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





Learning Contents:

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

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

Introduction

In the previous post that explored how a change in the price of substitute good changed the demand for the other good.  The demand for the substitute good is positively related to the price of other good.  In this post, we will study how a change in the price of complementary goods affects the demand for the other good that can be studied in the following situations:

a. Increase in the price of complementary good

b. Decrease in the price of complementary good

Complementary goods

These are the goods which are consumed together such as Bread and Butter, Car and Fuel, Lock and Key, etc.  Here, the consumption of one good is dependent upon the consumption of other.

a. Increase in the price of complementary good

Demand for the complementary good and the price of the other good is inversely related to each other i.e. if the price of one good (car) increases, consumers will be less attracted to buy cars at a high price or we can say that the demand for the car will reduce as the law of demand of applies. Accordingly, demand for the other good (fuel) will also be reduced as they are consumed together. Therefore, an increase in the price of the car will not only reduce the demand for the car but also decrease the demand for its fuel causing the demand curve to shift to the left. Figure 1.1 illustrates the situation.

Let’s consider car and fuel as two complements. D1 is the initial demand curve and OC1 is the initial quantity demand for fuel at OP1 price. Now, suppose the price of fuel remains constant but the price of car increases, the demand for its fuel will reduce from OC1 to OC2 . Hence, 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.



b. Decrease in the price of complementary good

Now, if the price of one good (car) decreases, consumers will be attracted to buy more cars at a low price as the law of demand applies. Accordingly, the demand for the other good (fuel) will also be increased as they are consumed together. Therefore, a decrease in the price of car will not only increase the demand for the car but also increase the demand for its fuel causing the demand curve to shift to the right. Figure 1.2 illustrates the situation indicating that D1 is the initial demand curve and OC1 is the initial quantity demand for fuel at OP1 price. Now, suppose the price of fuel remains constant but the price of car decreases, the demand for the fuel will increase from OC1 to OC2 . Hence, 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.

  


We summarize this by saying that when two goods are complements, there is an inverse or negative relationship between the price of one good and the demand for the other good.




Choose the correct answer based on the above learning

1. If two goods are complementary then rise in the price of one result 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. Which of the following shifts the demand for watches to the right?

a. An increase in the price of watches

b. A decrease in consumer incomes if watches are a normal good

c. decrease in the price of watch batteries if watch batteries and watches are complements

d. None of these answers

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

a. Positive

b. Negative

c. Both a. and b.

d. No relation exists



4. If coffee and milk are complements, then which of the following will occur if the price of coffee increases?

a. The quantity of coffee demanded will increase

b. The quantity of coffee supplied will decrease

c. The demand for milk will increase

d. The demand for milk will decrease

Answer Key:

 

1.b

2.c

3.b

4.d



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