Cross Price Cross Price Elasticity of Elasticity of

Demand (XED)Demand (XED)IB EconomicsIB Economics

XED Learning XED Learning Outcomes:Outcomes:

Outline the concept of cross-price Outline the concept of cross-price elasticity of demandelasticity of demand

Calculate XEDCalculate XED

Substitute vs. Complementary goodsSubstitute vs. Complementary goods

Value of XEDValue of XED

Examine the implications of XED for Examine the implications of XED for businesses if prices of substitutes or businesses if prices of substitutes or complements change.complements change.

Cross-Price Elasticity of Cross-Price Elasticity of demand (XED)demand (XED)

XED is a measure of the XED is a measure of the responsiveness of consumers responsiveness of consumers of one good to a change in of one good to a change in the price of a related good.the price of a related good.

Measure of how much the Measure of how much the demand for a product demand for a product changes when there is a changes when there is a change in the price of change in the price of another product.another product.

Cross-Price Elasticity Cross-Price Elasticity of demand (XED)of demand (XED)

% Qty Demanded of good X

% Price of good Y

Percent change in quantity demanded / Percent change in price

Cross Price Elasticity of Cross Price Elasticity of Demand (XED)Demand (XED)

With cross price elasticity With cross price elasticity we make an important we make an important

distinction between distinction between substitutesubstitute products and products and complementarycomplementary goods goods

and services.and services.

What is a What is a substitutesubstitute good (demand)?good (demand)?

Is one for which demand will Is one for which demand will increase when the price of increase when the price of another good increases.another good increases.

Demand for a substitute good Demand for a substitute good will decrease when the price will decrease when the price of its substitute decreases.of its substitute decreases.

How responsive are the How responsive are the consumers of one to a change consumers of one to a change in the price of the other?in the price of the other?

Example: Beef vs. ChickenExample: Beef vs. Chicken

Quantity (tonnes: 000s)

Pri

ce (

per

kg)

Price(per kg)

20

Market demand(tonnes 000s)

700A

Point

A

Market demand for chicken

D

Quantity (tonnes: 000s)

Pri

ce (

per

kg)

Price(per kg)

20

40

Market demand(tonnes 000s)

700

500

A

B

Point

A

B

D

Market demand for chicken

D1

Pric

e

P

O Q0 Q1

Quantity

Demand for beefDemand for beef

D0

Increase in the price of chicken,

increases the demand for beef

Identify some Identify some SubstitutesSubstitutes

What is What is complementarycomplementary goods?goods?

Goods that are typically Goods that are typically consumed togetherconsumed togetherDemand for one is Demand for one is decreased by the price decreased by the price increase of the otherincrease of the otherHow responsive are the How responsive are the consumers of one to a consumers of one to a change in the price of the change in the price of the other?other?Example: Cameras vs. Example: Cameras vs. Memory CardsMemory Cards

Pric

e

P2

O Q2 Q1

Quantity

Increase in price of camerasIncrease in price of cameras

D

P1

D0

Pric

e

P

O Q0 Q1

Quantity

Demand for Memory CardsDemand for Memory Cards

D1

Identify some Identify some ComplementsComplements

Example of XEDExample of XEDThe owners of a pizza stand The owners of a pizza stand find that when their find that when their competitor, a hamburger stand, competitor, a hamburger stand, lowers the price of a burger lowers the price of a burger from $2 to $1.80, the number from $2 to $1.80, the number of pizza slices that they sell of pizza slices that they sell each week falls from 400 to each week falls from 400 to 380, because of the lower 380, because of the lower priced burger. Calculate XED.priced burger. Calculate XED.

XED = -5% / -10% = +0.5XED = -5% / -10% = +0.5

Range of Values of Range of Values of XEDXED

XED may be XED may be positivepositive or or negativenegative. Sign is . Sign is

important since it tells important since it tells us what the relationship us what the relationship between the two goods between the two goods

in question is.in question is.

Range of Values Range of Values of XEDof XED

If the value of XED is positive, then If the value of XED is positive, then the two goods in question may be the two goods in question may be said to be substitutes for each said to be substitutes for each other.other.

If the value of XED is negative, If the value of XED is negative, then the two goods in question then the two goods in question may be said to be complements for may be said to be complements for each other.each other.

If the value of XED is zero, the two If the value of XED is zero, the two goods are unrelated.goods are unrelated.

XED Value

Relationship

Negative Zero Positive

Close Complements

Weak/Remote Complements

Unrelated Products

Weak/Remote Substitutes

Close Substitutes

XED values and the strength of the relationship between products

Cross Price Cross Price Elasticity for Elasticity for SubstitutesSubstitutesProduct Close Substitute Weak

SubstituteGood with no relationship

Coca Cola

Cheddar Cheese

KTX from Daejon to Seoul

Starbucks Coffee

Apple Computer

Cross Price Cross Price Elasticity for Elasticity for SubstitutesSubstitutesProduct Close Substitute Weak

SubstituteGood with no relationship

Coca Cola Pepsi Orange Juice Computer

Cheddar Cheese

KTX from Daejon to Seoul

Starbucks Coffee

Apple Computer

Cross Price Cross Price Elasticity for Elasticity for SubstitutesSubstitutesProduct Close Substitute Weak

SubstituteGood with no relationship

Coca Cola Pepsi Orange Juice Computer

Cheddar Cheese Jack Cheese Blue Cheese Apples

KTX from Daejon to Seoul

Starbucks Coffee

Apple Computer

Cross Price Cross Price Elasticity for Elasticity for SubstitutesSubstitutesProduct Close Substitute Weak

SubstituteGood with no relationship

Coca Cola Pepsi Orange Juice Computer

Cheddar Cheese Jack Cheese Blue Cheese Apples

KTX from Daejon to Seoul

“Slow” train Bus ride Soccer Ball

Starbucks Coffee

Apple Computer

Cross Price Cross Price Elasticity for Elasticity for SubstitutesSubstitutesProduct Close Substitute Weak

SubstituteGood with no relationship

Coca Cola Pepsi Orange Juice Computer

Cheddar Cheese Jack Cheese Blue Cheese Apples

KTX from Daejon to Seoul

“Slow” train Bus ride Soccer Ball

Starbucks Coffee Dunkin Donut Coffee

Nescafe instant coffee

Pencil Sharpener

Apple Computer

Cross Price Cross Price Elasticity for Elasticity for SubstitutesSubstitutesProduct Close Substitute Weak

SubstituteGood with no relationship

Coca Cola Pepsi Orange Juice Computer

Cheddar Cheese Jack Cheese Blue Cheese Apples

KTX from Daejon to Seoul

“Slow” train Bus ride Soccer Ball

Starbucks Coffee Dunkin Donut Coffee

Nescafe instant coffee

Pencil Sharpener

Apple Computer Dell Computer No name brand

Movie tickets

Complementary Complementary GoodsGoods

Product Close Complement

Weak Complement

Good with no relationship

Personal Computer

DVD Player

Short Break Weekend in Barcelona

Complementary Complementary GoodsGoods

Product Close Complement

Weak Complement

Good with no relationship

Personal Computer Mouse Stylus Eraser

DVD Player

Short Break Weekend in Barcelona

Complementary Complementary GoodsGoods

Product Close Complement

Weak Complement

Good with no relationship

Personal Computer Mouse Stylus Eraser

DVD Player DVDs (Video Discs)

Remote Control

Tables & Chairs

Short Break Weekend in Barcelona

Complementary Complementary GoodsGoods

Product Close Complement

Weak Complement

Good with no relationship

Personal Computer Mouse Stylus Eraser

DVD Player DVDs (Video Discs)

Remote Control

Tables & Chairs

Short Break Weekend in Barcelona

Tour Package (incl. running with the bulls)

Champagne breakfast

Toothpick

Cross-Price Elasticity of Cross-Price Elasticity of Demand (XED) Demand (XED)

++ = Substitutes= SubstitutesSubstitutesSubstitutes: : With substitute With substitute goods such as goods such as brands of razors, brands of razors, an increase in the an increase in the price of one good price of one good will lead to an will lead to an increase in increase in demand for the demand for the rival productrival product

Weak substitutes Weak substitutes – inelastic XED– inelastic XED

Close substitutes Close substitutes – elastic XED– elastic XED

Cross price elasticity will be

positive

+

Cross-Price Elasticity of Cross-Price Elasticity of Demand (XED) Demand (XED)

-- = Complements= ComplementsComplementsComplements: :

Goods that are in Goods that are in complementary complementary demanddemandWeak complements Weak complements – – inelastic XEDinelastic XEDClose complements Close complements – – elastic XEDelastic XED

The cross price elasticity of

demand for two complements is

negative

Cross Elasticity Cross Elasticity ExerciseExercise

Cross Elasticity Cross Elasticity ExerciseExercise

Calculate the XED and state Calculate the XED and state whether the goods are whether the goods are

complements or substitutes?complements or substitutes?1.1. A 10% rise in the price of fish may cause A 10% rise in the price of fish may cause

demand for chicken to increase by 2%.demand for chicken to increase by 2%.

2.2. The fall in the price of paper by 20% causes The fall in the price of paper by 20% causes the demand for pens to increase by 5%.the demand for pens to increase by 5%.

3.3. A 20% rise in the price of ice cream causes A 20% rise in the price of ice cream causes demand for sweets to increase by 4%.demand for sweets to increase by 4%.

4.4. A 12% fall in the price of air fares leads to a A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign 30% rise in the demand for foreign holidays.holidays.

5.5. A 10% rise in bikes will leave the demand A 10% rise in bikes will leave the demand for cheese unaffected.for cheese unaffected.

Answers…Answers…A 10% rise in the price of fish may cause A 10% rise in the price of fish may cause demand for chicken to increase by 2%. demand for chicken to increase by 2%. +2% / +10% = +0.2 +2% / +10% = +0.2

The fall in the price of paper by 20% The fall in the price of paper by 20% causes the demand for pens to increase causes the demand for pens to increase by 5%. +5% / -20% = -0.25by 5%. +5% / -20% = -0.25

A 20% rise in the price of ice cream A 20% rise in the price of ice cream causes demand for sweets to increase by causes demand for sweets to increase by 4%. +4% / +20% = +0.24%. +4% / +20% = +0.2

A 12% fall in the price of air fares leads A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign to a 30% rise in the demand for foreign holidays. +30% / -12% = -2.5holidays. +30% / -12% = -2.5

A 10% rise in bikes will leave the demand A 10% rise in bikes will leave the demand for cheese unaffected.for cheese unaffected. 0% / +10% = 00% / +10% = 0

Positive = substitute goods

Negative = complementary

XED Value

Relationship

Negative Zero Positive

Close Complements

Weak/Remote Complements

Unrelated Products

Weak/Remote Substitutes

Close Substitutes

XED values and the strength of the relationship between products

Importance of XED Importance of XED for businessesfor businesses

Firms can use XED estimates to Firms can use XED estimates to predict:predict:

The impact of a rivalThe impact of a rival’’s pricing strategies on s pricing strategies on demand for their own products: demand for their own products:

Pricing strategies for complementary goods: Pricing strategies for complementary goods: Popcorn and cinema tickets are strong Popcorn and cinema tickets are strong complements. Popcorn has a very high complements. Popcorn has a very high mark up i.e. popcorn costs pennies to mark up i.e. popcorn costs pennies to make but sells for more than a $1.00make but sells for more than a $1.00If firms have a reliable estimate for XED If firms have a reliable estimate for XED they can estimate the effect, say, of a they can estimate the effect, say, of a two-for-one cinema ticket offer on the two-for-one cinema ticket offer on the demand for popcorndemand for popcorn

Applications of Cross Applications of Cross Elasticity Elasticity

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

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

Applications of Cross Applications of Cross ElasticityElasticity

Effect on demand for Effect on demand for different modes of mass different modes of mass transport following transport following introduction of road introduction of road pricing schemes in pricing schemes in urban areas urban areas

Rise in the price of Rise in the price of natural gas – effect on natural gas – effect on the demand for coal the demand for coal used in power used in power generationgeneration

Cross Elasticity Cross Elasticity ExerciseExercise

Cross Elasticity Cross Elasticity ExerciseExercise

Additional ExercisesAdditional Exercises

Exercise“Light-Bites”, a sandwich shop, finds that when its rival, “Super-Snack”, reduces the price of its chicken wraps from $5 to $4.60, the demand for “Light-Bites” sandwiches falls from 400 sandwiches a week to 340 sandwiches a week. In addition, “Super-Snack” finds that following the fall in price of their chicken wraps, the demand for soft drinks rises from 600 cans to 630 cans per week.1.Calculate the cross elasticity of demand between “Light-Bite” sandwiches and “Super-Snack chicken wraps.2.Explain the relationship above in terms of

cross elasticity of demand.

Exercise“Light-Bites”, a sandwich shop, finds that when its rival, “Super-Snack”, reduces the price of its chicken wraps from $5 to $4.60, the demand for “Light-Bites” sandwiches falls from 400 sandwiches a week to 340 sandwiches a week. In addition, “Super-Snack” finds that following the fall in price of their chicken wraps, the demand for soft drinks rises from 600 cans to 630 cans per week.1.Calculate the cross elasticity of demand between “Super-Snack” sandwiches and the “Super-Snack” soft drinks.2.Explain the relationship above in terms of

cross elasticity of demand.