demand measures the response of the quantity demanded to changes in prices, the
income elasticity of demand measures the response of consumers to changes in
income and the cross price elasticity of demand measures the response of the quantity
demanded of one good to changes in the price of another good. While there are a large
number of elasticity measures and these are not limited to the response of consumers
to changes in demand constituents but can also include supply, we will focus on the
study of demand measures.
This chapter begins with an analysis of utility theory which includes the definition of
utility and the term marginal utility. These are used to build indifference curves which
are then put together with budget constraints to study the decisions of the consumer.
A number of applications of indifference curves analysis into decision-making are
then outlined. The chapter moves on to study the price elasticity of demand and its
contributions to revenue optimising pricing through the total revenue test. The income
elasticity of demand and the cross price elasticity of demand are also outlined. These
will be used in Study Guide 3 in the Managerial Economics course.

3.1 Indifference curves and budget constraints


The concept of utility is central to the study of the consumer. In Economics, utility is
used to measure the well-being obtained by consumers from the consumption of

output. The measurement of utility, in turn permits us to summarise the preferences of


the consumer. Furthermore, the consumers income and the prices of goods are used
to estimate consumption possibilities. Thus, one of the objectives of the current unit is
to construct a framework to support the study of the consumer who not only orders
her preferences in terms of utility, but who is also subject to her budget. In the context
of the issues commented, this section will begin with the study of preferences and the
measure of utility. It will then continue to describe the budget constraint, and it will
conclude by superimposing utility curves on budget constraints to encounter the
optimal consumption of goods and services.
3.1.1 Utility
Utility is defined as a measure of the satisfaction or well-being consumers obtain from
the consumption of goods and services. Thus, if a consumer drinks 3 cups of coffee,
her utility would be measured by the satisfaction she would gain from the 3 cups.
The relationship between the quantity of a good or a service consumed (q) and the
utility obtained (U) is summarised by a positively sloped utility function. The utility
function is expressed below:
U = f (q )

(3.1)

The term marginal utility, on the other hand, measures the change in utility resulting
from a one unit increase in the consumption of a good or service. It refers to the
contribution to utility resulting from consuming one extra unit of a product. The
contribution to utility from consuming the third cup of coffee would therefore be the
marginal utility of the third cup.
While we will assume, for simplicity that the higher quantity of a good or service
consumed, the higher the total utility, which determines the positive slope of the
utility function, we will also assume that extra units contribute less to total utility or
diminishing marginal utility. This assumption results from the contention that
consumers tend to grow tired of goods and services as their consumption increases,
and it is known in Economics as the Law of diminishing marginal utility. Figure 3.1
illustrates the representation of a positively sloped utility function, where utility
increases with quantity consumed, and where marginal utility diminishes with higher
output.

Figure 3.1 Utility curve


U

One of the main problems of the concept of utility resides in its difficulty to be
measured. Consumers cannot put a quantitative value to the utility they obtain from
consumption but only order. Thus, consumers are able to qualitatively put an order to
their preferences and state that they prefer one consumption bundle to another but not
by how much. Notwithstanding this limitation, the use of utility functions continues to
constitute the foundation of the theoretical study of consumer behaviour analyses. The
concept of utility is used in a number of applications in Managerial Economics. For
example, in decision making analysis utility functions are used to measure decision
makers attitude to risk.

3.1.2 Indifference curves


The analysis of utility could be extended to measure the well being obtained from the
consumption from bundles of two or more goods. This permits economists to analyse
of a trade off between two goods. In this sense, one must define indifference curves as
curves which summarise the bundles of two goods that yield a constant level of
utility. Consumers are thus indifferent to any of the bundles of goods along an
indifference curve since utility is constant. Figure 3.2 illustrates an example of an
indifference curve:

Figure 3.2 Indifference curve


q2
q0

q1
q0

q1

U
q1

The level of utility is held constant along the indifference curve. Thus, consumers are
indifferent between bundle A or B in Figure 3.2 as they are on the indifference curve
where utility is held unchanged. As consumers move from bundle A to bundle B, they
give up in the consumption of q2 in order to increase in the consumption of good q1
holding utility constant. Consequently, there is a trade off between the consumption of
the two goods.
While an indifference curve allows comparisons between bundles which yield
constant utility, one must illustrate an indifference map if it is wished to analyse
bundles with different utilities. There is an indifference curve for every level of

utility. But because there are infinite levels of utility, there will be infinite
indifference curves. An indifference map plots a whole set of indifference curves.

Figure 3.3 Indifference map


q2

B
C

U2
U1
U0

q1
Higher levels of utility are depicted in Figure 3.3 as higher indifference curves. Thus,
consumers are indifferent between bundles A and B located on the same indifference
curve but prefer bundle C to bundles A and B as it is on indifference curve U1
connected to a higher level of utility. In turn, consumers prefer any bundle on U2 to
bundles on U1.

3.1.3 Slope of indifference curve


One key feature of the indifference curves analysed up to this point is that they are
convex to the origin. This implies that their slope changes. As one moves on the
indifference curve downwards, the slope decreases. The reason for the diminishing
slope will be explained in Section 3.1.4.
The slope of the indifference curve is known as the marginal rate of substitution
(MRS) and it measures the amount of one good that must be given up in consumption
in order to increase the consumption of the other good by one unit holding utility
constant. In other words, it measures the opportunity cost of consuming one extra unit
of a good. Mathematically, the MRS at one point on the indifference curve is
measured by the derivative of the utility function with respect to the quantity
demanded of one good at the particular point and is illustrated as the slope of the
tangent line to the utility function at the point.

Figure 3.4 Decreasing indifference curve slope


q2

U1

q1

Figure 3.4 illustrates the Law of diminishing MRS. As a consumer decides to


increase her consumption of the good or service measured on the horizontal axis, she
is willing to give up less of the good measured on the vertical axis. The MRS thus
diminishes.

3.1.4. Characteristics of indifference curves


This subsection focuses on three of the main characteristics of indifference curves we
will use for the purposes of the Managerial Economics course. It must be noted that
indifference curves could differ from the ones presented in this unit. Their shape is
not necessarily convex to the origin and in some cases they are not negatively sloped,
however, the most general analysis of indifference curve outlined in this section
suffices for the purposes of our study.

Negatively sloped

The negative slope of the indifference curve illustrates the fact that in order to
consume higher amounts of one good consumers must give up in the consumption of
the other if they are to hold utility constant. The slope of the indifference curve, thus,
determines a trade off.

Convex to the origin

While the previous subsection demonstrated that the Law of diminishing MRS
resulted in a convex indifference curve, we must demonstrate why this law operates.
The Law of diminishing marginal utility is the key to the demonstration of the Law
of diminishing MRS. As consumers consume more of a good or service, it was
contended they would obtain smaller marginal utility. This means consumers value a
product less as they consume additional units. Given decisions between two goods,
thus, consumers will value a good less the more they consume of it which means they
will be willing to give up less of the other good. The MRS thus must diminish.

Indifference curves cannot intersect

Figure 3.5 Indifference curves do not intersect


q2

AC
B

U1
U0
q1

Because A and B in Figure 3.5 are bundles on the same indifference curve U0, they
are equally preferred. Likewise, because A and C are in turn bundles on the same
indifferent curve U1, they are equally preferred. Because consumers are indifferent
between A and B and A and C, we can conclude they are indifferent between B and
C. However, a closer look to Figure 3.5 shows that, while including the same amount
of q1, bundle C includes a higher amount of q2 than bundle B, which means
consumers would prefer C to B. This contradicts the previous contention that
consumers were indifferent between bundles B and C. Therefore utility curves cannot
intersect.

3.1.5 The budget constraint


The budget constraint summarises the bundles of two goods a consumer can afford
given her income and the prices of the goods. Indifference curves summarise the
subjective preferences of consumers, but do not illustrate their ability to consume
them. Thus, the superimposition of the budget constraint on the indifference curve
map is necessary if one wishes to analyse the highest utility one consumer could
obtain given her budget.
The budget constraint can be expressed in terms of the income of the consumer (M),
the price of q1 and the price of q 2 :

M = p1 q1 + p 2 q 2

(3.2)

where p1 q1 represents the expenditure on q1 and p 2 q 2 represents the expenditure on


q2 .
Figure 3.6 illustrates the budget constraint:

Figure 3.6 The budget constraint


q2

q1

Bundles of goods included in the region below the budget constraint illustrated in
Figure 3.6 can be afforded by consumers who do not spend all their income. The
bundles on the budget constraint can be afforded when consumers spend all their
income. Bundles included in the region above the budget constraint cannot be
afforded even when consumers spend all their income.

Other key points in the analysis of the budget constraint concern its slope and
position. The slope of the budget constraint is determined by the relative prices of the
two goods with a negative sign to indicate the negative slope: p1 p 2 . An increase
in p1 relative to p2 results in a steeper budget constraint. On the other hand, a
reduction in p1 relative to p2 results in a flatter budget constraint. The budget constrain
will shift upwards to the right when consumers income increases and will shift
downwards to the left when income decreases.

3.1.6 Consumer equilibrium


The Consumers objective is to optimise utility subject to a budget constraint. Thus,
consumers try to reach the highest indifference curve given their income and the
prices of the goods.
The highest indifference curve that can be reached is the one that shares a tangency
point with the budget constraint.

Figure 3.7 Consumer equilibrium


q2

q2 *

q1 *

U2
U1
U0
q1

Figure 3.7 illustrates that the highest indifference curve consumers can reach is U1 as
it shares a tangency point with the budget constraint. Consumers optimise their utility
when they consume q1* and q2*. At this equilibrium point, the slope of the budget
constraint is equal to the MRS.

3.1.7 Applications of consumer theory


There are a large number of applications of consumer theory. The use of utility
functions in decision-making analysis to describe attitudes to risk was already
outlined. Indifference curve analysis also plays a key role in explaining a large
number of economic phenomena. For example, it constitutes the theoretical basis used
to derive demand curves. In this sense, one could analyse the effects of changing the
price of a good or a service on the budget constraint and in turn on new consumer
equilibria. Similarly, the illustration of the effects of changes in prices on the quantity
demanded results in the demand curve. Indifference curves are also used to analyse
the effects of public policies on the labour market. Increased taxes, for example, could
have an impact on the budget constraint used in the analysis of workers who must

decide on whether to work more to outweigh their reduced purchasing power or to


work less as their work becomes worse paid. This analysis, in turn would
consequently define the labour supply curve.
But our interest in the analysis of indifference curves and budget constraints is rooted
in their role in explaining management decisions and in the description of the
objective of businesses under the separation of ownership from control. These issues
will be explored in Study Guide 1 in the Managerial Economics course where it is
contended that indifference curves can be ascribed to management behaviour. In this
context, managers may derive utility from both making profits and revenue, but there
may be a trade off between the two of them which can be illustrated with the use of an
indifference curve. In their pursuit to maximise utility, nevertheless, managers are
constrained by a profit function where output acts as a proxy for sales.

Figure 3.8 Managerial indifference curve


profit

pm
s

U
Qpm

Qs

sales

Figure 3.8, in this context illustrates Baumols contention that due to the separation of
ownership from control in modern corporations, management who have discretion
over the resources of the firm, may be able to increase revenue above the level
consistent with profit maximisation as long as their revenue contributes to their utility.
The tangency point between the profit constraint and managements indifferent curves
occurs to the right of the profit maximising level of revenue.
Study Guide 1 contends that the use of indifference curves to ascribe management
behaviour can also be used to illustrate other theories built in the context of the
agency relationships resulting from the separation of ownership from control such as
Marris theory of growth and Williamson theory on management discretion. These
issues will be explored in detail in Unit 1 and in the workshops in the Managerial
Economics course.

3.2 Elasticity
One of economists and businessmen most useful tools for the purpose of sensitivity
analysis is the use of elasticity. It is not difficult to underline the contribution of the
concept of elasticity to managerial decision-making as it measures the responsiveness
of a number of variables to the implementation of potential strategies. The ex ante
application of the concept of the price elasticity of demand, for example, resides in its
contribution to the understanding of the likely response of customers to price changes.
The ex post application of the price elasticity of demand, in contrast, permits the
evaluation of the effectiveness of price changes concerning customer response which,
coupled with the study of competitors reactions, constitutes the foundation for the
analysis of future price changes. While there are a large number of elasticity
measures, our focus is on demand measures of elasticity. This is the reason for the
inclusion of the concept of elasticity in a chapter dedicated to consumer theory.

3.2.1 The concept of elasticity


Elasticity is defined as a measure of the responsiveness of one variable to changes in
another variable. One could measure elasticities for a large number of pairs of
variables. Usually in Economics, measures of elasticity study the response of a
quantity variable to changes in another variable. Thus, for instance, the price elasticity
of demand measures the response of the quantity demanded to changes in prices, the
cross price elasticity of demand measures the response of the quantity demanded of
one good to changes in the price of another good or the price elasticity of supply
measures the response of the quantity supplied to changes in prices. Our focus is on
the price elasticity of demand, the income elasticity of demand and the cross price
elasticity of demand.

3.2.2 The price elasticity of demand


The price elasticity of demand measures the response of the quantity demanded to
changes in prices. This responsiveness is measured in percentage terms. Expression
(3.3) below summarises the computation of the price elasticity of demand ( p ):

p =

% q d
% p

(3.3)

where %q d is the percentage change in the quantity demanded and %p is the


percentage change in price.
When the price change results in a more than proportionate change in the quantity
demanded, the term %q d is larger than % p which implies an absolute value of the
price elasticity of demand ( p ) greater than one. The demand function is considered
to be elastic. In contrast when the price increase or decrease results in a less than
proportionate change in the quantity demanded, the term %q d is smaller than %p
which results in an absolute value of the price elasticity of demand p smaller than
one. The demand function is considered inelastic. Only when the price change

results in an equally proportional quantity change, the absolute value of the price
elasticity of demand p is one.
Because we only consider negatively sloped demand curves, the relationship between
the price and the quantity demanded is negative. This results in a negative price
elasticity value. For simplicity, nevertheless, a large number of economists consider
the absolute value of the price elasticity of demand ( p ). Thus, the formula can take
the values summarised by Table 3.1.

Table 3.1 Price elasticity of demand

p <1 inelastic
p =1 unit elastic
p >1 elastic

In the extreme when any change in the price does not effect the quantity demanded,
the p =0 and the demand curve is illustrated as a vertical line. In contrast, when the
price change results in an infinite change in the quantity demanded, p = , the
demand function is plotted as a horizontal line. The demand functions are perfectly
inelastic and perfectly elastic respectively.

3.2.3 Computation of the price elasticity of demand


There are two main methods used in the computation of the price elasticity of
demand. The method used depends on the purpose of the study and the data set
available. Thus, given two points on a demand curve, one can only compute the price
elasticity of demand on the arc defined between the two points. In contrast, a
demand function, expressed in its mathematical form, permits the computation of the
price elasticity of demand at any one point on the demand curve. While the first is
known as the arc measure of the price elasticity of demand, the latter is known as
the point price elasticity of demand. The usefulness and selection of the measure
depends on the study the analyst wishes to perform on the demand function.
The arc price elasticity of demand measures the value of the price elasticity between
two points on a demand function. The formula for the price elasticity of demand is
thus developed to consider the two points.

p =

%q d q d p 0
=

% p
p q d0

(3.4)

where q d is the change in the quantity demanded from the original to the new point
on the demand curve, p is the change in price, p 0 is the original price, and q d0 is the
original quantity demanded.
Note that while we have based our percentages from the original point with values p0
and q0, one could base the percentage on the middle point or any point as long as the
calculations used were consistent through the analysis.
Figure 3.9 illustrates graphically the calculation of the arc price elasticity of
demand.

Figure 3.9 Arc price elasticity of demand


p
p0

E0
E1

p1
q0

q1

D
qd

q
Suppose, for example, two points on a demand function are given: p0=9, q0=98, and
p1=39, q1=10. The absolute value of the arc price elasticity of demand would be:

p =

10 98 9

= 0.269
39 9 98

Because the absolute value is smaller than 1, the demand curve between the two
points is considered to be inelastic.
In contrast to the arc measure, the point price elasticity of demand measures the
value of the price elasticity of demand at one point on the demand function. This
measure results from reducing the arc existing between two points on a demand
function so much that the difference becomes infinitesimally small. The intuition
explaining this reduction is that the price elasticity of demand is computed at one
point. Mathematically, this can be expressed with the use of the derivative of the
demand function at that particular point:

p =

where

% q d dq d p 0
=

%p
dp q d0

dq d
is the derivative of the demand function with respect to the price.
dp

(3.5)

Suppose a demand function is given as q d = 39 8 p , the absolute value of the point


price elasticity of demand at a point where p=3 and q=15 is calculated below

p =8

3
= 1. 6
15

Because the absolute value of the point price elasticity of demand is greater than 1,
the demand curve at this point is elastic.

3.2.4 The total revenue test


One of the main applications of the concept of the price elasticity of demand to
managerial decision-making concerns the relation existing between the values of
elasticity along a demand function and the total revenue function. Unit 2 of this
course on Foundations of Economics introduced this issue by showing that linear
demand functions determine the fact that total revenue increases and then reduces as
output increases (See Section 2.2.2). Our analysis in this unit is extended by the
contention that the value of the point price elasticity of demand changes along a linear
demand function. Management can then implement appropriate price strategies in
order to increase total revenue as long as they know the elasticity of the demand faced
by the business.
One useful starting point is the analysis of the formula used to calculate the point
price elasticity of demand. This formula, summarised by expression (3.5) is composed
of two main parts: the derivative of the demand function with respect to price
( dq d dp ) and the price to quantity ratio ( p q d ). Because the geometric
interpretation of the derivative of a function at one point is the slope of the function at
that point, the derivative of the demand function must be constant along the linear
demand function. In contrast, the second term in the formula concerns the ratio price
to quantity demanded which decreases as one moves downwards along the demand
function. The value of the price elasticity of demand thus decreases as the price is
reduced and the quantity demanded increases. This issue is crucial in economics as it
implies that a linear demand function is always split into different price elasticity
ranges: an elastic range for high prices, a point where the demand is unit elastic and
an inelastic range on the bottom of the demand function. The elastic and the inelastic
ranges of the demand function coincide with the sections of the total revenue function
that increase and decrease respectively as the quantity demanded increases. The level
of output where the demand is unit elastic in turn coincides with the revenue
optimising level of output. Figure 3.10 extends the illustration of the relationship
between the demand and revenue functions to include the elasticities consistent with
different sections of the demand function. This relationship is known as the total
revenue test.

Figure 3.10 The total revenue test


p
p*
TR

p >1
=1
p
p <1
q*

MR

q*

D=AR

TR
q

The relationships summarised by Figure 3.10 offer prescriptions for management


optimising revenue. Thus managers should reduce prices when the demand is elastic
and increase prices when the demand is inelastic. Table 3.2 summarises the effects of
increases and decreases in prices on total revenue.

Table 3.2 Total revenue test

p
p

Inelastic demand
p <1

Elastic demand
p >1

TR
TR

TR
TR

The usefulness of the total revenue test resides in the prescriptions it offers to revenue
optimising managers. Nonetheless, the test can be criticised since it does not consider
the competitive response of rivals in oligopolistic industries. While consumers
increase the demand for a good when a firm decreases its price on the elastic range of
the demand curve in order to increase revenue, competitors may match a price
decrease so as not to lose market share. Other problems connected to the test are
discussed in much detail in Study Guide 3 in the Managerial Economics course.

3.2.5 Determinants of price elasticity of demand


The price elasticity of demand varies from one product to another. The demand for
some products like petrol is very inelastic, while the demand for other products such
as luxuries is very elastic. This section outlines some of the determinants of the price
elasticity of demand.

The number and closeness of substitute products. This is one of the most
important determinants of the price elasticity of demand. The possibility of
buying substitute products implies customers response to price changes is

huge compared to situations where there are no substitutes. In this sense, the
smaller the number and the more differentiated products are, the more inelastic
the demand function. In contrast, the higher the number and the closer
substitute products are, the more elastic the demand. Thus, customers decrease
the demand for green beans more than proportionately when their price is
increased since there are many other vegetables they can buy but keep buying
petrol even when its price increases as they cannot use other substitutes. The
demand for vegetables is therefore quite elastic while the demand for petrol is
quite inelastic. Producers could try to differentiate their products from those
produced by their competitors in order to gain sustainable competitive
advantage which can, in turn, result in more inelastic demands and the
possibility, through the total revenue test, to increase prices and profits.
The time period. The longer the time period under consideration the more
elastic the demand is likely to be. This is due to the fact that consumers are
able to adapt to price changes over time. Thus, for example, while the demand
for petrol is very inelastic in the short run, it tends to be more elastic over time
as consumers find other substitutes. A consumer who uses the car to get to
work every day will still have to buy petrol even if its price doubles in the
short run, however, in the long run, she may decide to use public transport,
buy a smaller car or even change the job. Europe became more efficient over
time in the use of petrol after the 1970s petrol crises by using less energy,
promoting smaller engines than their American counterparts and by
encouraging the use of other energy sources like gas.
Proportion of income spent on the good. The lower the proportion of
income spent on the good, the more inelastic the demand is likely to be. In
contrast, the higher the percentage of income spent on the good, the more
elastic the demand is likely to be. If a consumer with a yearly income of
39,000, for instance, buys 5p worth of chewing gum every morning, she is
not likely to stop buying chewing gum when its price goes up by 100 per cent
to 10p because 10p represents a minute percentage of total income. In contrast,
a miniscule percentage change in the price of a car, which constitutes a high
percentage of her yearly income, would have a large effect on the consumers
decision to buy it.
Habit creating and addictive goods. When consumers are addicted to some
products, they are not likely to reduce their consumption much when their
price increases. Thus, goods such as cigarettes, alcohol or drugs are consumed
even when their prices increase. Their demand is inelastic. Governments who
need a quick source of income tend to increase indirect taxes in these goods
because due to their inelastic demand, consumers will buy them even when
their prices increase.
Luxuries and necessities. The demand for luxuries tends to be more elastic
than the demand for necessities. Consumers could stop buying luxuries should
their price increase but must buy necessities even when their price is
increased.

3.2.6 The income elasticity of demand


The income elasticity of demand is useful in analysing the response of customers to
changes in their incomeu. The income elasticity of demand measures the percentage

response of the quantity demanded to a percentage change in income as summarised


by expression (3.6)

y =

%q d
%Y

(3.6)

where y is the income elasticity of demand, %q d is the percentage change in the


quantity demanded, and %Y is the percentage change in the income of the
consumer.
When an increase (decrease) in the consumers income results in a decrease (increase)
in the quantity demanded, the value of the income elasticity demand is negative.
Products that have a negative income elasticity of demand are known as inferior
goods. Examples include low quality food or cheap clothes.
In contrast, when an increase (decrease) in the consumers income results in an
increase (decrease) in the quantity demanded, the value of the income elasticity of
demand is positive. Goods that have a positive income elasticity of demand are known
as normal goods. These goods can be further divided into subsistence or luxury goods
depending on whether a change in consumers income results in a less or a more than
proportionate change in the quantity demanded respectively. The income elasticity of
demand of subsistence goods thus is smaller than 1. Examples of subsistence goods
include computers or books. In contrast, the income elasticity of demand of luxuries is
greater than 1. Examples of luxuries include designer products.
Note that the sign of the income elasticity of demand is important in order to
determine whether goods are inferior or normal. While in the computation of the price
elasticity of demand, the sign is ignored for simplicity, it is crucial to indicate whether
there is a positive or a negative relationship between income and the quantity
demanded.
Table 3.3 summarises the types of goods depending on the value of the price elasticity
of demand.

Table 3.3 Income elasticity of demand


Income elasticity of
demand value
y <0

relationship

Type of good

negative

Inferior good

0 < y <1

positive

Subsistence good

y >1

positive

luxuries

Some organisations include a number of types of goods in their product portfolios to


minimise the risk of the business cycle fluctuations. Thus in booming phases of the
business cycle, sales of normal goods increase as income levels increase. In contrast,
firms can increase sales of inferior goods during economy recessions.

3.2.7 The cross price elasticity of demand


In some cases goods are related to each other in such a way that changes in the price
of one good results in changes in the quantity demanded of another good. In this
sense, when goods are related, they can be complements or substitutes. The cross
price elasticity of demand indicates whether or not any goods are related and
measures the strength of the relationship.
The cross price elasticity of demand measures the response of the quantity demanded
of one good B to changes in the price of good A. the formula that measures the cross
price elasticity of demand is expressed below.

AB =

%q B
%p A

(3.8)

where AB is the cross price elasticity of demand, %q B is the percentage change in


the quantity demanded of product B, and %p A is the percentage change in the price
of good A.

When an increase (reduction) in the price of good A results in a reduction (increase)


in the quantity demanded of good B, the value of the cross price elasticity of demand
is subsequently negative. The goods are complements. Computers and printers
represent an example of complement goods.
In contrast, when an increase (reduction) in the price of good A results in an increase
(reduction) in the quantity demanded of good B, the value of the cross price elasticity
of demand is subsequently positive. The goods are substitutes. Examples of
complement goods include coffee and tea (although in some cultures they are taken
together).
The closer the cross elasticity of demand is to 0, the less related two products are. The
more negative and the more positive the cross price elasticity of demand, the stronger
complements and substitutes the pair of goods are respectively.
Table 3.4 summarises the relationships depending on the cross price elasticity of
demand.

Table 3.4 Cross price elasticity of demand


Cross price elasticity of demand

relationship

AB
AB < 0
AB = 0
AB > 0

complements
unrelated
substitutes

The cross elasticity of demand is useful in determining which are the products
competing in the same industry. It is crucial for example to know any firms substitute
products in the analysis of the likely response of competitors to the implementation of
any strategy.
The cross price elasticity is also used in the study of a relevant market as a first step in
antitrust investigations. Thus, for example, should a firm report a competitor for
anticompetitive practices such as predatory pricing or abuse of dominant position to
the competition authorities, it will firstly need to prove that they compete in the same
market. The cross price elasticity of demand is used to determine whether or not the
goods produced by the two firms are substitutes.

3.3 Conclusion
This unit has presented some crucial concepts in Economics related to the consumer.
On the one hand, the contribution of indifference curve analysis to decision making
was highlighted. Indifference curves will be used in Unit 1 in the Managerial
Economics course to describe the behaviour of the firm in a world where management
and ownership are divorced. On the other hand, the concept of the price elasticity of
demand and its application to revenue optimising pricing were outlined. The unit also
included the study of the income elasticity of demand and the cross price elasticity of
demand. These concepts will be used in Unit 3 in the Managerial Economics course
to study the response of customers and competitors to the implementation of
strategies.

References and further reading


Baumol, On the theory of Oligopoly, Economica, N.S. 25, 1985, p.187-98.
Cook, M. and Farquharson, C., Business Economics, United Kingdom, Financial
Times Prentice Hall, 1998.
Davies,H. and Lam, Managerial Economics. An Analysis of Business Issues, United
Kingdom, Financial Times Prentice Hall, 2001.
Katz, M. and Rosen, H., Microeconomics, United States of America, Mc Graw-Hill,
1998.
McNutt, P., Managerial Economics Unit 1. Management Objectives and Stakeholder
value, Bangor, U.K., Business & Management Education Limited, 2005.
McNutt, P., Managerial Economics Unit 2. Cost Leadership and the Production
Process, Bangor, U.K., Business & Management Education Limited, 2005.
McNutt, P., Managerial Economics Unit 3. Strategic Rivalry and the Competitive
Process, Bangor, U.K., Business & Management Education Limited, 2005.

Sloman, Essentials of Economics, United Kingdom, Financial Times Prentice Hall,


2004.

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