In economics, four tenets determine the markets for a product – price, demand, supply and elasticity. When you combine three of these concepts, things only get more complicated. And that is precisely why you may have a difficult time trying to understand all the facets of cross-price elasticity of demand.
But do not let the intricacy of the concept deter you from scoring well, for we have a detailed guide on cross-price elasticity fraught with examples and all.
Moreover, if you need customized help beyond this guide, you can hire the economics subject matter experts at MyAssignmenthelp.com.
Now, let us start with the basics.
What is Cross-Price Elasticity?
Cross-price elasticity is the parameter that ascertains how a product's demand reacts to a shift in a related product’s price. This means, an increase or decrease in one product’s price can affect another product’s demand positively or negatively.
How?
You will often see that certain goods are linked to another. For example, the price of fuel impacts almost all goods because a hike in transportation costs automatically affects the price of products that are being shipped. This was an example of a complementary product.
Now, what you need to remember is that the cross-price elasticity of demand may vary as per the relation of one product to another. Here are the connections to keep in mind:
- For a complimentary product A, an increase in its price will lower the demand for another product B. This is known as negative cross-price elasticity. (E.g., potatoes and French fries)
- Again, for a price hike of a substitute product A, demand for product B will increase, leading to positive cross-price elasticity. (E.g., tea and coffee)
- Also, keep in mind that cross-price elasticity doesn't affect unrelated products. (E.g., pen and butter)
Cross-price elasticity is all about product relationships. Therefore, you must know how to examine and ascertain whether the products in question are substitutes or complements or unrelated.
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Cross-Price Elasticity of Demand: Formula
The cross-price elasticity of demand is denoted Exy. It can be calculated by dividing the percentage change in the quantity of product X by the percentage change in the price of a related product Y.
The cross-price elasticity of demand formula looks like this:
In the above equation:
Qx = the average difference between the previous quantity and the changed quantity
Py = the average difference between the previous price and the changed price
(Note: Δ denotes the change of price or quantity of product X or Y)
The average figures may make the equation a lot more complex than apprehended. If you cannot figure out how to determine ΔQx or ΔPx, you can either use a cross-price elasticity of demand calculator for instant results. Alternatively, you can come to MyAssignmenthelp.com for step-by-step solutions.
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Cross-Price Elasticity of Demand for Substitute Products
Cross-price elasticity measures how much one products demand is reliant on another related product.
In the case of two substitute products, an increase in one’s price increases the demand for its competing product. Consumers are always on the lookout for cheaper alternatives to maximise utility. The less a person spends on an item, the higher is the level of satiation.
Therefore, when the price of a competing product falls, the phenomenon has a mirroring effect on the substitute product, increasing its demand.
Now, based on the price change, you may get positive or negative cross-price elasticity of demand. An increase in the price of substitutes would mean positive cross-price elasticity due to increased demand for the related product. Again, a fall in a competing product's price would lead to a negative coefficient for the other product due to a fall in demand.
Practical Example
Let us take Pepsi and Coke as the substitute products. If the price of Pepsi increases, consumers will automatically shift to Coke. Again, if the price of Pepsi falls, consumers who used to drink Coke will switch to the former.
Categories of Substitute Products
There are two kinds of substitutes - close or weak.
- For Close Substitutes, even the slightest increase in price will lead to a heavy demand for the substitute product.
- For Weak Substitutes, the change in demand for a substitute will be comparatively lesser than the change in the price of the other product.
If the examples aren't enough for you to understand the cross-price elasticity for demand between substitute products, you can pore through the samples hosted on our website. You can also hire the best economics experts for personalized assistance.
Cross-Price Elasticity of Demand for Complementary Products
In the case of complementary products, the relation between the price of one product and demand for another is inversely proportional. That is, when the price of one product increases, the demand for the complementary decreases. This is because of the rise in the joint cost that forces consumers to buy less.
Practical Example
An excellent example of complementary products is petrol and car. When fuel prices go up, the demand for vehicles automatically drops because a car cannot run without fuel. And with a hike in fuel prices, maintaining a car/bike becomes costly.
Categories of Complementary Products
Similar to substitute products, two complimentary items can have a close or a weak relationship.
- For Close Complements, a minimal increase in price leads to a greater decrease in demand for the complement item. (E.g., flour and bread)
- For Weak Complements, the demand for a complimentary product decreases to a lesser extent compared to a more significant rise in the price of another. (E.g., pen and notebooks)
Why are pens and notebooks weak complements as compared to flour and bread? For a more in-depth understanding, get in touch with the experts at MyAssignmenthelp.com. Share your requirements with us right away for instant help.
How to Calculate the Scale of Cross-Price Elasticity of Demand?
Different sets of products mark different levels on the scale of cross-price elasticity of demand. As explained earlier, complementary goods lead to negative cross-price elasticity. In stark contrast, substitutes lead to positive XED.
If you see the scale of XED above, you will see how strong complementary goods (like flour and bread) marks the extreme left of it. Next comes the weak complements (like pen and notebook), which has a lesser negative XED.
In the middle of the scale are unrelated products. Consider ice cream and snowboarding. There is no relation between the two whatsoever. So, the price of one does not affect the demand for another to any extent. Therefore, the XED for unrelated goods is 0.
On the positive hand of the zero, you can mark the cross-price elasticity of substitutes. Weak substitutes demonstrate a less positive XED than close substitutes. Therefore, weak substitutes come after unrelated goods, as strong substitutes mark the extremely positive end of the scale.
Need more examples to understand the scale of cross-price elasticity? Pore through the hundreds of samples on this topic on our website for free. Or, email us for instant help, and we will appoint the best expert to assist you.
Application of Cross-price Elasticity of Demand
Businesses use the concept of cross-price elasticity of demand to recognize the reliability and quotient of sensitivity of the goods they produce to others. According to the degree of sensitivity, brands set the prices for their offerings.
Quite often, businesses use the loss leader strategy to price complementary goods counterintuitively as a deliberate step. Several businesses that offer two complementary products, like milk and cheese, choose to price one below cost to increase the sale of the complementary good. This leads to an overall higher profit.
Businesses that offer products with the fierce competition due to close substitutes operating in the market use the competitive pricing strategy. In this strategy, brands try to keep the cost of their product lower than the substitute to attract the latter’s demand.
That brings us to the end of this guide.
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