Substitution and Elasticity

ByMike Fladlien

Muscatine High School

SubstitutesTwo goods are substitutes when the price of good x decreases and the demand for its substitute decreases.

In this case, the consumer behaves in a way that tacos and tamales are subs. When the price of tacos falls from $2 to $1, the consumer decreases the demand for tamales from 2 to 1.

The intuition is now that tacos are relatively cheaper, the consumer subs tacos for tamales. Because the price of tacos is so cheap and consumes a relatively small amount of her budget, the entire change in demand is due to the substitution effect.

SubstitutesTwo goods are substitutes when the price of good x decreases and the demand for its substitute decreases.

In this case, Juan likes to wear both red and green polo shirts. When the price of red polo shirts goes up, Juan increases his demand for green polo shirts.

At point s A Juan is spending $10 and consuming 5 units of each shirt. When the price increases to $2 for red polos, Juan buys 1 red polo and 8 green. Juan still spends $10, but the composition of his spending has changed.

Note that the two items are not perfect subs.

The Elasticity FormulaThe cross elasticity of demand formula shows that when two goods are subs, the coefficient will be positive. That is, when the price of good y increases so will the demand for its sub. Likewise, when the price of good y decreases so will the demand for its sub. Subs are directly related.

Please view AmosWeb.com for more discussion.

Some Cross Elasticities

Reference: Wikipedia.com

The table to the left shows that butter and margarine and beef and pork are substitutes, but entertainment and food are complements.

Good Price Change X

XED

Butter Margarine +0.81

Beef Pork +0.28

Entertainment

Food -0.72