Cross Elasticity of Demand measures the responsiveness in the quantity demanded of one good to a change in price of another good. It is calculated by dividing the percentage change in the quantity demanded of one good by the percentage change in the price of another good.
In previous topics we have already learnt about substitutes and compliments. Cross elasticity is used to determine whether two goods are substitutes or complements or whether they fall into any of the two categories at all.
If cross price elasticity of two goods are positive, they are substitutes, where as if the cross price elasticity is negative, they are complements.
Explaining Cross Elasticity of Demand
(i) Substitute Goods
The cross elasticity of demand for substitute goods is always positive because the demand for one good increases when the price for the substitute good increases. For example, if the price of coffee increases, the quantity demanded for tea (a substitute beverage) increases as consumers switch to a less expensive yet substitutable alternative. This is reflected in the cross elasticity of demand formula, as both the numerator (percentage change in the demand of tea) and denominator (the price of coffee) show positive increases.
Items with a coefficient of 0 are unrelated items and are goods independent of each other. Items may be weak substitutes, in which the two products have a positive but low cross elasticity of demand. This is often the case for different product substitutes, such as tea versus coffee. Items that are strong substitutes have a higher cross-elasticity of demand. Consider different brands of tea; a price increase in one company’s green tea has a higher impact on another company’s green tea demand.
(ii) Complementary Goods
Alternatively, the cross elasticity of demand for complementary goods is negative. As the price for one item increases, an item closely associated with that item and necessary for its consumption decreases because the demand for the main good has also dropped.
For example, if the price of coffee increases, the quantity demanded for coffee stir sticks drops as consumers are drinking less coffee and need to purchase fewer sticks. In the formula, the numerator (quantity demanded of stir sticks) is negative and the denominator (the price of coffee) is positive. This results in a negative cross elasticity.
Usefulness of Cross Elasticity of Demand
Companies utilize cross-elasticity of demand to establish prices to sell their goods. Products with no substitutes have the ability to be sold at higher prices because there is no cross-elasticity of demand to consider. However, incremental price changes to goods with substitutes are analyzed to determine the appropriate level of demand desired and the associated price of the good.
Additionally, complementary goods are strategically priced based on cross-elasticity of demand. For example, printers may be sold at a loss with the understanding that the demand for future complementary goods, such as printer ink, should increase.
- The cross elasticity of demand is an economic concept that measures the responsiveness in the quantity demanded of one good when the price for another good changes.
- The cross elasticity of demand for substitute goods is always positive because the demand for one good increases when the price for the substitute good increases.
Alternatively, the cross elasticity of demand for complementary goods is negative.