Cross Price Elasticity of Demand

AS Economics

Cross Elasticity of Demand (CPed)

Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the price of good Y (a related good)

CPeD = % change in qty D of product A% change in price of product B

With cross price elasticity we make an important distinction between substitute products and complementary goods and services.

Identify some Substitutes

Identify some Complements

Cross Price Elasticity for Substitutes

Product Close Substitute

Weak Substitute

Good with no relationship

Coca Cola

Camembert Cheese

Euro Star Journey from London to Paris

Dowe Egberts Filter Coffee

Ticket to a film at the UGC Cinema in Slough

Complementary Goods

Product Close Complement

Weak Complement

Good with no relationship

Personal Computer

A bottle of expensive white wine

Short Break Weekend in Barcelona

Cross Elasticity of Demand (CPed) + = SubstitutesSubstitutes:

With substitute goods such as brands of razors, an increase in the price of one good will lead to an increase in demand for the rival product

Weak substitutes – inelastic CPed

Close substitutes – elastic CPed

Cross price elasticity will be positive

+

Cross Elasticity of Demand (CPed) - = Complements

Complements: Goods that are in

complementary demandWeak complements –

inelastic CPedClose complements – elastic CPed

The cross price elasticity of demand for two complements is negative

The Diagrams!

SubstitutesPrice of Good S

Quantity demanded of Good T

Demand

Two Weak Substitutes

P1

P2

Goods S and T are weak substitutes

A rise in the price of Good S leads to a small rise in the demand for good T

The cross price elasticity of demand will be positive but the coefficient of elasticity will be less than one

Ice cream and lollies!

+

ComplementsPrice of Good X

Quantity demanded of Good Y

Demand

Two Close Complements

P2

P1

Goods X and Y are close complements

A fall in the price of good X leads to a large rise in the demand for good Y

The cross price elasticity of demand will be negative and the coefficient of elasticity will be more than one

Complements are said to be in JOINT DEMAND

Foreign holidays & air flights!

-

Goods with zero cross-price elasticity of demand aka. INDEPENDENTPrice of Good A

Quantity demanded of Good B

Demand

P1

P2

P3

Goods A and B have no relationship.

A fall in the price of good A leads to no change in the demand for good B

Therefore the cross-price elasticity of demand is zero

Apples and gloves!

Get your calculators ready

CPeD = % change in qty D of product A% change in price of product B

Calculate the CPeD and state whether the goods are complements or substitutes?

1. A 10% rise in the price of fish may cause demand for chicken to increase by 2%.

2. The fall in the price of paper by 20% causes the demand for pens to increase by 5%.

3. A 20% rise in the price of ice cream causes demand for sweets to increase by 4%.

4. A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign holidays.

5. A 10% rise in bikes will leave the demand for cheese unaffected.

Answers…

A 10% rise in the price of fish may cause demand for chicken to increase by 2%.+2/+10 = +0.2

The fall in the price of paper by 20% causes the demand for pens to increase by 5%.+5/-20 = -0.25

A 20% rise in the price of ice cream causes demand for sweets to increase by 4%.+4/+20 = +0.2

A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign holidays.+30/-12 = -2.5

A 10% rise in bikes will leave the demand for cheese unaffected.0/+10 = 0

Positive = substitute goods

Negative = complementary

Look at some figures for interpretation…

Real statistics!

Estimated Elasticity for Alcohol

Estimated elasticities for the UK, 1993-96

Change in quantity of

Change in price of

Beer Wine Spirits

Beer -0.76 -0.6 -0.59

Wine -0.17 -1.69 0.66

Spirits -0.21 0.77 -0.86

Source: Crawford and Tanner (IFS, Fiscal Studies 1999)

How can beer be a good complement to beer?

Positive = substitute goods

Negative = complementary

In your own words explain the ‘wine’ CPeD numbers

Importance of CPed for businesses

Firms can use CPed estimates to predict:The impact of a rival’s pricing strategies on demand for

their own products: Pricing strategies for complementary goods:

Popcorn and cinema tickets are strong complements. Popcorn has a very high mark up i.e. popcorn costs pennies to make but sells for more than a pound

If firms have a reliable estimate for XED they can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn

Applications of Cross Elasticity (1)

Effects of the national minimum wage on demand for younger and older workers (might younger workers be replaced?)

Higher indirect taxes on goods such as tobacco – the impact on demand for nicotine patches and other substitutes

Applications of Cross Elasticity (2)

Effect on demand for different modes of mass transport following introduction of road pricing schemes in urban areas (e.g. the London congestion charge and the M6 Toll Road)

Rise in the price of natural gas – effect on the demand for coal used in power generation

Homework

Revise for test next lesson – to review basic definitions, formulas, diagrams, elastic & inelastic numbers

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