12/3/2017 Cross Elasticity Of Demand

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Cross Elasticity Of Demand

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What is 'Cross Elasticity Of Demand'

Cross elasticity of demand is an economic concept that measures the
responsiveness in the quantity demand of one good when a change in price
takes place in another good. Also called cross price elasticity of demand, this
measurement is calculated by taking the percentage change in the quantity
demanded of one good and dividing it by the percentage change in price of
the other good.

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BREAKING DOWN 'Cross Elasticity Of Demand'

Items with a coe icient of 0 are unrelated items and are goods independent of each other. Items may
be weak substitutes, in which the two products have a positive but low cross elasticity of demand.
This is o en the case for di erent product substitutes, such as tea versus co ee. Items that are
strong substitutes have a higher cross elasticity of demand. Consider di erent brands of tea; a price
increase in one company’s green tea has a higher impact on another company’s green tea demand.

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Substitute Goods
The cross elasticity of demand for substitute goods is always positive because the demand for one
good increases if the price for the other good increases. For example, if the price of co ee increases,
the quantity demanded for tea (a substitute beverage) increases as consumers switch to a less
expensive yet substitutable alternative. This is reflected in the cross elasticity of demand formula, as
both the numerator (percentage change in the demand of tea) and denominator (the price of co ee)
show positive increases.

Complementary Goods
Alternatively, the cross elasticity of demand for complementary goods is negative. As the price for
one goods increases, an item closely associated with that item and necessary for its consumption
decreases because the demand for the main good has also dropped. For example, if the price of
co ee increases, the quantity demanded for co ee stir sticks drops as consumers are drinking less
co ee and need to purchase fewer sticks. In the formula, the numerator (quantity demanded of stir
sticks) is a negative figure and the denominator (the price of co ee) is positive. This results in a
negative cross elasticity.

Usefulness of Cross Elasticity of Demand

Companies utilize cross elasticity of demand to establish prices to sell their goods. Products with no
substitutes have the ability to be sold at higher prices, because there is no cross elasticity of demand
to consider. However, incremental price changes to goods with substitutes are analyzed to
determine the appropriate level of demand desired and the associated price of the good.

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12/3/2017 Cross Elasticity Of Demand

Additionally, complementary goods are strategically priced based on cross elasticity of demand. For
example, printers may be sold at a loss with the understanding that the demand for future
complementary goods, such as printer ink, should increase.

Price Elasticity Of Demand

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Price elasticity of demand is a measure of the relationship between a change in the quantity
demanded of a particular good and a change in its price. Price elasticity of demand is a term in
economics o en used when discussing price sensitivity. The formula for calculating price elasticity of
demand is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

If a small change in price is accompanied by a large change in quantity demanded, the product is
said to be elastic (or responsive to price changes). Conversely, a product is inelastic if a large change
in price is accompanied by a small amount of change in quantity demanded.

BREAKING DOWN 'Price Elasticity Of Demand'

Price elasticity of demand measures the responsiveness of demand to changes in price for a
particular good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e.,
demand does not change when price changes). Values between zero and one indicate that demand
is inelastic (this occurs when the percent change in demand is less than the percent change in price).
When price elasticity of demand equals one, demand is unit elastic (the percent change in demand is
equal to the percent change in price). Finally, if the value is greater than one, demand is perfectly
elastic (demand is a ected to a greater degree by changes in price).

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Demand Elasticity
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12/3/2017 Cross Elasticity Of Demand

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Demand elasticity refers to how sensitive the demand for a good is to changes in other economic
variables, such as the prices and consumer income. Demand elasticity is calculated by taking the
percent change in quantity of a good demanded and dividing it by a percent change in another
economic variable. A higher demand elasticity for a particular economic variable means that
consumers are more responsive to changes in this variable, such as price or income.

BREAKING DOWN 'Demand Elasticity'

Demand elasticity measures a change in demand for a good when another economic factor changes.
Demand elasticity helps firms model the potential change in demand due to changes in price of the
good, the e ect of changes in prices of other goods and many other important market factors. A
grasp of demand elasticity guides firms toward more optimal competitive behavior and allows them
to make more precise forecasts of their production needs. If the demand for a particular good is
more elastic in response to changes in other factors, companies must be more cautions with raising
prices for their goods.

Types of Demand Elasticities

One common type of demand elasticity is the price elasticity of demand, which is calculated by
dividing the percent change in quantity demanded of a good by the percent change in its price.
Firms collect data on price changes and how consumers respond to such changes and later calibrate
their prices accordingly to maximize their profits. Another type of demand elasticity is cross-
elasticity of demand, which is calculated by taking the percent change in quantity demanded for a
good and dividing it by percent change of the price for another good. This type of elasticity indicates
how demand for a good reacts to price changes of other goods.

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Income Elasticity Of
Demand
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12/3/2017 Cross Elasticity Of Demand

Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to
a change in real income of consumers who buy this good, keeping all other things constant. The
formula for calculating income elasticity of demand is the percent change in quantity demanded
divided by the percent change in income. With income elasticity of demand, you can tell if a
particular good represents a necessity or a luxury.

BREAKING DOWN 'Income Elasticity Of Demand'

Income elasticity of demand measures the responsiveness of demand for a particular good to
changes in consumer income. The higher the income elasticity of demand in absolute terms for a
particular good, the bigger consumers' response in their purchasing habits, if their real income
changes. Businesses typically evaluate income elasticity of demand for their products to help predict
the impact of a business cycle on product sales.

Calculation of Income Elasticity of Demand

Consider a local car dealership that gathers data on changes in demand and consumer income for its
cars for a particular year. When the average real income of its customers fell from $50,000 to $40,000,
the demand for its cars plummeted from 10,000 to 5,000 units sold, all other things unchanged. The
income elasticity of demand is calculated by taking a negative 50% change in demand, a drop of
5,000 divided by the initial demand of 10,000 cars, and dividing it by a 20% change in real income,
the $10,000 change in income divided by the initial value of $50,000. This produces an elasticity of
2.5, which indicates local customers are particularly sensitive to changes in their income when it
comes to buying cars.

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