Cross Price Elasticity of Demand

Cross Price Elasticity of Demand (XED) is 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 change in the price of Good Y. In business, XED is important because it will help determine whether or not it is a good move to increase or decrease prices or to substitute one product for another for revenue.

Types of Cross Elasticity of Demand

There are three types of cross price elasticity of demand: substitute goods, complimentary goods and unrelated products.

Cross Elasticity of Demand for Substitutes

When the cross elasticity of demand for product A relative to a change in the price of product B is positive, it means that in response to an increase in the price of product B, the quantity demanded of product A has increased. An increase in the price of product B means that more people will consume A instead of B, and this will increase the quantity demanded of product A.

Substitutes will always have a positive Cross Price Elasticity or greater than zero.

Cross Elasticity of Demand for Compliments

When the cross elasticity of demand for product A relative to the change in the price of product B is negative, it means that the quantity demanded of A has decreased relative to an increase in the price of product B. An increase in the price of B will reduce the quantity demanded of A.

Compliments will always have a negative Cross Price Elasticity or less than zero.

Cross Elasticity of Demand for Unrelated

These are goods that show no relationship. Unrelated goods will always have a Cross Price Elasticity of Demand = 0

Uses of Cross Price Elasticity of Demand

Knowing the XED of its own and other related products allows a firm to map out the market. The firm can then calculate how many competitors it has, and how closely related they are. It also allows a firm to measure how important its complementary products are to its own products.

To reduce exposure to risk, firms can develop strategies associated with price changes by other firms, such as a rise in the price of a complement or a fall in the price of a substitute.

How to Calculate Cross Price Elasticity of Demand

Cross Price Elasticity of Demand (XED) = Percentage Change in Quantity Demanded of Good x / Percentage Change in Price of Good y

= (New Quantity Demanded of Good x – Old Quantity Demanded of Good x)/(Old Quantity Demanded of Good x) / (New Price of Good y – Old Price of Good y)/(Old Price of Good y)

The Cross Price Elasticity of Demand formula

= %∆ in Quantity Demanded of Good x / %∆ in Price of Good y

If CPE > o, then the two goods are substitutes. For example: Coke and Pepsi

If CPE < o, then they are compliments. For example: Bread and Butter

If CPE  = 0, then they are unrelated. For example: Bread and Soda

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