Cross Elasticity of Demand

Elasticity refers to the relationship of one economic variable, such as quantity, demanded to a change in another, such as price.

There are four basic flavors of elasticity. Comin' at ya, bullet-style:

1) Price elasticity of demand shows the relationship between quantity demanded and price. For example, if a product is highly sensitive or elastic to price, a small change in price will lead to a large change in quantity demanded.

Take fast food burgers. You might love a Big Mac. But if they start creeping up the price, you can just go down the street to Wendy's or Burger King or Jack In The Box, or even just dust off the George Foreman grill and make your own.

If a product is highly inelastic to price, a change in price will have very little effect on quantity demanded. Gasoline is a common example here. We need to drive to work and get the kids to school and show off our rides at our drag racing clubs. Gas prices can go up quite a bit before we start to curtail demand in a meaningful way.

2. Price elasticity of supply measures how sensitive the quantity supplied is to a change in price. A firm wants to crank up production as prices rise. Gas prices are rising. You own a refinery. How easily can you increase output to take advantage of the improved prices?

Gallatin!, the sequel to Hamilton, hits Broadway. It gets great reviews and becomes another sensation. Prices skyrocket. But there are only so many seats in the theater. It's difficult to produce more supply, no matter what the prices do. Inelastic.

Meanwhile, the merch for Gallatin! is made in sweatshops in Vietnam. With the popularity of the show, prices for t-shirts and coffee mugs and the like...start to rise. It's relatively easy to increase supply...just extend the workday from 12 hours to 16 hours. Down the road, when the merchandise gets less popular and prices fall, it's simple to scale back production. Elastic.

3. Cross elasticity of demand happens when a price change of one product leads to higher or lower quantity demanded for a related product.

Think: razors and razor blades. If the price of razors suddenly goes sky-high, the demand for razor blades will decrease, because everyone will assumedly be switching to electric razors. This is called "substitution power," and in this case, razors have low power, in that they can easily be...switched.

This type of cross elasticity is considered negative. But if two products might be substituted for each other, such as pineapple juice for orange juice, the cross elasticity will be considered positive. If the two goods are totally unrelated, such as shoes and hair brushes, the cross elasticity is zero. The basic idea revolves around how linked pricing remains against the supply and demand curves as they...wiggle around.

4. Income elasticity of demand measures the change in quantity demanded to changes in income. As our incomes rise or fall, what kind of purchases are most impacted?

You get laid off. You used to be a high-powered corporate lawyer making a six-figure salary. Now you get $400 a week in unemployment. You might trade in the lease on the Lexus for a bus pass, and you might downgrade from a 4,000-square-foot McMansion to a one-room studio apartment. But you still need to pay for electricity and water and cell service. The Lexus is elastic when it come to income. The cell service is inelastic.