Degrees of cross price elasticity of demand

 

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·         Degrees of cross price elasticity of demand

The effect of change in price of one good on the demand of another good is measured by cross price elasticity of demand. It is calculated as percentage change in quantity demanded for one good divided by percentage change in price of another good. It explains the nature and degree of relationship between price of one good and the demand of another good i.e. whether the goods are substitutes, complements or independent. It is explained by three different degrees or possibilities as below:

1.      Positive Cross price elasticity of demand ( competing demand or substitutes)

2.      Negative Cross price elasticity of demand ( Joint demand or complements)

3.      Zero Cross price elasticity of demand (Absence of demand relationship)

1. Positive Cross price elasticity of demand

Positive cross price elasticity implies that a rise in demand for one good due to rise in price of another good and vice versa. The cross price elasticity of demand for substitute goods is positive as if price of one good increases, the demand for its substitute goods increases. For e.g. If Pizza Hut increases the price of its cheese pizza by 25%. As a result of it, consumers switch to Dominos and increase its demand by 30%. Its elasticity co-efficient value is positive greater than zero.

Calculating and understanding positive cross price elasticity,

Fig 1: Positive Cross Price Elasticity-Substitute Goods

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2. Negative Cross price elasticity of demand

Negative cross price elasticity implies that a rise in demand for one good due to fall in price of another good and vice versa. The cross price elasticity of demand for complementary goods is usually negative because the demand will only happen when they are consumed together. If price of one good rises, it decreases the demand for its own well as well as its complementary good and vice versa. For e.g. an increase in the price of cars by 30% reduces the demand for its fuel by 20%. This shows a negative relationship exists between the two. Its elasticity co-efficient value is negative less than zero.  

Calculating and understanding negative cross price elasticity,

Fig 2: Negative Cross Price Elasticity- Complementary Goods

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3. Zero Cross price elasticity of demand

Cross price elasticity of demand comes out to zero when two goods are not related to each other i.e. neither substitutes nor complements. In other words, rise in price of one good neither increases nor decreases the demand for another good. Therefore, unrelated goods have zero cross price elasticity of demand. For e.g. an increase in the price of clothes by 20% has no effect the demand of smart phones because these goods are not related to each other. Its elasticity co-efficient value is zero.  

Calculating and understanding zero cross price elasticity,

Fig 3: Zero Cross Price Elasticity-Unrelated Goods

 

 

 

 

 

 

Let’s try some questions

Choose the Correct Answer

1. The greater the substitutability between McCafe Coffee and Costa Coffee, the ________ is the cross elasticity of demand between coffee of coffee outlets and the ________ is the elasticity of demand for McCafe Coffee?

a. smaller; smaller

b. larger; smaller

c. smaller; larger

d. larger; larger

2. The cross elasticity of demand between Coca-Cola and Pepsi-Cola is

a. positive, that is, Coke and Pepsi are complements.

b. negative, that is, Coke and Pepsi are complements.

c. positive, that is, Coke and Pepsi are substitutes.

d. negative, that is, Coke and Pepsi are substitutes.

3. Of the following, which one is most likely to have a zero cross price elasticity of demand?

a. Complementary goods

b. Substitute goods

c. Unrelated goods

d. None of above

4. Which of the following faces an upward sloping demand curve?

a. Negative Cross price elasticity

b. Positive Cross price elasticity

c. Zero Cross price elasticity

d. None of above

5. If a fall in the price of good A increases the quantity demanded of good B, then

a. A and B are substitutes.

b. A and B are complements.

c. B is a substitute for A, but A is a complement to B

d. A is a substitute for B, but B is a complement to A.

6. If a fall in the price of good A has no effect on the quantity demanded of good B, then

a. A and B are substitutes.

b. A and B are complements.

c. A and B are unrelated goods.

d. None of above

 

Answer Key

 

1.d	2.c	5.b
3.c	4.b	6.c

 

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