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Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of the quantity demanded of one product to a change in the price of another product. It indicates whether products are substitutes, complements, or independent. A positive cross elasticity means the products are substitutes, while a negative value means they are complements. The formula uses percentage changes in quantity demanded and price to calculate cross elasticity. Examples are provided to demonstrate calculating cross elasticity and determining if product pairs are substitutes or complements based on the sign of the value.

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5K views2 pages

Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of the quantity demanded of one product to a change in the price of another product. It indicates whether products are substitutes, complements, or independent. A positive cross elasticity means the products are substitutes, while a negative value means they are complements. The formula uses percentage changes in quantity demanded and price to calculate cross elasticity. Examples are provided to demonstrate calculating cross elasticity and determining if product pairs are substitutes or complements based on the sign of the value.

Uploaded by

mark ceasar
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Cross Elasticity of Demand

Cross elasticity of demand is the ratio of percentage change in quantity demanded of a


product to percentage change in price of another product. It is used to measure how
responsive the quantity demanded of one product is to a change in price of another product.
Cross elasticity of demand indicates whether any two products are substitute goods,
complementary goods or independent goods. A positive cross elasticity of demand means
that the products are substitute goods. A negative cross elasticity of demand means that
the products are complementary goods. A near zero cross elasticity of demand means that
the products are independent goods i.e. quantity demanded of product A is not affected by
any movement in price of product B.

Formula
% increase in quantity demanded of A
Cross Elasticity of Demand EA, B =
% increase in price of product B
Percentage changes in the above formula are calculated using the mid-point formula which
divides actual change by average of initial and final values.
The formula to calculate cross elasticity thus becomes:

Qf − Qi Pf − Pi
EA, B = ÷
(Qf + Qi) ÷ 2 (Pf + Pi) ÷ 2
Where,
Qf and Qi are the final and initial quantities demanded of product A, respectively; and
Pf and Pi are the final and initial prices of product B.

Substitute Goods
When the cross elasticity of demand for product A relative to a change in price of product B
is positive, it means that in response to an increase (decrease) in price of product B, the
quantity demanded of product A has increased (decreased). Since A, say Coke, and B, say
Sprite, are substitutes, an increase in price of product B means that more people will
consume A instead of B, and this will increase the quantity demanded of product A. Increase
in quantity demanded of product A relative to increase in price of product B gives us a
positive cross elasticity of demand.

Complimentary Goods
When the cross elasticity of demand for product A relative to change in price of product B is
negative, it means that the quantity demanded of A has decreased (increased) relative to
an increase (decrease) in price of product B. As A, say car, and B, say gas, are
complimentary goods, and an increase in price of B will reduce the quantity demanded of A.
This is because people consume both A and B as a bundle and an increase in price reduces
their purchasing power and decreases quantity demanded.

Examples
Example 1: The quantity demanded or product A has increased by 12% in response to a
15% increase in price of product B. Calculate the cross elasticity of demand and tell whether
the product pair is (a) apples and oranges, or (b) cars and gas.
Cross elasticity of demand = % change in quantity demanded of A ÷ % change in price of B
= 12%/15% = 0.67.
Since the cross elasticity of demand is positive, product A and B are substitute goods. They
are most likely apples and oranges.
Example 2: The government of Selgina is very serious about drugs. Possession of drugs is
illegal and is severely penalized. However, a black market exists which the government has
failed to dismantle despite serious attempts. Khusenichho Chamling, the health minister, is
worried about the situation. In early 2009, a consultant working with health ministry
suggested that the government should increase the price of a pack of cigarettes from 200
Selgina dollars (S$) to S$600. A survey conducted in December 2009 suggested that over
the year, the quantity demanded of marijuana decreased from 2,000 kgs per day to just
800 kgs. Calculate the cross elasticity of demand and tell why has the policy proved so
effective.
Percentage increase in price of cigarettes = (600-200) ÷ {(600+200) ÷ 2} = 100%
Percentage increase in quantity demanded of marijuana = (800-2,000) ÷ {(800+2000) ÷
2} = -85.71%
Cross elasticity of demand = % change in quantity demanded/% change in price = -
85.71%/100% = -0.86
Cigarettes and marijuana have negative cross elasticity of demand which tells that they are
complimentary goods.
The policy has proved effective because cigarettes and marijuana are consumed together.
Increase in price of cigarettes increased the price of the whole bundle and reduced the
purchasing power of people and resulted in a drop in consumption of marijuana.

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