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Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of demand for one good when the price of a related good changes. It can be positive for substitute goods, meaning demand increases when the substitute's price rises, or negative for complementary goods, where demand decreases when the complement's price rises. The formula uses the percentage change in quantity demanded of one good over the percentage change in price of the other. Businesspeople use cross elasticity to inform pricing and production decisions, such as lowering prices if substitutes cut theirs to avoid lost sales, or reducing production of cars if petrol prices rise since demand will fall.

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45 views

Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of demand for one good when the price of a related good changes. It can be positive for substitute goods, meaning demand increases when the substitute's price rises, or negative for complementary goods, where demand decreases when the complement's price rises. The formula uses the percentage change in quantity demanded of one good over the percentage change in price of the other. Businesspeople use cross elasticity to inform pricing and production decisions, such as lowering prices if substitutes cut theirs to avoid lost sales, or reducing production of cars if petrol prices rise since demand will fall.

Uploaded by

satishluchmun
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Cross elasticity of demand (xed) is a numerical measure of the responsiveness of demand of one

product following a change in the price of a related product alone. The price of substitutes and
complements are important factors that may affect the demand of a commodity. When they change
they have impact on quantity demanded (Qty dd). For instance, when price of substitute increases,
demand for the related commodities rises and vice versa. Likewise,when the price of a complement
rises,demand for its related good falls. The formula used is as follows using two goods as example
Good A and Good B.

XED = % change in quantity demanded of good A

% change in the price of good B

This type of elasticity arises in the case of inter-related goods such as substitutes and complementary
goods. It is usually Positive (+Ve) for substitute goods and Negative (-Ve) for complementary goods.

Positive Cross Elasticity of Demand

Cross elasticity of demand is positive for substitute goods if one good in relation to another express a
positive XED, it implies that they are close substitutes for each other. This can be better explained in
terms of mathematical terms. If the price of a substitute rises (positive), consumers will demand
more of its related commodity (positive). Thus, two positive (+Ve) sign will finally lead to positive by
the same token.

If the price of substitute falls (-Ve) consumers will demand less demand less its related commodity (-
Ve), two negative (-Ve) signs will finally lead to a positive sign (+Ve). This is basic theory can be
exemplified by two substitutes goods say, tea and coffee. If the price of tea rises, consumers will
demand more of coffee and vice-versa. Thus two positive sign will lead to a final positive sign.

Negative cross elasticity of demand

Cross elasticity of demand is negative (-Ve) complementary goods, if a commodity has a negative
cross elasticity of demand, it implies that is a complement relation to another commodity. This can
better be explained in terms of mathematical terms. If the price of a complement rises say, for
example: petrol, consumers will demand less of its related commodity, that is, car.

Likewise if the price of a complement falls, say for example: petrol, consumers will demand more of
its related goods say, for example: cars. Thus one negative sign and one positive sign will ultimately
lead to a negative sign.

Importance to a businessman

Businessman makes use of the concept of cross elasticity of demand in formulating their pricing
strategies that is, when they should increase or decrease their prices of their products. For instance,
if two commodities have a positive cross elasticity of demand, it implies that they are close
substitutes to each other. In this case if the producer of one of the commodity, say for example: glass
bottle, reduces its price, the producer of plastic bottle will definitely suffer from a decrease in its level
of sales of its product. So in this case, following a price cut by the producer of the glass bottle, the
pricing decision of the bottle manufacturer will be also a price cut in order to avoid any fall in its
sales. Additionally, if the producer of the glass bottle raises its price, the plastic bottle manufacturer
will normally leave its price unchanged in order to attract additional customers who will be stop
buying glass bottles.

The concept of cross elasticity of demand can also be used y businessman in their production
decisions, that is, whether to expand or reduce their production under a given situation. Consider
two complementary products, petrol and car. A businessman will normally take into account the
price of petrol before under taking the production of cars. If the price of petrol is increasing, a car
manufacturer will normally reduce its level of production as demand will be definitely low. On the
other hand if price of petrol is declining to a record level, a car manufacturer will undertake a greater
production of car as demand will eventually be rising. Thus, the value of cross elasticity of demand
tells the producer whether one product relation of another is a substitute or a complement via the
mathematical signs, based on such information, they can take decision about pricing and production.

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