What Is Cross Elasticity of Demand?
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. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good.
- 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.
Cross Elasticity of Demand
Cross Elasticity Demand Formula
Exy=Percentage Change in Price of YPercentage Change in Quantity of XExy=PyΔPyQxΔQxExy=QxΔQx×ΔPyPyExy=ΔPyΔQx×QxPywhere:Qx=Quantity of good XPy=Price of good YΔ=Change
In economics, the cross elasticity of demand refers to how sensitive the demand for a product is to changes in price of another product.
Explaining Cross Elasticity of Demand
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.
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.
Toothpaste is an example of a substitute good; if the price of one brand of toothpaste increases, the demand for a competitor's brand of toothpaste increases in turn.
Usefulness of Cross Elasticity of Demand
Companies utilize the 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.
Frequently Asked Questions
What does the cross elasticity of demand measure?
Cross elasticity of demand evaluates the relationship between two products when the price in one of them changes. It shows the relative change in demand for one product as the price of the other rises or falls.
What does a positive cross elasticity of demand indicate?
A positive cross elasticity of demand means that the demand for good A will increase as the price of good B goes up. This means that goods A and B are good substitutes, so that if B gets more expensive, people are happy to switch to A. An example would be the price of milk. If whole milk goes up in price, people may switch to 2% milk. Likewise, if 2% milk rises in price instead, whole milk becomes more in demand.
What does a negative cross elasticity of demand indicate?
Likewise, a negative cross elasticity of demand indicates that the demand for good A will decrease as the price of B goes up. This suggests that A and B are complementary goods, such as a printer and printer toner. If the price of the printer goes up, demand for it will drop. As a result of fewer printers being sold, less toner will also be sold.
How does cross elasticity of demand differ from demand elasticity?
Cross elasticity looks at the proportional changes in demand among two goods. Demand elasticity (or price elasticity of demand) by itself looks at the change in demand of a single item as its price changes.
How does this differ from the cross elasticity of supply?
In contrast to changes in demand of two goods in response to prices, the cross elasticity of supply measures the proportional change in the quantity supplied or produced in relation to changes in the price of a good.