In Chapter 7 ("Consumer Choice and Elasticity"), there is coverage of material concerning complements, substitutes, and income elasticities. You may wish to refer back to this chapter to complement the content here.
In the previous section, we examined what happens to the market equilibrium when the supply and/or demand curves move. Because markets are dynamic things, that is, they are always changing with time, the market equilibrium is always moving. From the previous section, you should understand what happens to a market when the demand and supply curves move up or down (or in or out.) Now we want to consider why these curves move.
It is important to remember that the supply and demand diagram is a static object, but the economy is not static, and things are changing all the time. A supply and demand diagram is only a snapshot of a market at some fixed point in time. We need to understand what causes changes, and what results from these changes.
Causes of Demand Curve Movements
When thinking of things like this, I always like to go back to “first principles.” Or what are sometimes called “fundamentals.” That is, when trying to understand why something happens, try to go back to the underlying root causes. To do that in this instance, we first have to understand what a demand curve is. You should be able to tell me at this point: it is a functional relationship that describes the quantity of goods that consumers in a market will want to purchase at any given price. Digging a bit deeper into the fundamentals, we understand where the demand curve comes from: marginal utility, or how much happiness the consumers obtain from consuming the good.
So, if the demand curve comes from the amount of utility a consumer will get from consuming the good, then the demand curve can only change if the consumers get a different amount of utility from the good in question.
That’s a bit of a mouthful. I’ll try to make it simpler: demand curves change because people change their willingness to pay. They want to buy more or less of the good. The next question then arises: what causes this change in utility?
There are several factors that can cause the demand curve to shift. If the curve shifts upwards (or outwards, away from the origin), then more of a good is demanded by the consumers at a given price. Or, looked at another way, for a fixed quantity, the price will be higher. This means that people derive more utility from a unit of the good. If the reverse happens, and the curve shifts down (or inwards, toward the origin) then less is demanded at a given price, or a lower price will be offered for a certain quantity, and this happens because something has caused the consumer to derive less utility from consumption of the good.
Some Causes of Demand Shifts
Cause #1 – Population
This one is pretty trivial. As we know, a market demand curve is simply an aggregation of every consumer’s individual demand curve. So, it is a matter of arithmetic to understand that if there are more consumers, then there are more individual demand curves to add together, and therefore, the demand curve will be further to the right. There are many examples of this. For example, when Penn State was a much smaller school, in the 1960s and 1970s, there were far fewer apartment complexes in State College. We now have many more apartments than we had in 1970 because there are far more students, and not because students today want to consume more apartments than they did 40 years ago.
Cause #2 – Income
As a person makes more money, their ability to consume more goods increases. The “willingness to pay” increases because the consumer has more money to spend. For this reason, for a lot of goods, as a person makes more money, the individual demand curve shifts to the right. In a community, the wealthier the community, the more the aggregate demand curve moves outwards. This explains why stores that sell luxury goods are usually in well-to-do suburbs, and not poor, inner-city neighborhoods.
To describe this situation, we define something called the “income elasticity of demand.” This is written as follows:
where “I” is the symbol for income
Spelled out, this means “the percent change in the quantity demanded for a given percent change in income.” If your consumption of sushi goes from 2 times a month to 3 when your salary goes up 10%, then your income elasticity of demand for sushi is .
Example, assume demand for economy car falls from 4000 to 3000 units per year if the average real income of the customers decreases from $60,000 to $50,000. Find the income elasticity of demand for the economy car in this town.
Using the income elasticity of demand formula,
The income elasticity can either be positive or negative. If it is positive, then the quantity demanded increases as income increases (a positive number divided by a positive number). Goods that have positive income elasticities are usually referred to as “normal” goods by economists. Luxury cars have positive income elasticities.
It is also possible for a good to have a negative income elasticity. This means that as I increases, Q decreases (a negative number divided by a positive number = a negative number). What does this mean? It means that as a person makes more money, their marginal utility from consuming a certain good declines. I mentioned above that while luxury cars have positive income elasticities, we might say that used cars, or economy cars, have negative elasticities: as people in a society make more money, they are less likely to consume a good. I know that as I have gone through life, my willingness to buy new cars has increased, and my desire to purchase used cars has declined.
Another example might be ramen noodles: students typically do not have a lot of money, so they buy a lot of cheap food, and ramen noodles are about as cheap as it comes. However, when students graduate and get jobs, they can afford to eat better, more satisfying meals, and given that most of us eat a fixed amount of food, this means that the quantity of ramen noodles decreases as income rises. (For the record, I still like a brick of noodles every once in a while, but I do not eat them nearly as much as when I was a student.)
Goods that have negative income elasticities are referred to by economists as “inferior” goods. An inferior good is one that we consume less of as we become wealthier. As we have more money, we can substitute for the inferior good with something that is more expensive, but more enjoyable. We will talk more about substitutes in a minute.
Cause #3 – The Price of Other Goods
The willingness to pay for a good is always relative to the willingness to pay for any and all other goods. The price of some other good can have an effect on our consumption choices.
When we think of how the price of one good can affect the demand curve for another good, we have to define two categories of goods: substitutes and complements.
A substitute is a good that you would consume instead of the good in question. As mentioned above, ramen noodles and steaks can be thought of as substitutes: if you are eating a lot of one, you are likely not eating a lot of the other. Life is full of substitution options: working instead of going to school, taking the bus instead of driving, renting a house instead of buying, taking an expensive vacation versus buying football tickets, going to a movie instead of going to a nightclub, and so on.
A complement is a good that you consume in addition to the good in question, with the condition that without one, you would not consume the other. For example, cars and gasoline (and tires) are all complements. On their own, each of these goods is fairly useless. But use them together, and they suddenly have more value. And, as you consume more of one, you are likely to consume more of another. Think of DVDs and DVD players, or iPods and earbuds, or shoes and shoelaces.
Now, we have to think about how the price of one good can affect the price of another. For this, we define the term “cross-elasticity of demand”. This is defined as follows:
where X and Y are subscripts denoting the two goods in question.
Spelled out, this statement reads: the cross-elasticity of goods X and Y is the percent change in the quantity of good X demanded that corresponds to a percent change in the price of good Y.
Assume demand for chicken is 2000 lbs per day and beef price $3/lb. Holding everything else constant, demand for chicken increases to 3000 lbs per day when beef price increase to $4/lb. Calculate cross-elasticity of demand for chicken.
The cross-elasticity can be either positive or negative, and the sign will tell us if goods are substitutes or complements. In the previous example cross-elasticity of chicken and beef is positive. So, we can say they are substitutes.
Let’s think of two common substitutes: chicken and beef. It is not hard to understand that if the price of beef goes up while the price of chicken stays the same, then people will tend to substitute chicken for beef. So, as the price of beef increases, the quantity of chicken demanded increases. The cross-elasticity in this case is a positive number divided by a positive number (or a negative divided by a negative), which gives us a positive number. Therefore, substitute goods have a positive cross-elasticity.
Now, let us think about complements. In the 1980s, CD players came on to the market. At first, CD players were very expensive, and very few people had them. Correspondingly, there were fewer music CDs sold. Over time, the price of CD players came down, and as a result, the quantity of CDs sold increased dramatically (even though the price did not change much for many years). It is easy to see that CD players and CDs are complements: one of the two is of little use without the other. So, when we look at our formula for the cross-elasticity, a decrease in the price of CD players led to an increase in the quantity of CDs demanded. A positive number ( ) is divided by a negative number ( ). Thus, the cross-elasticity is negative.
This leads to the definition of a handy rule: if the cross-elasticity of two goods can be shown to have a consistently positive value, then the goods are substitutes. If the cross-elasticity is shown to be consistently negative, the goods are complements. If the cross elasticity is either zero, or inconsistent, then it is likely that the goods are neither complements nor substitutes, but unrelated. Obviously, in our complicated economy, everything is related to everything else - the price of jet planes in Europe probably has some effect on the price of corn in Illinois, but the effect of one on the other is so dispersed as to be unobservable in any meaningful manner.