Cross-price elasticity

Definition

Cross-price elasticity measures the responsiveness of the quantity demanded for one good to a change in the price of another good. This concept helps to identify whether two goods are substitutes or complements. A positive cross-price elasticity indicates that the goods are substitutes, meaning when the price of one rises, the quantity demanded for the other also increases. Conversely, a negative cross-price elasticity suggests that the goods are complements, meaning that when the price of one goes up, the quantity demanded for the other tends to decrease.

5 Must Know Facts For Your Next Test

1. A positive cross-price elasticity indicates that two goods are substitutes, meaning an increase in price of one leads to an increase in demand for the other.
2. A negative cross-price elasticity shows that two goods are complements; a rise in the price of one results in a decrease in demand for the other.
3. The magnitude of cross-price elasticity can provide insight into how closely related two products are in terms of consumer choice.
4. Cross-price elasticity is calculated using the formula: $$E_{xy} = \frac{\% \Delta Q_d^x}{\% \Delta P^y}$$ where $$E_{xy}$$ is cross-price elasticity, $$Q_d^x$$ is quantity demanded of good x, and $$P^y$$ is price of good y.
5. Understanding cross-price elasticity is crucial for businesses when setting prices and predicting how changes in market conditions will affect sales.

Review Questions

• How does cross-price elasticity help businesses understand consumer behavior?
  • Cross-price elasticity provides businesses with insights into how changes in prices affect consumer demand for their products. By analyzing whether their products are substitutes or complements to others, companies can make informed pricing strategies. For instance, if two products are identified as substitutes with a positive cross-price elasticity, a business might consider raising prices on one to boost sales on the other.
• Evaluate how knowledge of cross-price elasticity can influence a company’s pricing strategy for complementary goods.
  • Understanding cross-price elasticity is vital for pricing strategies involving complementary goods. If a company realizes that raising the price of one product (e.g., printers) will lead to a decrease in demand for its complementary good (e.g., ink cartridges), it may choose to adjust pricing carefully. This knowledge helps them maintain overall sales volume and profitability by strategically managing product relationships instead of just focusing on individual product prices.
• Analyze a real-world scenario where cross-price elasticity significantly impacted market outcomes and consumer choices.
  • Consider a situation where a popular streaming service raises its subscription fee. This price increase could lead to higher cross-price elasticity with competing services. As consumers seek alternatives, they may shift to rival platforms if those services have lower prices. This response illustrates how significant changes in cross-price elasticity can reshape market dynamics and consumer behavior by pushing users away from higher-priced options toward more affordable substitutes.

Related terms

Price elasticity of demand: Price elasticity of demand measures how much the quantity demanded of a good responds to changes in its own price.

Substitutes:

Substitutes are goods that can replace each other; when the price of one rises, the demand for the other typically increases.

Complements:

Complements are goods that are often consumed together; when the price of one rises, the demand for the other usually decreases.