Cross price elasticity of demand definition
/What is the Cross Price Elasticity of Demand?
Cross price elasticity of demand measures the responsiveness of the quantity demanded for one good when the price of a related good changes. It is calculated as the percentage change in the quantity demanded of Good A divided by the percentage change in the price of Good B. A positive cross price elasticity indicates that the goods are substitutes, meaning that an increase in the price of one leads to an increase in demand for the other. A negative cross price elasticity suggests the goods are complements, where a price increase in one results in a decrease in demand for the other.
How to Calculate Cross Price Elasticity of Demand
It is calculated as the percentage change in the demand for one product, divided by the percentage change in the price of a different product. The formula is:
Percentage change in demand of one product ÷ Percentage change in price of a different product
= Cross price elasticity of demand
Example of the Cross Price Elasticity of Demand
The price of coffee increases by 10%, and as a result, the quantity demanded for tea rises by 5%. This indicates that consumers are shifting their consumption from coffee to tea due to the higher cost of coffee, treating tea as a substitute. The cross price elasticity of demand in this case would be 0.5 (5% ÷ 10%), reflecting a positive relationship between the price of coffee and the demand for tea. This example demonstrates how businesses can anticipate shifts in demand for their products based on changes in the prices of related goods, especially when those goods serve similar purposes.
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Understanding Cross Price Elasticity of Demand
If there is no relationship between the two products, then this ratio will be zero. However, if a product is a valid substitute for the product whose price has changed, there will be a positive ratio - that is, a price increase in one product will yield an increase in demand for another product. Conversely, if two products are typically purchased together (known as complementary products), then a price change will result in a negative ratio - that is, a price increase in one product will yield a decrease in demand for the other product. Here are examples of different ratio results for the cross price elasticity of demand:
Positive ratio = When the admission price at a movie theater increases, the demand for downloaded movies increases, because downloaded movies are a substitute for a movie theater.
Negative ratio = When the admission price at a movie theater increases, the demand at the nearby parking garage also declines, because fewer people are parking there to go to the movie theater. These are complementary products.
Zero ratio = When the admission price at a movie theater increases, the demand at a nearby furniture store is unchanged, because the two are unrelated.
When there is a strong complementary relationship between two products, then a price increase for one product will have a strong negative impact on the other product. Similarly, if there are two close substitutes, a price increase for one product will have a strong positive impact on the other product.
How to Set Prices Based on Cross Price Elasticity of Demand
A company can use the concept of cross price elasticity of demand in its pricing strategies. For example, the food served in a movie theater has a strong complementary relationship with the number of theater tickets sold, so it may make sense to drop ticket prices in order to attract more movie viewers, which in turn generates more food sales. Thus, the net effect of lowering ticket prices may be more total profit for the theater owner.
How to Use Branding to Minimize the Substitution Effect
A business can also use heavy branding of its product line to mitigate the substitution effect. Thus, by spending money on advertising, a business can make customers want to buy its products so much that a price increase will not send them out to buy substitute products (at least not within a certain price range).