Question

Cross Price Elasticity of Demand:

How can we use cross price elasticity to determine whether two goods are substitutes or compliments?

Answer 1

How can we use cross price elasticity to determine whether two goods are substitutes or compliments?

Cross price elasticity of demand is the percentage change in the quantity of a one good in response to the change in price of another.Cross price describes that change in price of one good,affects the quantity demanded of another good.

Cross price elasticity of demand= %change in Quantity of good A/ %change in the price of good B.

Cross price elasticity of demand may be negative,positive or zero.It helps us to determine if the goods are substitutes,compliments or not related to each other.

When(E>0),When the cross price elasticity is greater than zero,we can determine that the goods are substitutes,and can be used in place of each other.Here when price of one good increases,its demand decreases,and consumers start finding cheaper substitutes.So when price of a good increases,the demand for its substitute increases.If there is an increase in the price of Pepsi,the consumers start demanding more of Coke[coca cola],as they can be easily replaced for each other.So,we can say that price elasticity of demand for substitute goods is positive as it is E>0

When (E<0),When the cross price elasticity is less than zero,we can determine that the goods are compliments,and their demand depends on the price of other goods.When two goods are used together,then when price of one good increases,it will reduce the demand for another good which is its compliment.If the price for coffee increases,it would result in the decrease the demand of coffee paper filters,as the demand for coffee will decline in the first place.Coffee and coffee filter papers are thus compliments.Thus price elasticity of demand for compliment goods is negative,E<0

When the cross elasticity of price is 0,then the goods are neither compliments nor substitutes,they are not related to each other.Like an increase in price of marbles,will not in any way affect the demand for Base balls.Marbles and Base balls are thus not related to each other.