Have you noticed how a change in the price of petrol affects the demand for automobiles that run on diesel? Have you ever wondered why the consumption of tea increases when there is an increase in the price of coffee? Now, let us familiarize ourselves with Cross Elasticity of Demand.
Economists define elasticity of demand as to how reactive the demand for a product is to changes in factors such as price or income. However, the elasticity of demand does not just stop there. There are times when the price change of one product affects the demand for another product. And this concept is called cross-elasticity of demand, which we will discuss in this article. However, before we go further, let us briefly revisit the laws of supply and demand.
Laws of Demand and Supply
The law of demand states that all conditions being equal, as the price of a product increases, the demand for that product will decrease. Consequently, as the price of a product decreases, the demand for that product will increase. Therefore, the law of demand defines an inverse relationship between the price and quantity factors of a product.
The law of supply, on the other hand, states that all factors being constant, an increase in price will cause an increase in the quantity supplied. That is quantity and price moves in the same direction. Production units will invest more in production and supply more products for sale at an increased price. Therefore, the law of supply defines a direct relationship between price and quantity.
Cross Elasticity of Demand
Now, in economic terms, cross elasticity of demand is the responsiveness of demand for a product in relation to the change in the price of another related product. The relevant word here is “related” product. Unrelated products have zero elasticity of demand. An increase in the price of pulses will have no effect on the demand for chocolates. You can measure the cross elasticity of demand by dividing the percentage of change in the demand for one product by the percentage of change in the price of another product.
Cross Elasticity of Demand = % of the change in the demand for Product A / % of the change in the price of product B
The most important concept to understand in terms of cross elasticity is the type of related product. The cross elasticity of demand depends on whether the related product is a substitute product or a complementary product.
Substitute and Complementary Products
As mentioned earlier, cross elasticity measures the demand responsiveness in relation to related products. And these related products can be either substitutes or complementary products. Let us understand the difference between the two.
However, if the related product is a weak substitute, then the demand will be less cross elastic, but positive. That is, a change in the price of a product might not greatly affect the demand for its substitute.
Substitute products have a positive cross elasticity of demand. As the price for Y increases, the demand for substitute X also increases.
Complementary goods, on the other hand, are products that are in demand together. An ideal example would be coffee beans and coffee paper filters. If the price of coffee increases, then the demand for filters would reduce because the demand for coffee will reduce. The cross elasticity of demand for two complementary products is always negative.
Again, the stronger the complementary relationship between two products, the more negative the cross elasticity coefficient would be. For instance, if the price of XBOX increases, the demand for XBOX compatible games would reduce.
Products that complement each other show a negative cross elasticity of demand. As the price of Y rises, the demand for X falls.
Solved Question on Cross Elasticity of Demand
Q: What is the relevance of Cross Elasticity of Demand?
Ans: Cross elasticity of demand is an important and relevant concept for industries and production units. Research analysts in a company closely analyze the cross elasticity trends in the market between related products and then set prices for their products.
A company can sell its premium product at a higher price if it has no substitutes. However, if a product has a strong substitute available in the market, then the company will strategically market and price that product to ensure a steady demand.