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Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of demand for one product when the price of a related product changes. Related products can be substitutes or complements. Substitute products are in direct competition, so their cross elasticity is positive - if the price of one rises, demand for the other rises. Complementary products are used together, so their cross elasticity is negative - if the price of one rises, demand for the other falls. The closer the substitution or complementarity, the higher the positive or negative cross elasticity value.

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409 views2 pages

Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of demand for one product when the price of a related product changes. Related products can be substitutes or complements. Substitute products are in direct competition, so their cross elasticity is positive - if the price of one rises, demand for the other rises. Complementary products are used together, so their cross elasticity is negative - if the price of one rises, demand for the other falls. The closer the substitution or complementarity, the higher the positive or negative cross elasticity value.

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Cross Elasticity of Demand

Now, in economic terms, cross elasticity of demand is the responsiveness of demand for a
product in relation to the change in the price of another related product. The relevant word here is
“related” product. Unrelated products have zero elasticity of demand. An increase in the price of
pulses will have no effect on the demand for chocolates. You can measure the cross elasticity of
demand by dividing the percentage of change in the demand for one product by the percentage of
change in the price of another product.
Cross Elasticity of Demand = % of the change in the demand for Product A / % of the
change in the price of product B
The most important concept to understand in terms of cross elasticity is the type of related
product. The cross elasticity of demand depends on whether the related product is a substitute
product or a complementary product.
Substitute and Complementary Products
As mentioned earlier, cross elasticity measures the demand responsiveness in relation to
related products. And these related products can be either substitutes or complementary products.
Let us understand the difference between the two.
Substitute Products
Substitute products are goods that are in direct competition. An increase in the price of one
product will lead to an increase in demand for the competing product. For instance, an increase in
the price of petrol will force consumers to go for diesel and increase the demand for diesel. Now,
the cross elasticity value for two substitute goods is always positive. The more close the substitutes
are in terms of use and quality, the more positive the cross elasticity of demand would be. That is,
even a minor change in the price of one product highly affects the demand for the substitute
product.
However, if the related product is a weak substitute, then the demand will be less cross
elastic, but positive. That is, a change in the price of a product might not greatly affect the demand
for its substitute.
Substitute products have a positive cross elasticity of demand. As the price for Y increases, the
demand for substitute X also increases.
Complementary Products
Complementary goods, on the other hand, are products that are in demand together. An ideal
example would be coffee beans and coffee paper filters. If the price of coffee increases, then the
demand for filters would reduce because the demand for coffee will reduce. The cross elasticity of
demand for two complementary products is always negative.
Again, the stronger the complementary relationship between two products, the more
negative the cross elasticity coefficient would be. For instance, if the price of XBOX
X increases, the
demand for XBOX compatible games would reduce.

Products that complement each other show a negative cross elasticity of demand. As the price of Y
rises, the demand for X falls.

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