What Is Cross Elasticity of Demand?

What Is Cross Elasticity of Demand?

Let me explain cross elasticity of demand to you directly: it's a way to measure how the demand for one good shifts when the price of another good changes. You might also hear it called cross price elasticity of demand. To calculate it, you take the percentage change in the quantity demanded of the first good and divide it by the percentage change in the price of the second good. For instance, if hot dog prices go up, you could see a shift in demand for hot dog buns.

Key Takeaways

You should know that for substitute goods, cross elasticity of demand is always positive—demand for the substitute rises when the original good's price increases. For complementary goods, it's negative. Unrelated goods typically show no cross elasticity at all. Businesses rely on this to set prices for their products and services.

Understanding Cross Elasticity of Demand

Cross elasticity of demand shows you how sensitive demand for a product is to price changes in another product. It quantifies the demand shift for one good when a related good's price moves. This is one key type of demand elasticity.

You can apply the formula to compare perfect substitutes or complements. For substitutes, elasticity stays positive: demand for one goes up as its substitute's price rises. For complements, demand drops with a price rise in the paired good, giving negative elasticity.

Remember, unrelated products don't influence each other. If egg prices rise, it won't directly affect olive demand.

Substitute Goods

For substitute goods, cross elasticity is always positive—demand increases for the substitute when the original good's price goes up.

Take tea as a substitute for coffee: if coffee prices rise, tea demand grows as people switch to the cheaper option. In the formula, both numerator and denominator are positive, reflecting this.

A zero coefficient means unrelated items. Weak substitutes, like tea and coffee generally, show low positive elasticity. Strong substitutes, such as competing tea brands, have higher elasticity—a price hike in one boosts demand for the other significantly.

Complementary Goods

Complementary goods have negative cross elasticity. When one good's price rises, demand for its complement falls because overall consumption drops.

If coffee prices increase, demand for coffee stir sticks decreases as people buy less coffee. Here, the numerator is negative and the denominator positive, yielding negative elasticity.

Cross Elasticity of Demand Formula

Here's the formula you use: Exy = (Percentage Change in Quantity of X) / (Percentage Change in Price of Y). It breaks down to Exy = (ΔQx / Qx) / (ΔPy / Py), or equivalently Exy = (ΔQx / ΔPy) * (Py / Qx), where Qx is quantity of good X, Py is price of good Y, and Δ means change.

How to Calculate Cross Elasticity of Demand

To calculate it, start with the initial quantity demanded of X and initial price of Y. Then note the final quantity of X and final price of Y.

Compute the percentage change in quantity of X: subtract initial from final, divide by their average. For price change: subtract initial from final price, divide by their average.

Finally, divide the quantity percentage by the price percentage to get the elasticity.

How Cross Elasticity of Demand Is Used

Companies use this to set prices. Goods without substitutes can be priced higher since there's no cross elasticity risk. For goods with substitutes, they analyze price tweaks to hit desired demand levels.

For complements, pricing is strategic—sell printers cheap knowing ink demand will follow.

Examples of Cross Elasticity of Demand

Consider two restaurants selling chicken burritos at $6 each. If one raises to $8, demand likely shifts to the other as substitutes.

For complements like burgers and fries: lower burger prices could boost fries demand since they pair together.

How Will I Use This in Real Life?

You make choices daily based on prices, switching restaurants if your favorite gets pricier or adding drinks if appetizers cheapen. This is cross elasticity at work, even if you don't realize it.

Explain Like I'm Five

Cross-price elasticity checks how price changes in one thing affect how much you want another. Goods like burgers and fries go together—if movies cost more, you might skip popcorn too, showing positive elasticity wait no, that's negative for complements. For substitutes, if pizza costs more, you eat more hamburgers, which is positive elasticity.

What Does a Positive Cross Elasticity of Demand Indicate?

Positive elasticity means demand for Good A rises as Good B's price increases—they're substitutes. Like switching to 2% milk if whole milk gets pricier.

What Does a Negative Cross Elasticity of Demand Indicate?

Negative elasticity means demand for Good A falls as Good B's price rises—they're complements. Printer demand drops if prices rise, reducing toner sales.

How Does Cross Elasticity of Demand Differ From Demand Elasticity?

Cross elasticity examines demand changes between two goods due to price shifts, while price elasticity of demand looks at one good's demand response to its own price change.

How Does Cross Elasticity of Demand Differ From the Cross Elasticity of Supply?

Cross elasticity of supply measures supply changes for one good due to another's price change, unlike demand-side responses in cross elasticity of demand.

The Bottom Line

In economics, prices and demand link closely. When one good's price rises, demand for related goods often shifts—this is cross price elasticity. Calculate it by dividing percentage change in one good's quantity demanded by the other's price percentage change.