Question

A study of consumers in Mexico found that the cross-price elasticity of demand between soda and milk was 0.11 , while the cross-price elasticity of demand between soda and candy was -0.32 . Is soda a substitute or a complement for milk? Is soda a substitute or a complement for candy? Briefly explain.

Short answer

Soda is a substitute for milk and a complement for candy.

Step-by-step solution

Analyze the cross-price elasticity of demand between soda and milk

The cross-price elasticity of demand between soda and milk was found to be 0.11, which is a positive number. By definition of cross-price elasticity, if the coefficient is positive, then the goods are substitutes.

Analyze the cross-price elasticity of demand between soda and candy

The cross-price elasticity of demand between soda and candy was found to be -0.32, which is a negative number. By definition of cross-price elasticity, if the coefficient is negative, then the goods are complements.

Explanation of findings

Soda is a substitute for milk because when the price of milk increases, consumers turn to soda as an alternate drink, and thus the demand for soda increases. On the other hand, soda and candy are complements because if the price of candy increases, consumers reduce their consumption of candy and thus also reduce their consumption of soda, leading to a decrease in demand for soda.

Key concepts

Substitute Goods

Substitute goods are items that can replace each other in consumer preferences. When the price of one increases, the demand for its substitute tends to rise as consumers switch preferences. For example, if soda and milk are substitutes, an increase in the price of milk can lead consumers to buy more soda. This is reflected in a positive cross-price elasticity, indicating that the goods fulfill similar needs or wants. Understanding substitutes helps businesses and economists predict how changes in market conditions can shift consumer behavior and affect demand.

Complementary Goods

Complementary goods are products that are often used together. When the price of one drops, the demand for both may increase because they are consumed in conjunction. In our example, soda and candy have a negative cross-price elasticity. This means when the price of candy goes up, the demand for both candy and soda goes down, showing these goods are complements. Recognizing complements is crucial for businesses as it allows them to bundle products effectively or offer promotions that drive the sale of both items simultaneously. These relationships highlight the interdependent nature of certain goods in everyday consumption.

Consumer Behavior

Consumer behavior examines how individuals make decisions to allocate their resources among various options. This study includes understanding the impact of factors like price changes, income, and tastes on purchasing choices. When analyzing consumer behavior, it's essential to consider how consumers respond to the prices of substitute and complementary goods. For instance, if the price of milk increases, consumers might alter their consumption patterns by purchasing more soda (a substitute), showcasing adaptability. By studying these patterns, businesses can tailor their strategies to align more closely with consumer preferences and maximize satisfaction.

Economic Analysis

Economic analysis is the process of assessing the factors that affect the economy, including the study of consumer behavior patterns, market structures, and resource allocation. Cross-price elasticity is a valuable component of this analysis, as it quantifies how the demand for one good responds to price changes in another. Through economic analysis, businesses and policymakers can make informed decisions, like identifying potential substitutes or complements for new products. It combines theory and empirical data to create models that simulate real-world economic scenarios, helping predict outcomes and optimize resource distribution.