Economics 217

Chapter 6: “Elasticities and Demand

Relationships Among Goods”

Nadine Yamout
American University of Beirut

Spring 2022-2023

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Class Outline

1. Demand Elasticities
2. Consumer Surplus
3. Demand Relationship for Two Goods
4. Substitutes and Complements
5. Substitutability with Many Goods
6. Class Summary

Readings: Nicholson and Snyder, Chapters 5.7-5.9 & 6.1-6.4

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Demand Elasticities
Demand Elasticities

• Focusing on derivatives has one major disadvantage for empirical

work: The sizes of derivatives depend directly on how variables are
measured.

• That can make comparisons among goods or across countries and

time periods difficult.

• For this reason, most empirical work in microeconomics uses some

form of elasticity measure.

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Marshallian Demand Elasticities

1. Price elasticity of demand (ex,px ): measures the proportionate change

in quantity demanded in response to a proportionate change in a
good’s own price
∆x/x ∆x px ∂x(px , py , I ) px
ex,px = = · = ·
∆px /px ∆px x ∂px x

2. Income elasticity of demand (ex,I ): measures the proportionate change

in quantity demanded in response to a proportionate change in income
∆x/x ∆x I ∂x(px , py , I ) I
ex,I = = · = ·
∆I /I ∆I x ∂I x

3. Cross-price elasticity of demand (ex,py ): measures the proportionate

change in the quantity of x demanded in response to a proportionate
change in the price of some other good (y ):
∆x/x ∆x py ∂x(px , py , I ) py
ex,py = = · = ·
∆py /py ∆py x ∂py x 4
Price Elasticity of Demand

• The (own-) price elasticity of demand provides a convenient way of

summarizing how people respond to price changes for a wide variety
of economic goods.
• A distinction is usually made between cases of elastic demand (where
price affects quantity significantly) and inelastic demand (where the
effect of price is small).
• The price elasticity of demand is negative, except in the unlikely case
of Giffen’s paradox.
• The dividing line between large and small responses is generally set
at 1:
• if ex,px = −1, changes in x and px are of the same proportionate size.
Demand is said to be unit-elastic.
• if ex,px < −1, quantity changes are proportionately larger than price
changes. Demand is said to be elastic.
• if ex,px > −1, quantity changes are proportionately smaller than price
changes. Demand is said to be inelastic.
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Price Elasticity and Total Spending

• The price elasticity of demand determines how a change in price,

ceteris paribus, affects total spending on a good:

∂(px · x) ∂x
= px · + x = x(ex,px + 1)
∂px ∂px

• The sign of this derivative depends on whether ex,px is greater or less

than -1:
• if 0 > ex,px > −1, demand is inelastic and price and total spending
move in the same direction.
• if ex,px < −1, demand is elastic and price and total spending move in
opposite directions.
• if ex,px = −1, demand is unit-elastic and total spending is constant
no matter how price changes.

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Compensated Price Elasticities

It is also useful to define elasticities based on the compensated demand

function.

1. Compensated price elasticity of demand (ex c ,px ): measures the

proportionate compensated change in quantity demanded in response
to a proportionate change in a good’s own price
∆x c /x c ∆x c px ∂x c (px , py , U) px
ex c ,px = = · c = · c
∆px /px ∆px x ∂px x

2. Compensated cross-price elasticity of demand (ex c ,py ): measures

the compensated proportionate change in the quantity demanded in
response to a proportionate change in the price of some other good:
∆x c /x c ∆x c py ∂x c (px , py , U) py
ex c ,py = = · c = · c
∆py /py ∆py x ∂py x

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Compensated Price Elasticities

• Whether the Hicksian price elasticities differ much from their

Marshallian counterparts depends on the importance of income effects
in the overall demand for good x.
• The precise connection between the two can be shown by multiplying
the Slutsky equation by the factor px /x:
px ∂x px ∂x c px ∂x
· = · − ·x ·
x ∂px x ∂px x ∂I

⇒ ex,px = ex c ,px − sx ex,I

where sx = px x/I is the share of total income devoted to the purchase
of good x.
• This equation shows that compensated and uncompensated own-price
elasticities of demand will be similar if either of two conditions hold:
1. the share of income devoted to good x (sx ) is small
2. the income elasticity of demand for good x (ex,I ) is small
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Homogeneity

• The homogeneity of demand functions can also be expressed in

elasticity terms.
• Because any proportional increase in all prices and income leaves
quantity demanded unchanged, the net sum of all price elasticities
together with the income elasticity for a particular good must sum to
zero:
∂x ∂x ∂x
0 = px · + py · +I ·
∂px ∂py ∂I

• Dividing by x, we get:

0 = ex,px + ex,py + ex,I

• This result shows that any proportional change in all prices and income
will leave the quantity of x demanded unchanged.
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Engel Aggregation

• Engel’s law suggests that the income elasticity of demand for food
items is less than one. This implies that the income elasticity of
demand for all nonfood items must be greater than one
• We can see this by differentiating the budget constraint with respect
to income (treating prices as constant):
∂x ∂y
1 = px · + py ·
∂I ∂I

• A bit of algebraic manipulation of this expression yields:

∂x xI ∂y yI
1 = px · + py · = sx ex,I + sy ex,I
∂I xI ∂I yI
where si represents the share of income spent on good i.
• This result shows that the weighted average on income elasticities for
all goods that a person buys must be 1.
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Cournot Aggregation

• The size of the cross-price effect of a change in the price of x on the

quantity of y consumed is restricted because of the budget constraint.
• We can demonstrate this by differentiating the budget constraint with
respect to px :
∂I ∂x ∂y
= 0 = px + x + py ·
∂px ∂px ∂px

• Multiplication of this equation by px /I yields:

∂x px x ∂y px y
0 = px · · · + py · · ·
∂px I x ∂px I y
0 = sx ex,px + sx + sy ey ,px
• So the final Cournot result is:

sx ex,px + sy ey ,px = −sx

• The budget constraint imposes some limits on the degree to which
the cross-price elasticity ey ,px can be positive.
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Consumer Surplus
Consumer Welfare

• An important problem in welfare economics is to devise a monetary

measure of the gains and losses that individuals experience when prices
change.

• One way to evaluate the welfare cost of a price increase (from px0
to px1 ) would be to compare the expenditures required to achieve U0
under these two situations:

expenditure at px0 = E (px0 , py , U0 )

expenditure at px1 = E (px1 , py , U0 )

• In order to compensate for the price rise, this person would require a
compensating variation (CV) of:

CV = E (px1 , py , U0 ) − E (px0 , py , U0 )

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CV and Compensated Demand Curve

• Shephard’s lemma shows that the compensated demand function

for a good can be found directly from the expenditure function by
differentiation:
∂E (px , py , U)
x c (px , py , U) =
∂px

• Hence the compensating variation can be found by integrating across

a sequence of small increments to price from px0 to px1 :
Z px1 Z px1
∂E (px , py , U)
CV = dpx = x c (px , py , U)dpx
px0 ∂px px0

while holding py and utility constant.

• The integral has a geometric interpretation: It is the shaded area to
the left of the compensated demand curve and bounded by px0 and
px1 .
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CV and Compensated Demand Curve

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The Consumer Surplus Concept

• Because a price change generally involves both income and

substitution effects, it is unclear which compensated demand curve
should be used.

• Do we use the compensated demand curve for the original target

utility (U0 ) or the new level of utility after the price change (U1 )?

• Luckily, the Marshallian demand curve provides a convenient

compromise between these two measures.

• We will define consumer surplus as the area below the Marshallian

demand curve and above market price. It shows what an individual
would pay for the right to make voluntary transactions at this price

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The Consumer Surplus Concept

For small changes in price, the area to the left of the Marshallian demand
curve is a good measure of welfare loss.
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Example: Welfare Loss from Price Increase

• Suppose that the compensated demand function for x is given by:

Vpy0.5
x c (px , py , V ) =
px0.5

• The welfare cost of a price increase from px = 1 to px = 4 is given

by:
Z 4 px =4
Vpy0.5 px−0.5 dpx = 2Vpy0.5 px0.5 

CV =
1 px =1

• If we assume V = 2 and py = 4, then:

CV = 2 · 2 · 2 · (4)0.5 − 2 · 2 · 2 · (1)0.5 = 8

• If instead we believe that the utility level after the price increase (V =
1) were the more appropriate utility target, then
CV = 1 · 2 · 2 · (4)0.5 − 1 · 2 · 2 · (1)0.5 = 4 17
Example: Welfare Loss from Price Increase

• Suppose that we use the Marshallian demand function instead

x(px , py , I ) = 0.5Ipx−1

• The welfare loss of a price increase from px = 1 to px = 4 is given

by:
Z 4 px =4

Loss = 0.5Ipx −1dpx = 0.5I ln px 
1 px =1

• If I = 8, then:

Loss = 4 ln(4) − 4 ln(1) = 5.55

• The computed loss from the Marshallian demand function is

a compromise between the two amounts computed using the
compensated demand functions.
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Demand Relationship for Two
Goods
Directions of Cross-Price Effects

• In (a), substitution effects are small; therefore, the quantity of x consumed

∂x
increases along with y . Because ∂p y
< 0, x and y are gross complements.
• In (b), substitution effects are large; therefore, the quantity of x chosen
∂x
decreases. Because ∂p y
> 0, x and y are gross substitutes. 19
A Mathematical Treatment

• The change in x caused by changes in py can be shown by a

Slutsky-type equation:

∂x ∂x  ∂x
= −y ·
∂py ∂py U = constant ∂I

• In elasticity terms:
ex,py = ex c ,py − sy ex,I

• Notice that the size of the income effect is determined by the share of
good y in this person’s purchases. The impact of a change in py on
purchasing power is determined by how important y is to this person.

• The combined effect is ambiguous so ∂x/∂py could be either positive

or negative.
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Substitutes and Complements
Substitutes and Complements

• For the case of many goods, we can generalize the Slutsky analysis

∂xi ∂xi  ∂xi
= −xj ·
∂pj ∂pj U = constant ∂I

• In elasticity terms:
exi ,pj = exic ,pj − sj exi ,I

• This implies that the change in the price of any good induces income
and substitution effects that may change the quantity of every good
demanded.
• Two goods are substitutes if one good may, as a result of changed
conditions, replace the other in use. Some examples are tea and
coffee, hamburgers and hot dogs, and butter and margarine.
• Two goods are complements, if they are used together such as coffee
and cream, or fish and chips.
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Gross (Marshallian) Substitutes and Complements

• The concepts of gross substitutes and complements include both

substitution and income effects
• Two goods are gross substitutes if
∂xi
>0
∂pj

• Two goods are gross complements if

∂xi
<0
∂pj
• One undesirable characteristic of the gross definitions of substitutes
and complements is that they are not symmetric.
• It is possible for x1 to be a substitute for x2 and at the same time for
x2 to be a complement of x1 .
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Net (Hicksian) Substitutes and Complements

• Because of the possible asymmetries involved in the definition of gross

substitutes and complements, an alternative definition that focuses
only on substitution effects is often used.
• Two goods are net substitutes if

∂xi 
>0
∂pj U = constant
• Two goods are net complements if

∂xi 
<0
∂pj U = constant
• These definitions look only at the substitution terms to determine
whether two goods are substitutes or complements.
• Once xi and xj have been discovered to be substitutes, they stay
substitutes, no matter in which direction the definition is applied:
 
∂xi  ∂xj 
=
∂pj U = constant ∂pi U = constant
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Substitutability with Many
Goods
Substitutability with Many Goods

• A major theoretical question that has concerned economists is whether

substitutability or complementarity is more prevalent.
• According to Hicks’ second law of demand, “most” goods must be
net substitutes.
• To prove this, we can start with the compensated demand function
for a particular good xic (p1 , . . . , pn , V ) and apply Euler’s theorem:
∂xic ∂x c ∂x c
p1 · + p2 · i + · · · + pn · i = 0
∂p1 ∂p2 ∂pn
• In elasticity terms, we get:
c c
ei1 + ei2 + · · · + einc = 0
• Since the negativity of the substitution effect implies that eiic ≤ 0, it
must be the case that X
eijc ≥ 0
j̸=i
• The sum of all the compensated cross-price elasticities for a particular
good must be positive. So, “most” goods are net substitutes. 24
Class Summary
Class Summary

• Demand elasticities are often used in empirical work to summarize

how individuals react to changes in prices and income. The most
important such elasticity is the (own-) price elasticity of demand.
• Welfare effects of price changes can be measured by changing areas
below either compensated or Marshallian demand curves. Such
changes affect the size of the consumer surplus that individuals receive
from being able to make market transactions.
• Two goods xi and xj are gross substitutes if ∂xi /∂pj > 0 and gross
complement if ∂xi /∂pj < 0. Unfortunately, because these price effects
include income effects, they need not be symmetric.
• Focusing only on the substitution effects from price changes eliminates
this ambiguity because substitution effects are symmetric. Two goods
are defined as net (or Hicksian) substitutes if ∂xic /∂pj > 0 and net
complements if ∂xic /∂pj < 0.
• Hicks’ second law of demand shows that net substitutes are more
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prevalent.