Answer to Question #208476 in Microeconomics for SHAZEE

Question

Gross substitute and gross complementarity of a good is established on the basis of its substitution and income effects.

Answer 1

Solution:

Yes, it is true that gross substitutes and gross complimentary of a good are established on the basis of its substitution and income effects.

Two goods are gross substitutes if the elasticity of substitution between the two products exceeds the maximum of the respective income elasticities of demand. Normally, two commodities are considered gross substitutes if a price increase of one of the products results in non-decreasing demand for the other good, due to a decrease in increase of income levels. As such, there will be a substitution effect due to a change of the relative prices when the consumer's income is adjusted in a manner that the old preferred consumption bundle is still affordable at new prices. Similarly, the income effect will capture the change in demand when the consumer's income changes.