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.
Key Takeaways
- Cross elasticity of demand measures the responsiveness in the quantity demanded of one good when the price of another good changes.
- It’s always positive for substitute goods because demand for one good increases when the price of the substitute increases.
- For complementary goods, cross elasticity of demand is negative as these goods are often consumed together.
- Unrelated goods generally have no cross-elasticity of demand.
- Companies leverage cross elasticity to strategically price their goods and services.
The Formula for Cross Elasticity of Demand
[ E_{xy} = \frac {\text{Percentage Change in Quantity of X} }{ \text{Percentage Change in Price of Y} } ]
Where:
- (E_{xy}) = Cross elasticity of demand
- (Q_x) = Quantity of good X
- (P_y) = Price of good Y
- Δ = Change
How to Calculate Cross Elasticity of Demand
Here’s a step-by-step guide to calculate cross price elasticity of demand:
- Determine the initial and final quantity demanded of good X, and the initial and final price of good Y.
- Calculate the percentage change in quantity demanded of X: [ \text{Percentage change in Q_x} = \frac{ΔQ_x}{Q_{initial}} ]
- Calculate the percentage change in price of Y: [ \text{Percentage change in P_y} = \frac{ΔP_y}{P_{initial}} ]
- Finally, divide the percentage change in the quantity demanded of X by the percentage change in price of Y to get the cross elasticity of demand.
Understanding Cross Elasticity of Demand
Cross elasticity of demand examines how sensitive the quantity demanded for one product is to changes in the price of another product. Depending on whether these goods are substitutes, complements, or unrelated, the cross elasticity will vary.
Substitute Goods
For substitute goods, the cross elasticity of demand is positive. For instance, if the price of coffee rises, more consumers may switch to tea. This parallel increase implies a high cross-elasticity.
Complementary Goods
In the case of complementary goods, the cross elasticity of demand is negative. Taking coffee and stir sticks as an example: if coffee prices go up, fewer people will buy coffee, resulting in a decrease in the demand for stir sticks.
Strategic Implications
Companies use cross elasticity of demand for strategic pricing. Products without substitutes can be priced higher due to negligible cross elasticity, whereas pricing strategies for products with substitutes or complements are more nuanced.
Examples
Substitute Goods Example: Consider chicken burritos at two restaurants. If Restaurant A raises its price, the demand for Restaurant B’s burritos increases.
Complementary Goods Example: A drop in the price of burgers may lead to increased demand for fries as these are often consumed together.
Conclusion
Understanding cross elasticity of demand is crucial in evaluating market behaviors and setting strategic prices. It examines how the demand for one good shifts with the price change of another, offering valuable insight for businesses and economists alike.
Related Terms: demand elasticity, price elasticity of demand, cross elasticity of supply, substitute goods, complementary goods.
References
- Corporate Finance Institute. “Cross-Price Elasticity”.
- Economics Online. “Cross Elasticity of Demand”.
