Cross Price effects: Effect of change in price of substitute good on the demand of other good.

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Learning Contents:

·            Effect of Increase in price on the demand of substitute goods.

·            Effect of Decrease in price on the demand of substitute goods.

 

Introduction

The previous post explored some factors other than the price that cause a change in the demand for a commodity or demand curve to shift.

Related goods are of two types namely substitute and complementary goods. The price of the related goods may either increase or decrease causing the demand curve to shift forward or backward respectively. This effect of change in the price of related goods on the demand for a commodity is called the cross-price effect.

In this post, we will only understand how a change in the price of a substitute good changes the demand for other good in the following situations:

a.      Increase in the price of substitute good

b.      Decrease in the price of substitute good

Substitutes

Substitutes are the goods which can be used in place of one another like tea and coffee, Pepsi and coke, etc. Here, consumers don’t find much difference in these goods except their price.

a. Increase in the price of a substitute good

Demand for the substitute good and price of the other good is positively related to each other i.e. if the price of one good (Pepsi) increases, the consumer will buy less Pepsi because the Law of demand applies but the consumer will increase the demand for the other good (coke) as its price has not been changed. Therefore, an increase in the price of Pepsi leads to an increase in the demand for coke causing the demand curve for coke to shift to the right. Figure 1.1 illustrates the situation.

Let’s consider Pepsi and coke as two substitutes. D1 is the initial demand curve and OC1 is the initial quantity demand for coke at OP1 price. Now, suppose the price of coke remains constant but the price of Pepsi increases, and in this situation consumer will increase the quantity demand of coke from OC1 to OC2 and therefore, the demand curve will shift to the right from D1 to D2. This forward shifting of the demand curve is called an increase in demand.


b. Decrease in the price of a substitute good

Let’s consider again Pepsi and coke as two substitutes. Now, if the price of one good (Pepsi) decreases, the consumer will buy more Pepsi because the Law of demand applies but the consumer will decrease the demand for another good (coke) as its price has not been changed. Therefore, a decrease in the price of Pepsi leads to a decrease in the demand for coke causing the demand curve for coke to shift to the left. Figure 1.2 illustrates the situation indicating that D1 is the initial demand curve and OC1 is the initial quantity demand for coke at OP1 price. Now, suppose the price of coke remains constant but the price of Pepsi decreases then the consumer will reduce the quantity of coke from OC1 to OC2, and therefore, the demand curve will shift to the left from D1 to D2. This backward shifting of the demand curve is called a decrease in demand.

We summarize this by saying that when two goods are substitutes, there is a positive relationship between the price of one good and the demand for the other good.


Multiple Choice Questions:

(Choose the correct answer based on the above learning)

1. If two goods are substitutes then the rise in the price of one results in:

a. rise in the demand for the other

b. fall in the demand for the other

c. rise in the demand for the both

d. none of these

2. The demand for a good decrease when the price of a substitute?

a. rises

b. falls

c. constant

d. All of above

3. What type of relationship exists between price and the demand of substitute goods?


a. Positive

b. Negative

c. Both a. and b.

d. No relation exists

4. If the demand for CNG increases as the price of petrol increases, how are these two goods related?


a. substitute goods

b. complementary goods

c. normal goods

d. inferior goods

Answer Key:

1.a

2.b

3.a

4.a

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