Cross Price Elasticity

Introduction

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.

It is 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 other goods.

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 price elasticity measures how sensitive the demand of a product is over a shift of a corresponding products price.
  • A price increase of a complementary product will lead to lower demand or negative cross price elasticity and a price increase in a substitute product will lead to increased demand or a positive cross-price elasticity.
  •  Unrelated products have zero cross-price elasticity.
  • Cross Price elasticity of demand measures the relationship between two products and how the price change of one affects the demand of the other.
  • These can be categorized in three type: substitute goods, complementary goods and unrelated goods.
  • Cross Price Elasticity of Demand can be calculated by dividing change in demand of X by change is price of Y.

Cross Price Elasticity of demand (XED) covers three types of good, substitute goods and complementary goods and unrelated goods. By determining the cross price elasticity of demand we can determine the relationship between them.

XED > 0 : The two products / services are substitute goods, which indicates Positive Cross price Elasticity.

XED < 0 : The two products / services are complementary goods and indicate Negative Cross Price Elasticity.

XED = 0 : The two products / services are unrelated.

Types of Cross Price Elasticity

Cross price elasticity can come in three forms : positive elasticity, negative elasticity, and unrelated. Let’s look at them below :

1. Positive Cross Price Elasticity (Substitutes)

Positive cross price elasticity occurs when the formula produces a result greater than zero. That means when the price of a product X increases, the demand for product Y also increases.

For example McDonald’s may increase the price of its product by 20%. Inturn customers would prefer to go to Burger King as they may offer a cheaper meal.

Consequently, Burger King sees a rise in demand of 10%. This would suggest that there is a positive relationship between the two.

Price cross elasticity is also known as cross elasticity of demand for substitutes. In short this means that the two goods being compared are substitute products.

This can come in the form of close substitutes such as Starbucks and Costa coffee or it can come in the form of weak substitutes such as tea and coffee.

By contrast, weak substitute goods still have a relationship between them but it is not substantial. For example, ordinary tea and coffee in the supermarket are not widely exchange for one another.

However, they are substitute goods.

2. Negative Cross Price elasticity

Negative cross price elasticity occurs when the formula produces a result of less than zero. This means that when the price of a product X increases the demand for a product Y decreases.

In other words consumer see price rise of one product and actually buy less of the other product. This is also known as a complementary good.

 A complementary goods may be something like an iPhone and and iPhone case. In essence a consumer won’t buy an iPhone case without fire for purchasing an iPhone.

So the complementary good is reliant on the other’s demand.

when the price of an iPhone goes up demand is likely to fall. At the same time if fewer people that buying iPhones, there will also be fewer people buying iPhone cases.

Weak complementary goods are therefore two goods that are used with each other, but not on a frequent basis.

3. Unrelated Cross Price Elasticity

Unrelated cross price elasticity occurs when the formula produces a result of exactly zero. This means that the price of product X can increase by 100% but have no effect of demand for product Y.

When comparing the two products they have no relationship.

For example, we can compare two random product milk and iPhone. if the price of milk was to increased by 10% it would have no impact on the number of iPhone sold.

Cross Price Elasticity Formula

We can calculate Cross Price Elasticity using the formula:

Cross Elasticity of Demand (XED) = % Change in Demand of X / %Change in Price of Y

Example:-

Let us compare Pizza Hut and Domino’s. After deep consideration Pizza Hut increases its price by 10%. Consumers do not like the price increase and think they are getting ripped off.

Consequently they switched to Domino’s thereby increasing demand by 5%.

Solution:-

Formula : % Change in Demand of X / % Change in Price of Y

               5 / 10 = 0.5

This would indicate that the relationship between  Pizza Hut and Domino’s is that of a substitute good. Therefore we can conclude that the relationship is elastic.

Why is Cross Price Elasticity of Demand useful ?

1. Identify complementary products

The firm can potentially use such products to bundle together to create extra demand. For example, most retailers offer a Play station bundled with games.

They usually offer a slide discount  over buying them separately, which can help stimulate demand.

2. Pricing Strategy

The firm can see how consumers respond to prices. If Company A increases prices and sees the products of Company B increase in demand, it shows that it needs to consider this impact.

3. Organizational Strategy

Whether this occurs with a complementary products of substitute, if the firm can identify a crucial areas, they may look to integrate.

This could come through acquiring or merging with competitors, or through acquiring other firms in the supply chain.


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