BAM 040: Managerial Economics

SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

Lesson title: Cross Price and Income Elasticity of Demand Materials:

Lesson Objectives: Student Activity Sheets
1. I can compute cross price elasticity of demand. References:
2. I can compute income elasticity of demand. Managerial Economics by Viloria,
3. I can interpret the results of cross price and income elasticity of Halcon, Avila-Bato & Viray
demand computation. Managerial Economics Business
Strategy Ninth Edition by
Baye,Prince,2017
Investopedia.com

“Strive not to be a success but rather to be of

value.”

A. LESSON PREVIEW/REVIEW
1) Introduction (2 min)
A pleasant day to you buddy. Our lesson for today is still about elasticity of demand – “Cross Price and
Income Elasticity of Demand. On our previous discussion, we talked about the impact of own price
elasticity to total revenue of a firm. We only consider one good/service and what will happen if there is an
increase or decrease on the price of the good/service. Today, we will examine the effect of changes in
the price of a good to the quantity demanded of the other related good. Are you ready?

Pre-Test (5 mins)
Direction: Fill out the missing words in the following sentences.

1. The _____________________________________tells us the degree of responsiveness of consumers

to a price change of the commodity.

2. If the elasticity value is less than one, the good is said to be ____________________. Inelastic

3. If the elasticity value is equal to one, the good is said to be ________________, hence, total revenue
will __________________. Unit elastic, remain unchanged.

4. If the good is elastic, an increase in the price will result to a __________________ in the quantity
demanded. Decrease

5. If the good is perfectly inelastic, quantity demanded will ___________________ as price increases.
Remain unchanged
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This document and the information thereon is the property of PHINMA Education
 BAM 040: Managerial Economics
SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

B.MAIN LESSON
1) Activity 2: Content Notes (45 min)

Bring out your ballpen, highlighter, calculator and reference book to help you understand the topic.

CROSS PRICE ELASTICITY OF DEMAND

The cross elasticity of demand is an economic concept that measures the responsiveness in the
quantity demanded of one good when the price for another good changes. Also called cross-price
elasticity of demand, this measurement is calculated by taking the percentage change in the quantity
demanded of one good and dividing it by the percentage change in the price of the other good.

*Note: The computation for “percentage change” is the same with the formula in the computation of
percentage change related to own price elasticity of demand.

Substitute Goods
The cross elasticity of demand for substitute goods is always positive because the demand for one good
increases when the price for the substitute good increases. For example, if the price of coffee increases,
the quantity demanded for tea (a substitute beverage) increases as consumers switch to a less
expensive yet substitutable alternative. This is reflected in the cross elasticity of demand formula, as both
the numerator (percentage change in the demand of tea) and denominator (the price of coffee) show
positive increases.

Items with a coefficient of 0 are unrelated items and are goods independent of each other. Items may be
weak substitutes, in which the two products have a positive but low cross elasticity of demand. This is
often the case for different product substitutes, such as tea versus coffee. Items that are strong
substitutes have a higher cross-elasticity of demand. Consider different brands of tea; a price increase in
one company’s green tea has a higher impact on another company’s green tea demand.

Complementary Goods
Alternatively, the cross elasticity of demand for complementary goods is negative. As the price for one
item increases, an item closely associated with that item and necessary for its consumption decreases
because the demand for the main good has also dropped.

For example, if the price of coffee increases, the quantity demanded for coffee stir sticks drops as
consumers are drinking less coffee and need to purchase fewer sticks. In the formula, the numerator
(quantity demanded of stir sticks) is negative and the denominator (the price of coffee) is positive. This
results in a negative cross elasticity.

Usefulness of Cross Elasticity of Demand

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This document and the information thereon is the property of PHINMA Education
 BAM 040: Managerial Economics
SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

Companies utilize cross-elasticity of demand to establish prices to sell their goods. Products with no
substitutes have the ability to be sold at higher prices because there is no cross-elasticity of demand to
consider. However, incremental price changes to goods with substitutes are analyzed to determine the
appropriate level of demand desired and the associated price of the good.
Additionally, complementary goods are strategically priced based on cross-elasticity of demand. For
example, printers may be sold at a loss with the understanding that the demand for future complementary
goods, such as printer ink, should increase.

INCOME ELASTICITY OF DEMAND

The degree to which buyers respond to a change in their incomes is known as the income
elasticity of demand It is given by the formula:

Ei is positive when the good is a normal good such that more of the good is demanded when income
increases and vice versa. A negative income elasticity of demand suggests that the good is an inferior
good,ie., demand for the good decreases as income increases.

2) Activity 3: Skill-Building Activities (30min)

Part 1
Direction: Answer the following problems. Indicate your solutions if necessary.

The accompanying table lists the cross-price elasticities of demand for several goods, where the percent
quantity change is measured for the first good of the pair, and the percent price change is measured for
the second good.

Questions:

a. Explain the sign of each of the cross-price elasticities. What does it imply about the relationship
between the two goods in question?

This document and the information thereon is the property of PHINMA Education
 BAM 040: Managerial Economics
SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

___________________________________________________________________________________
_________________________________________________________________________________

b. Compare the absolute values of the cross-price elasticities and explain their magnitudes. For example,
why is the cross-price elasticity of McDonald’s burgers and Burger King burgers less than the cross-price
elasticity of butter and margarine?

___________________________________________________________________________________
_________________________________________________________________________________

c. Use the information in the table to calculate how a 5% increase in the price of Pepsi affects the
quantity of Coke demanded.

___________________________________________________________________________________
_________________________________________________________________________________

d. Use the information in the table to calculate how a 10% decrease in the price of gasoline affects the
quantity of SUVs demanded.

___________________________________________________________________________________
_________________________________________________________________________________

This document and the information thereon is the property of PHINMA Education
 BAM 040: Managerial Economics
SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

Part 2 (Problem Solving)

Question: According to a Honda press release on October 23, 2006, sales of the fuel-efficient four-
cylinder Honda Civic rose by 7.1% from 2005 to 2006. Over the same period, according to data from the
U.S. Energy Information Administration, the average price of regular gasoline rose from $2.27 per gallon
to $2.57 per gallon. Using the midpoint method, calculate the cross-price elasticity of demand between
Honda Civics and regular gasoline. According to your estimate of the cross-price elasticity, are the two
goods gross complements or gross substitutes? Does your answer make sense?

Note: This is the formula for midpoint method. For % change in the quantity, the denominator is the
average of the old + new, same with the computation for the % change in price.

3) Activity 5: Check for Understanding (25min)

Let’s check if you really understand our discussion for today.

Practice Problems
1. For each of the following, calculate the cross elasticity of demand. Are the goods substitutes or
compliments.
a. A 10% increase in the price of lettuce results in a 15% increase in the quantity of spinach
demanded.
b. A 5% increase in the price of beef results in a 10% increase in the quantity of pork demanded.
c. A 4% increase in the price of a golf club results in a 2% decrease in the quantity of golf balls
demanded.

This document and the information thereon is the property of PHINMA Education
 BAM 040: Managerial Economics
SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

2. For each of the following, calculate the income elasticity of demand. Are the goods normal or inferior
goods/
a. A 3% increase in income results in a 1% increase in the quantity demanded.
b. A 6% increase in income results in a 3% decrease in the quantity demanded.
c. A 2% increase in income results in a 4% increase in the quantity demanded.

Fill in the blanks

The _____ (price; cross; income) elasticity of demand is a measure of the extent in which the demand for
a good changes when the price of a substitute or complement changes, other things remaining the same,
The cross elasticity of demand is ___________ (positive; negative) for a substitute and __________
(positive; negative) for a complement. The income elasticity of demand equals the percentage change in
__________ (the quantity demanded; income) divided by the percentage change in __________
(quantity demanded; income). The income elasticity of demand is __________ (positive; negative) for a
normal good and _________ (positive’ negative) for an inferior good.

Complete the graph Short answer and numeric questions

Figure 12,1
%age Change %age Change Cross
in Price of in Quantity Elasticity
Good A Demanded of of Demand
Good B
A 3 6 2.0
B 5 - 10 - 2.0
C - 4 - 8 2.0
D 8 4 0.5
The income elasticity of demand for large screen Complete the table above. Which row indicates
Televisions is positive. In Figure 12.1 show the inferior good and which row indicates a good
change when income increases. that is income elastic

C. LESSON WRAP-UP
1) Activity 6: Thinking about Learning (5mins)

A. Work Tracker
Congratulations! You are done with our session! Let’s track your progress. Shade the session number
you just completed.

B. Think about your Learning

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This document and the information thereon is the property of PHINMA Education
 BAM 040: Managerial Economics
SAS Module #12

Name:______________________________________________________________ Class number: _______

Section: ____________ Schedule:_____________________________________ Date:_______________

1. What is the most important lesson you gained on this session?

___________________________________________________________________________________
________________________________________________________________________________

2. Do you have question/s about the topic?

___________________________________________________________________________________
_________________________________________________________________________________

Key to Corrections

Skill Building Activities

Part 1
Answer to Question:
a. A negative cross-price elasticity of demand implies that the two goods are gross complements. So
air-conditioning units and kilowatts of electricity are gross complements, as are sport-utility vehicles and
gasoline. A positive cross-price elasticity of demand implies that the two goods are gross substitutes.
So Coke and Pepsi are gross substitutes, as are McDonald’s and Burger King burgers as well as butter
and margarine.
b. The larger (and positive) the cross-price elasticity of demand is, the more closely the two goods are
gross substitutes. Since the cross-price elasticity of butter and margarine is larger than the cross-price
elasticity of McDonald’s burgers and Burger King burgers, butter and margarine are closer gross
substitutes than are McDonald’s and Burger King burgers. Similarly, the greater (and negative) the
cross-price elasticity of demand is, the more strongly the two goods are gross complements.
c. A cross-price elasticity of 0.63 implies that a 1% increase in the price of Pepsi would increase the
quantity of Coke demanded by 0.63%. Therefore, a 5% increase in the price of Pepsi would increase
the quantity of Coke demanded by five times as much, that is, by 5 × 0.63% = 3.15%.
d. A cross-price elasticity of −0.28 implies that a 1% fall in the price of gasoline would increase the
quantity of SUVs demanded by 0.28%. Therefore, a 10% fall in the price of gasoline would increase the
quantity of SUVs demanded by 10 times as much, that is, by 10 × 0.28% = 2.8%.

Part 2
Answer to Question: An increase in price from $2.27 to $2.57, using the midpoint method, is a percent increase
of $2.57 - $2.27 $0.30 −−−−−−−−−−−−−−−− x 100 = −−−−−− x 100 = 12.4% ($2.57 + $2.27)/2 $2.42 So the
cross-price elasticity of demand is 7.1%/12.4% = 0.6 Since the cross-price elasticity of demand between Honda
Civics and regular gasoline is positive, your estimate says that the two are gross substitutes. This answer might
seem perplexing because cars and gasoline are generally gross complements: you need gasoline to run a
(gasoline-powered) car like a Honda Civic. So the complementary relationship between gas and cars implies that
the cross-price elasticity between them is negative. But a Honda Civic adds another dimension to the
comparison: it is a fuel-efficient car, not a gas-guzzler. And fuel-efficient cars and gas guzzlers are gross
substitutes. So as gasoline prices rise, the demand for gas-guzzling cars falls and the demand for fuel-efficient
cars (such as the Honda Civic), which are gross substitutes, rises. So the substitute nature between gas-
guzzlers and Honda Civics implies a positive cross-price elasticity between gas and Honda Civics. Which effect
is stronger? Clearly it is the substitution effect that is stronger, because the data show a positive cross-price
elasticity.
Submit your activity sheets before the end of the session!
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