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Definition – What is cross-price elasticity of demand?
Cross-price elasticity of demand (XED) measures the responsiveness of the quantity demanded for one good when the price of another good changes. This concept helps determine the relationship between two goods, whether they are substitutes or complements.
- If XED > 0, the goods are substitutes. As the price of one good increases, demand for the other rises.
- If XED < 0, the goods are complements. As the price of one good increases, demand for the other decreases.
- If XED = 0, the goods are unrelated, meaning a price change in one good has no effect on the demand for the other.
Cross-price elasticity helps businesses understand how products interact in the marketplace, guiding pricing and product strategies.
Formula – How to calculate cross-price elasticity of demand
Cross Price Elasticity of Demand = (% Change in Demand of Good #1) ÷ (% Change in Price of Good #2)
Where:
- Good A is the product whose quantity demanded is affected. % Change in Demand of Good #1 = (Demand of Good #1 End – Demand of Good #1 Start) ÷ Demand of Good #1 Start
- Good B is the product whose price changes. % Change in Price of Good #2 = (Price of Good #2 End – Price of Good #2 Start) ÷ Price of Good #2 Start
Example
Let’s say the price of butter (Good B) rises by 10%, and the quantity demanded of margarine (Good A), a substitute, increases by 5%. The cross-price elasticity of demand would be:
XED = 5% ÷ 10% = 0.5
This positive value indicates that butter and margarine are substitutes.
Alternatively, if butter and bread were complements, a 10% increase in the price of butter might lead to a 4% decrease in the quantity demanded of bread, yielding an XED of -0.4.
What is Cross-Price Elasticity of Demand Used For?
Cross-price elasticity of demand helps businesses and economists understand the relationships between products. It is particularly useful for pricing decisions, product bundling, and market strategy.
For example:
- Substitutes: If a competitor raises their prices, a firm can anticipate increased demand for its substitute product.
- Complements: A firm may reduce the price of one product to boost sales of a complementary good, such as printers and ink cartridges.
Cross-price elasticity also helps retailers design promotional campaigns, such as discounts on one product to increase sales of a related item.
Cross-Price Elasticity of Demand vs. Price Elasticity of Demand
While cross-price elasticity of demand focuses on the relationship between two goods and how the demand for one changes due to the price change in another, price elasticity of demand measures how the demand for a single good responds to changes in its own price. Both are useful for understanding consumer behavior but provide insights into different aspects of market dynamics.
Sources and more resources
- Wikipedia contributors. (2024i, September 16). Cross elasticity of demand. Wikipedia. https://en.wikipedia.org/wiki/Cross_elasticity_of_demand
- Khan Academy. (n.d.-k). https://www.khanacademy.org/economics-finance-domain/ap-microeconomics/unit-2-supply-and-demnd/25/v/cross-elasticity-of-demand
- Kacapyr, E., & Redelsheimer, J., & Musgrave, F. Barron’s AP Microeconomics / Macroeconomics (6th ed.). (2018). United States of America: Barron’s. ISBN: 978-1-4380-1065-6. Page 69.
- Pindyck, R., & Rubinfeld, D., Microeconomics (8th ed.), (2013). United States of America: Pearson. ISBN 13: 978-0-13-285712-3. Page 35.
- Nicholson, W., & Snyder, C. Microeconomic Theory – Basic Principles and Extensions (10th ed.). (2008). United States of America: Thomas South-Western. ISBN 13: 978-0-324-42162-0. Page 159.
- Greenlaw, S., & Shapiro, D., Principles of Microeconomics 2e. (2018). Houston: Rice University OpenStax. ISBN 13: 978-1-947172-35-7. Page 123.