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Cross-Price Elasticity of Demand:: Substitute Goods

The document discusses cross-price elasticity of demand, which measures the responsiveness of demand for one good to a change in the price of another good. It is calculated as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good. Substitute goods have a positive cross-price elasticity, as demand for one increases when the price of the substitute increases. Complementary goods have a negative cross-price elasticity, as demand for one decreases when the price of the complement increases. The document provides examples of these relationships and diagrams illustrating the concepts.

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41 views2 pages

Cross-Price Elasticity of Demand:: Substitute Goods

The document discusses cross-price elasticity of demand, which measures the responsiveness of demand for one good to a change in the price of another good. It is calculated as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good. Substitute goods have a positive cross-price elasticity, as demand for one increases when the price of the substitute increases. Complementary goods have a negative cross-price elasticity, as demand for one decreases when the price of the complement increases. The document provides examples of these relationships and diagrams illustrating the concepts.

Uploaded by

awan 7
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Cross-Price Elasticity of Demand:

Cross Price Elasticity of Demand measures the responsiveness of demand for one
good to the change in the price of another good. It is the ratio of the percentage change
in quantity demanded of Good X to the percentage change in the price of Good Y.
PbЄda = Percentage change in Demand for good x / Percentage change in Price of
good y
If, for example, the demand for butter rose by 2% when the price of margarine rose by
8%,
Then the cross price elasticity of demand of butter with respect to the price of margarine
will be.

PbЄda = 2%/8% = 0.25

If, on the other hand, the price of bread (a compliment) rose, the demand for butter
would fall.
If a 4% rise in the price of bread led to a 3% fall in the demand for butter, the cross-price
elasticity of demand for butter with respect to bread would be:
PbЄda = - 3% /4%= - 0.75

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 as
shown in figure 1.1.

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.
Fig 1.1

Price of coffee
P2

P1

Q1 Q2

Demand of tea

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 as shown in figure 1.2.

For example, if the price of car increases, the quantity demanded for petrol drops
as consumers are purchasing less petrol and need to purchase car. 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.

Fig
1.2

P1
Price of car

P2

Q Q
1 2

Demand of petrol

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