The concept of cross-elasticity of demand

When it comes to Cross-elasticity of demand, we must first illustrate the concept of elasticity of demand. We can say that elasticity of demand is the building blocks of the theory of cross-elasticity of demand because elasticity of demand is related to only 1 good while cross-elasticity of demand is about the connection of 2 goods. We ought to first compare the elasticity of demand with the cross-elasticity of demand.

Elasticity of demand is sometimes referred to as the own-price elasticity of demand for a good, like the elasticity of demand with regards to the good's own price. Flexible demand shows that consumers are incredibly price delicate.

This idea is understandable because everybody knows price is one of important determinant of quantity, and the quantity demanded of the good is adversely related to its price. We can imagine: for a seller, lower price promotes sales; for a buyer, higher price constraints their desire of purchase.

Take the example from the textbook, suppose that a 10% upsurge in the price tag on an ice-cream cone causes the amount of ice cream you get to fall by 20%. According to the formula

We estimate your elasticity of demand as 20%/10%= 2. This result can be described as the elasticity 2 shows the change in the number demanded is proportionately doubly large as the change in the purchase price. This consequence owes to reasons the following: First, market for glaciers cream is very competitive rather than monopolistic. Second, consumers have choices of other substitutes such as other desserts. Third, when the price of ice cream increases, consumers can purchase cakes, milk-shake or other desserts.

The above method usually yields a poor value, because of the inverse nature of the relationship between price and amount demanded, as described by the "law of demand" (Gillespie, Andrew (2007). p. 43. ) but economists often make reference to price elasticity of demand as a good value (i. e. , in overall value terms).

Definition of Cross-elasticity of Demand

Based on the theory mentioned above about price elasticity of demand, we can go further to determine the connection of two goods. To be able to differentiate it from the elasticity of demand for that good with regards to the change in the price of some other good, i. e. , a complementary or substitute good. (Png, Ivan (1999). p. 57. ) The latter kind of elasticity measure is called a cross-price elasticity of demand.

In economics, the cross-elasticity of demand is also known as cross-price elasticity of demand, which actions the responsiveness of the demand for a good to an alteration in the price of another good. It is measured as the ratio change in demand for the first good that occurs in response to a percentage change in price of the second good. The formula to determine cross-elasticity of demand is

Major Determinant

The cross-price elasticity of demand is often used to observe how sensitive the demand for a good is to a cost change of another good. The major determinant of cross-elasticity of demand is the closeness of the swap or complement. A high positive cross-price elasticity shows that if the price tag on one good rises, the demand for the other good goes up as well. A poor tells us just the contrary, that an upsurge in the price tag on one good causes a drop in the demand for the other good. A little value (either negative or positive) tells us that there surely is little relation between the two goods.

Cross-price Elasticity

Indication

Example

Graph

A positive cross-price elasticity

If the price tag on one good rises, the demand for the other good goes up as well.

Pork and hen, etc.

A negative cross-price elasticity

An upsurge in the price of one good triggers a drop in the demand for the other good.

Bicycles and helmets; Petroleum and automobiles, etc.

A small value

There is little relation between the two goods.

Things have little if any relationship at all

For example, assume the price tag on chicken goes up by 10%, and as a result the quantity demanded of pork increases by 2%, with no change in the price tag on pork or other things that would influence the demand for pork. Then your cross-elasticity of demand for pork, with respect to the price of chicken breast, is 2%/10% = 0. 2.

This theory is also easy to understand. Firstly, as we know that for just two goods that supplement the other person show a poor combination elasticity of demand, which means that an increase in the price of one good slices the demand for the other. For instance, if the price of bicycles rises, we will be prepared to see a decline in the demand for bicycle helmets; if the price of petroleum falls, the demand for car will be likely to go up. In this sort of case, we can say the goods are complements and they have an in depth link in cost and demand.

Secondly, on the contrary, two goods that are substitutes have a positive cross elasticity, this means that an upsurge in the price of one good will improve the demand for the other good. Whenever we observe a confident cross-elasticity, we say that both goods are substitutes, much like poultry and pork, butter and margarine.

The Third situation is two impartial goods. If two goods are impartial, absolutely they have a zero mix elasticity of demand.

Practical Application

For a company, it needs to know the cross-elasticity of demand for their product when considering the result on the demand for their product of the change in the price tag on a rival's product or a complementary product. If the product quality and appearance is nearly the same (whatever the factors of passion location, and loyalty, etc. ) but the price of Company A is greater than that of Firm B, most consumers will choose the products of Firms B. Among theories of marketing, "pricing" isn't only difficult but technological. These are essential bits of information for organizations when coming up with their production plans.

However, for goods those match each other, a good is supposed to promote the sales of both the products and their matches. Nowadays, the price of petroleum is continually high and it'll consistently get higher in the near future. This is certainly a disaster for motor vehicle industry. Some of the automobile companies choose the strategy of reduction but gets an unsatisfactory reviews. What affects the decision of the consumer is mainly the price of petroleum rather than the auto, so some companies think out of your promotional tactic: buy car get petro discounted (although price of a car may be very expensive), and this may be to some extent cater to the consumers' psychology.

Another software of the idea of cross-elasticity of demand is in neuro-scientific international trade and the balance of payments. Also, for different companies and fields, the idea of cross-elasticity of demand may be used to gauge the closeness of relationship of every other. For all those monopoly enterprises, they will be the unique suppliers in market and they're powerful enough to regulate the whole market, so they won't suffer from the pressure from others. However, for some establishments, such as Ministry of Railway, if it determines to raise the price in a large scale, many passengers will choose other transportation, which will make aviation industry or highroad industry successful. This will certainly lay itself in an unadvantageous position.

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