Cross Price Elasticity of DemandAS Economics

Cross Elasticity of Demand (CPed)Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of good Y (a related good)

CPeD = % change in demand of product A% change in price of product B

With cross price elasticity we make an important distinction between substitute products and complementary goods and services.

Identify some Substitutes

Identify some Complements

Cross Elasticity of Demand (CPed) + = SubstitutesSubstitutes: With substitute goods such as brands of razors, an increase in the price of one good will lead to an increase in demand for the rival product

Weak substitutes inelastic CPedClose substitutes elastic CPedCross price elasticity will be positive+

Cross Elasticity of Demand (CPed) - = ComplementsComplements: Goods that are in complementary demandWeak complements inelastic CPedClose complements elastic CPedThe cross price elasticity of demand for two complements is negative

The Diagrams!

SubstitutesPrice of Good SQuantity demanded of Good T DemandTwo Weak SubstitutesP1P2Goods S and T are weak substitutesA rise in the price of Good S leads to a small rise in the demand for good TThe cross price elasticity of demand will be positive but the coefficient of elasticity will be less than one Ice cream and lollies!+

ComplementsPrice of Good XQuantity demanded of Good Y DemandTwo Close ComplementsP2P1Goods X and Y are close complementsA fall in the price of good X leads to a large rise in the demand for good YThe cross price elasticity of demand will be negative and the coefficient of elasticity will be more than oneComplements are said to be in JOINT DEMANDForeign holidays & air flights!-

Goods with zero cross-price elasticity of demand aka. INDEPENDENTPrice of Good AQuantity demanded of Good B DemandP1P2P3Goods A and B have no relationship.A fall in the price of good A leads to no change in the demand for good BTherefore the cross-price elasticity of demand is zeroApples and gloves!

Get your calculators readyCPeD = % change in qty D of product A% change in price of product B

Calculate the CPeD and state whether the goods are complements or substitutes?A 10% rise in the price of fish may cause demand for chicken to increase by 2%.The fall in the price of paper by 20% causes the demand for pens to increase by 5%.A 20% rise in the price of ice cream causes demand for sweets to increase by 4%.A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign holidays.A 10% rise in bikes will leave the demand for cheese unaffected.

AnswersA 10% rise in the price of fish may cause demand for chicken to increase by 2%.+2/+10 = +0.2The fall in the price of paper by 20% causes the demand for pens to increase by 5%.+5/-20 = -0.25A 20% rise in the price of ice cream causes demand for sweets to increase by 4%.+4/+20 = +0.2A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign holidays.+30/-12 = -2.5A 10% rise in bikes will leave the demand for cheese unaffected.0/+10 = 0Positive = substitute goods

Negative = complementary

Importance of CPed for businessesFirms can use CPed estimates to predict:The impact of a rivals pricing strategies on demand for their own products: Pricing strategies for complementary goods: Popcorn and cinema tickets are strong complements. Popcorn has a very high mark up i.e. popcorn costs pennies to make but sells for more than a pound

If firms have a reliable estimate for XED they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn

Applications of Cross Elasticity (1)Effects of the national minimum wage on demand for younger and older workers (might younger workers be replaced?)

Higher indirect taxes on goods such as tobacco the impact on demand for nicotine patches and other substitutes

Applications of Cross Elasticity (2)Effect on demand for different modes of mass transport following introduction of road pricing schemes in urban areas (e.g. the London congestion charge and the M6 Toll Road)Rise in the price of natural gas effect on the demand for coal used in power generation

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