Question

1) Explain that by using elasticity we can characterize goods as complementary and substitutes.
2) In what form of demand elasticity does a producer reduce its total revenue with an increase in price? Explain diagrammatically.
3) In what form of demand curve does a producer keep his total revenue constant with an increase in price? Explain diagrammatically.

Answer 1

1) We can characterize goods as complementary and substitutes based on cross-price elasticity of demand. Cross-price elasticity measures the responsiveness of demand to changes in price of related goods. When price of a substitute increases, the demand for the good under consideration increases and hence cross-price elasticity will be positive for substitutes. When price of a complimentary good increases, the demand for the good under consideration falls and hence the cross-price elasticity will be negative in case of complimentary goods. Thus by looking at the sign of coefficient of cross-price elasticity of demand we can characterize goods as complementary and substitutes.