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IB DP Economics Study Notes

2.5.3 Cross Elasticity of Demand (XED)

Cross elasticity of demand, commonly referred to as XED, is an essential concept in economics that provides insights into the interrelationships between products in a market. By understanding XED, businesses and policymakers can make informed decisions about pricing, production, and policy interventions.

Definition

Cross elasticity of demand (XED) quantifies the responsiveness of the quantity demanded of one good (Good A) to a change in the price of another good (Good B). It's a tool that helps to categorise the relationship between two goods in terms of substitutes, complements, or unrelated products.

  • Substitutes: A positive XED indicates that the goods are substitutes. For instance, if the price of tea rises, and people start buying more coffee as a result, tea and coffee are substitutes.
  • Complements: A negative XED suggests that the goods are complements. An example would be if the price of printers rises, leading to a decrease in the demand for ink cartridges, then printers and ink cartridges are complements.
  • Unrelated Goods: An XED close to zero signifies that the goods are unrelated. The demand for one product remains unaffected by the price changes of the other.

Understanding how consumers respond to changes in income is also critical, as explored in the notes on Income Elasticity of Demand (YED), which further complements the analysis of XED.

Graph of cross elasticity of demand

A graph illustrating cross elasticity of demand for substitute goods and complementary goods.

Image courtesy of geeksforgeeks

Calculation

The formula for calculating XED is:

XED=% change in quantity demanded of Good / % change in price of Good B​

Where:

  • % change in quantity demanded of Good A = (New quantity demanded - Original quantity demanded) / Original quantity demanded
  • % change in price of Good B = (New price - Original price) / Original price

Example:

Imagine the price of petrol increases by 15%, and as a result, the demand for cars with high fuel efficiency rises by 7.5%. To find the XED:

XED = 7.5% / 15% = 0.5​

This positive value indicates that petrol and fuel-efficient cars are substitute goods, albeit not perfect substitutes.

Determinants of XED

The magnitude of cross elasticity of demand can be influenced by several factors:

1. Closeness of Substitution or Complementarity:

  • The more closely two goods can be substituted for one another, the higher the positive XED. For instance, different brands of mineral water might have a higher XED compared to mineral water and orange juice.
  • Similarly, the stronger the complementary relationship between two goods, the higher the absolute value of the negative XED. Computers and software might have a higher (negative) XED than computers and office chairs.

2. Necessity vs. Luxury:

  • Goods perceived as necessities usually have a lower XED. For example, a rise in the price of basic bread might not significantly affect the demand for butter.
  • On the other hand, luxury goods, being more discretionary, often have a higher XED. If the price of luxury cruises rises, the demand for complementary luxury travel accessories might drop significantly, highlighting the role of Taxation and its impact on consumer choices.

3. Time Period:

  • Initially, consumers might not change their consumption habits immediately after a price change, resulting in a lower XED in the short term.
  • Over a more extended period, as consumers adjust and explore alternatives, the XED might increase. This is particularly relevant when considering the Non-price Determinants of Demand, which affect consumer behaviour over time.

4. Availability of Information:

  • Informed consumers can quickly adapt to price changes by switching between products, leading to a higher XED. For instance, in a market where price comparison apps are popular, goods might have a higher XED as consumers can easily find substitutes.

5. Brand Loyalty:

  • Strong brand loyalty can suppress XED. Loyal Apple users, for example, might not switch to Android phones even if Android phone prices drop, resulting in a lower XED between Apple and Android phones.

6. Breadth of the Market:

  • In broader markets with more product variety, there might be a higher XED as consumers have more alternatives to choose from. In niche markets with limited product variety, XED might be lower.

7. Consumer Income:

  • People with higher incomes might be less responsive to price changes of related goods, leading to a lower XED. Conversely, those with tighter budgets might be more price-sensitive, resulting in a higher XED.
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A summary table of the determinants of XED.

Understanding the determinants of XED is paramount for businesses. It can guide pricing strategies, especially when considering the prices of related goods. For policymakers, it can offer insights into the potential market impacts of taxes, subsidies, or other interventions on related goods, including the effects of Government and Market Failures. Moreover, by analysing XED, firms can anticipate competitor moves, predict consumer behaviour during economic fluctuations, and craft effective marketing strategies. This analysis is enhanced by understanding the Definition of Externalities, which provides context for the broader impacts of market activities.

FAQ

Goods with an XED close to zero are typically unrelated in consumption. This means that a change in the price of one good does not significantly affect the demand for the other. For instance, the demand for bananas is unlikely to be affected by a change in the price of televisions. Such goods do not serve similar purposes, are not consumed together, and are not seen as alternatives to each other. In essence, they cater to different consumer needs and desires, making their demand patterns independent of each other's price changes.

Yes, XED can be a valuable tool in predicting market outcomes during economic fluctuations. During an economic downturn, consumers might become more price-sensitive and look for cheaper substitutes. Goods with a high positive XED could see an increase in demand if their substitutes become pricier. Conversely, during economic booms, consumers might be more willing to purchase luxury items and their complements. Goods with a high negative XED could benefit from increased demand if their complementary goods experience a surge in sales. By understanding XED values and relationships, businesses can anticipate these shifts and adjust their strategies accordingly.

Firms utilise XED to craft effective marketing strategies by understanding the relationships between their products and others in the market. If two products have a high positive XED, firms might highlight the advantages of their product over the substitute, especially if the substitute's price rises. For products with a high negative XED, firms might bundle complementary goods together at a discounted rate, encouraging consumers to purchase both. Additionally, understanding XED can help firms position their advertising campaigns, targeting audiences that might be swayed by price changes in related goods.

Absolutely. Government policies, such as taxes, subsidies, or regulations, can influence the prices of goods, which in turn can affect XED values. For instance, if the government imposes a tax on sugary drinks, their prices might rise, leading to an increase in demand for substitute products like fruit juices or water. This would increase the positive XED between sugary drinks and their substitutes. Similarly, a subsidy on renewable energy might reduce the demand for non-renewable sources, impacting the XED between them. Understanding these potential shifts can help both businesses and policymakers anticipate market reactions to policy changes.

While both XED and PED measure responsiveness, they focus on different aspects. Price Elasticity of Demand (PED) gauges the responsiveness of the quantity demanded of a good to its own price change. It tells us how much the quantity demanded of a product will change when its price changes. On the other hand, Cross Elasticity of Demand (XED) measures the responsiveness of the quantity demanded of one good to a change in the price of another good. Essentially, PED looks at the relationship between price and demand for a single product, while XED examines the interrelationship between two different products.

Practice Questions

Define Cross Elasticity of Demand (XED) and explain how it can be used to determine the relationship between two goods.

Cross Elasticity of Demand (XED) quantifies the responsiveness of the quantity demanded of one good to a change in the price of another good. It's a vital tool in categorising the relationship between two goods. A positive XED indicates that the goods are substitutes, meaning an increase in the price of one leads to an increase in the demand for the other. A negative XED suggests the goods are complements, where a price rise in one results in a decrease in demand for the other. An XED close to zero signifies that the goods are unrelated, meaning the demand for one remains unaffected by the price changes of the other.

What are the implications for businesses when considering the determinants of Cross Elasticity of Demand (XED) in their pricing and production decisions?

The determinants of XED offer businesses insights into consumer behaviour and market dynamics. For instance, if two products have a high positive XED, they are close substitutes. This means a price increase for one product could lead to a significant increase in demand for the other. Conversely, a high negative XED indicates complementary goods, so a price rise in one might reduce demand for both. Understanding these relationships allows businesses to make informed pricing decisions, anticipate market reactions, and adjust production levels accordingly. Additionally, knowledge of XED can guide marketing strategies, helping firms position their products effectively against competitors.

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