Cross Price Elasticity: Definition, Formula for Calculation, and Example

What is the Cross Elasticity of Demand?

The cross-price elasticity (or cross elasticity) of demand is a concept in economics that assesses the responsiveness of one good's quantity demanded when the price of another good varies. The calculation for this indicator, also known as "Cross-Price Elasticity of Demand", involves dividing the "%" change in the amount demanded of one item by the "%" change in the price of another item.

Understanding Cross Elasticity of Demand

In economics, it describes how responsive the demand for one good is to fluctuations in the price of another. It is usually affected by substitute products or complementary goods.

Substitute Products

Due to the fact that demand for one item rises as the price of its alternative rises, the cross elasticity of demand for a substitute product is always positive; for instance, if coffee prices rise, buyers will shift to tea, a less costly and replaceable substitute beverage, increasing the demand for tea. Since both the numerator ("% change in tea demand") and denominator ("the coffee price") show positive increases, this is represented in the cross elasticity of the demand formula.

Items/Goods having a coefficient of zero are not related to one another and are considered independent goods. Items might be poor alternates/replacements, wherein the demand elasticity for the two things is positive but low, and this frequently applies to distinct product alternatives, like tea and coffee. Strong replacements for a given good have a higher cross-elasticity of demand. Consider various tea brands; a price surge in one firm's black tea has a greater effect on the demand for black tea in a different firm.

Complementary Goods

In contrast, the demand for complementary items typically has a negative cross-elasticity; as the price of one product grows, the price of a thing closely related to that product and required for its consumption declines as demand for the primary product drops.

For instance, if the coffee's price rises, fewer people will need to buy coffee stir sticks since they will be drinking less coffee overall. The denominator ("the price of a coffee") is positive, while the numerator ("the number of stir sticks demanded") is negative in the formula. In such cases, the negative cross elasticity is the outcome.

Cross-Elasticity of Demand's Usefulness

Companies set pricing for their products based on the cross-elasticity of demand. Products/Goods with no alternatives can command higher prices since there is no "Cross-Elasticity of Demand" to take into account. Incremental price adjustments to items with substitutes are examined to ascertain the proper degree of demand desired and the related price of the item.

The cross elasticity of demand is also used to strategically price related ("Complementary") products. For instance, it's possible to sell printers at a loss while anticipating rising demand for related products like printer ink in the future. Therefore, it is essential for any business to understand the concept of cross-price elasticity of demand and follow strategic practices accordingly.