Cross elasticity of demand

Cross elasticity of demand (XED) measures the percentage change in quantity demand for a good after a change in the price of another.

cross-elasticity-of-demand

For example: if there is an increase in the price of tea by 10%. and the quantity demanded for coffee increases by 2%, then the cross elasticity of demand = 2/10  = +0.2

  • Substitute goods will have a positive cross-elasticity of demand.
  • Complements will have a negative cross elasticity of demand
  • Unrelated goods will have a cross-elasticity of demand of zero. The price of apples has no effect on demand for Apple computers.

Substitute Goods and XED

xed-substitutesExplanation of XED (Tea and coffee)

% change in Q.D. = (210-200)/200 = 10/200 = 5%

% change in price (1.5-1.2)/1.2 = 0.3/1.2 = 25%

 

  • Weak substitutes like tea and coffee will have a low cross elasticity of demand. If the price of tea increases, it will encourage some people to switch to coffee. But for most people, their preference for a particular drink is more important than a small difference in price
  • For two alternative brands, for example, Starbucks Coffee and Costa Coffee, these goods are closer substitutes as the difference is much smaller. If the price of Costa Coffee increases, more consumers will switch to an alternative brand such as Starbucks. WIth close substitutes, the XED will be higher.
  • The aim of advertising is to increase brand loyalty and make consumers less willing to switch to another brand – even if price rises.

Complementary Goods and XED

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.

xed-complements

  • If the price of tea increases, there will only be a very small fall in demand for milk. It will have a negative cross elasticity of demand, but it will be a low figure.
  • However, for two goods like Android Phones and Android Apps, there is a stronger relationship. If the price of Android Phones increases, this will reduce the demand for Android Phones and therefore, there will be less demand for Android Apps.

Using knowledge of cross elasticity of demand

  • Substitutes? 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.
  • Loss leaders Firms can use knowledge of complementary products to increase overall revenue. For example, many companies sell printers as cheaply as possible because if they sell a printer, they know the demand for their replacement ink cartridges will increase. (These ink cartridges are very profitable)
  •  If a firm makes a small increase in price and finds people are very willing to switch to alternatives (high XED) they may make greater efforts to pursue product differentiation and brand loyalty to reduce XED.

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