Cross elasticity of demand (XED) measures the percentage change in quantity demand for a good after the change in price of another.
XED = % change in Q.D. good A
% change in P good B
Cross elasticity of demand for Coffee / Tea
For example: if there is an increase in the price of tea by 10%. and Q.D of coffee increases by 2%, then XED = +0.2
For goods which are substitutes, we expect to see a positive cross elasticity of demand. If the price of Asda bread increases, people will buy more of an alternative, such as Mother’s Pride bread.
- Weak substitutes like tea and coffee will have a low cross elasticity of demand
- Alternative brands of chocolate, e.g. Dairy Milk vs Wispa are quite similar, so will have a higher cross elasticity of demand.
These are goods which are used together, therefore the cross elasticity of demand is negative. If the price of one goes up, you will buy less of both goods.
- For example, if the price of DVD players goes down, you will buy more DVD players and also there will be a increase in demand for DVD disks.
- If the price of Samsung mobile phones goes down, we will also buy more Samsung related phone apps.
Using knowledge of cross elasticity of demand
- When setting prices firms will have to look at what alternatives the consumer has, if there are no close substitutes they will be able to increase the price. For this reason firms spend a lot of money on advertising to differentiate their products and reduce cross elasticity of demand.
- A firm may offer a loss leader to attract complementary sales. For example, a firm may offer a printer, at a low price, because it knows this will lead to increased sales for the highly profitable ink cartridges.