Introduction

Select the correct terms in brackets:

Bob, our wine-drinking student, has graduated and is now working at the Competition Commission. An application for a merger between the Coca-Cola and Pepsi Cola companies lands on his desk. From what he learnt in his first-year Economics module, Bob remembers that Coca-Cola and Pepsi Cola cool drinks are (substitutes/complements) and have a (positive/negative) cross-elasticity.

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Coca-Cola and Pepsi Cola cool drinks are substitutes and have a positive cross-elasticity.

Substitute goods have positive cross-elasticities of demand: If good A is a substitute for good B, like coffee and tea, then a higher price for B will mean a larger quantity consumed of A.

If the goods are close substitutes, the cross-elasticity will be large, and if they are not close substitutes, the cross-elasticity will be small. Thus, when the cross-elasticity of demand is positive, we are dealing with substitutes, while the size is a measure of how closely substitutable the two goods are.

For instance, Coke and Pepsi, which are close substitutes for most people, will have a large cross-elasticity. However, Coke and orange juice may not be close substitutes for most people, and will therefore have a smaller cross-elasticity.