Cross-Price Elasticity of Demand

Definition

Cross-price elasticity of demand measures the responsiveness of the demand for one good to a change in the price of another good. It reflects the degree to which two goods are substitutes or complements in consumption.

5 Must Know Facts For Your Next Test

1. Cross-price elasticity of demand is calculated as the percentage change in quantity demanded of one good divided by the percentage change in price of another good.
2. Cross-price elasticity is positive for substitute goods and negative for complement goods.
3. The magnitude of the cross-price elasticity coefficient indicates the strength of the relationship between the two goods.
4. Goods with high cross-price elasticity are considered to be close substitutes, while goods with low cross-price elasticity are considered to be weak substitutes or complements.
5. Knowledge of cross-price elasticity is important for firms to understand consumer behavior and make pricing decisions accordingly.

Review Questions

• Explain how the sign of the cross-price elasticity of demand coefficient indicates whether two goods are substitutes or complements.
  • The sign of the cross-price elasticity of demand coefficient indicates the relationship between two goods. If the coefficient is positive, the goods are considered substitutes - an increase in the price of one good leads to an increase in the demand for the other good. If the coefficient is negative, the goods are considered complements - an increase in the price of one good leads to a decrease in the demand for the other good. The magnitude of the coefficient reflects the strength of the substitution or complementary relationship between the two goods.
• Describe how a firm could use knowledge of cross-price elasticity to make pricing decisions.
  • Understanding the cross-price elasticity of demand between its products and those of competitors is crucial for a firm's pricing strategy. If two goods are close substitutes with a high cross-price elasticity, a firm may need to price its product competitively to retain market share. Conversely, if the firm's product is a complement to another good, it could potentially raise its price without significantly impacting demand, as consumers would still need the complementary product. Firms can use cross-price elasticity estimates to predict how changes in their own prices or their competitors' prices will affect the demand for their products, allowing them to make more informed and strategic pricing decisions.
• Analyze how the concept of cross-price elasticity of demand relates to the broader topic of elasticity in areas other than price.
  • Cross-price elasticity of demand is one specific application of the broader concept of elasticity, which measures the responsiveness of one variable to changes in another. Just as price elasticity of demand measures the responsiveness of quantity demanded to changes in a good's own price, cross-price elasticity measures the responsiveness of demand for one good to changes in the price of another related good. This concept can be extended beyond just prices to other areas, such as the elasticity of demand with respect to income (income elasticity) or the elasticity of supply with respect to factors of production (factor elasticity of supply). Understanding these various elasticity measures provides valuable insights into consumer and producer behavior that can inform economic decision-making across a wide range of contexts.

Related terms

Substitute Goods:

Goods that can be used in place of one another, such as Coke and Pepsi. An increase in the price of one substitute good will lead to an increase in demand for the other.

Complement Goods:

Goods that are used together, such as printers and printer ink. An increase in the price of one complement good will lead to a decrease in demand for the other.

Elasticity of Demand:

The measure of how responsive the quantity demanded of a good is to a change in its price, income, or the price of a related good.