Question

6. Describe the cross elasticity of demand between two goods that are substitutes? what happens when the two goods are complements? (10 points)

Answer 1

Cross price elasticity of demand measures the responsiveness of demand for good X following a change in the price of good Y which is a related good .

Cross elasticity of demand = % change in quantity demanded of good X / %change in price of good Y.

Cross elasticity of demand for substitutes :-

If price of one good increases, the demand for the other good also increases and vice versa .Thus the cross elasticity of demand between two substitute goods are positive (+).

It is very evident from the above figures that a smaller rise in price leads to higher rise in demand of good Y for close substitute and lower rise in demand for weak substitute.

(A) - Weak Substitutes :-

Two goods are said to be weak substitutes when a rise in price of good X leads to a smaller rise in the demand for good Y. Thus the cross price elasticity of demand is positive but the coefficient of elasticity is less than 1.

(B) - Close substitutes :-

Two goods are said to be close substitutes when a fall in price of one good leads to a larger fall in demand for the other good and vice versa . Thus the cross elasticity of demand between two substitute goods is positive however the coefficient of elasticity is more than 1.

Cross elasticity of demand for complements :-

If price of one good increases, the demand of other good decreases and vice versa . Thus the cross elasticity of demand between two complementary goods is negative (-).

It is evident from the above figure that a smaller decrease in price leads to higher rise in Demand for close compliments and comparatively lower rise in demand for weak compliments.

(A) Weak complements :-

Two goods are said to be weak compliments when a fall in price of good X leads to a a smaller rise in the demand for good Y .The cross price elasticity of demand is negative but the coefficient of elasticity is less than 1.

(B) Close complements :-

Two goods are said to be close complements when a fall in price of good X leads to a larger rise in the demand for good Y. The cross price elasticity of demand is negative but the coefficient of elasticity is more than 1. The compliments are said to be in joint demand.