Cross Elasticity of Demand Explained

Economics is a very interesting subject with immense potential to describe almost any problem in society and has the power to solve it. All it needs is information and data. It is generally studied as a commerce subject or as a core stream in the art segment. In this article, we will discuss the concept of cross elasticity of demand. It is about the determination of the responsiveness of the demanded quantity of a product when there is a change in the price of other products.

What is Cross Elasticity of Demand?

The cross elasticity of demand is defined as an economic concept where the responsiveness of a product’s quantity is measured using a mathematical formula when the price of another product changes. With this concept, we can determine the effect on a product’s demand when there is a significant change in other products’ prices.

This measurement is done by calculating the percentage change in the quantity of a product demanded divided by the percentage change of the price of another product. As you can see, there are two products mentioned in the definition. The change in demand of the concerned product will remain at the numerator position whereas the change in the price of the other product will remain at the denominator position.

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Types of Cross Elasticity of Demand

We can conclude that this ratio can go in two different ways. Let us discuss the ratio first in order to understand the concept well. For this, consider the different terms below.

Cross Elasticity of Demand = E_XY (where X and Y are two products)

Quantity of X ​= Q_X

Price of Y = P_Y

Change in Quantity of X = ΔQ_X

Change in Quantity of Y = ΔP_Y

If we now interpret the formula using the definition then the mathematical interpretation becomes:

\[E_{XY}\] = \[\frac{Percentage\: Change\: in\: Quantity\: of\: Y}{Percentage\: in\: Change\: in\: Price\: of\: X}\]

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As per the definition and mathematical interpretation of cross elasticity of demand, we can conclude how to calculate the sensitivity of the demand of a product based on the changes in the price of the other one. In this aspect, the types of cross elasticity of demand are:

• Substitute Goods

In this economic concept, the demand for a product increases when the price of a substitute product increases significantly. It is obvious that the increase in the price of a product will automatically drive the consumers to buy the other product in comparison resulting in an increase in its demand.

Consider an example to get the idea of this concept. As per the cross elasticity of demand for substitute goods, when the price of iPhones increases in the market, the consumers will definitely think of replacing it with another type such as Android phones unless they are loyal to that brand product traits. In general, it has been substantiated with data that the increase in the price of a product will result in a significant increase in the demand for products of the same genre. It can be understood that when the prices of Android mobile phones will reduce ( as shown in the below diagram ) then the demand of the iphones will tend to reduce. Thus this is how substitute goods work.

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It can also happen in the same genre of products. For instance, if the price of a soft drink product increases, the consumers will shift their inclination towards another product that costs less than the former one. This is called substitution of demand. If you now observe the stated formula then the increase in price in the denominator will show a positive increase in the demand for another product.

In this aspect, the products should be correlated and should have an influence on each other. For instance, the increase in coffee price will not affect the demand for cars or petrol.

• Complementary Goods

On the contrary, when we are considering complementary products, an increase in the price of a product will result in a decrease in demand for the other. the items that are closely associated will witness a reduction in demand when the price of one item in the reference frame increases.

Let us consider an example first. If the price of iPhone increases then the demand for their mobile cases and other accessories will also witness a downfall. It shows a negative graph and is considered to be complementary goods showing a negative cross elasticity effect. Now that we can explain what is cross elasticity of demand with the help of its mathematical representation, it can be easily understood how this negativity in the demand for complementary products happens.

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To make it easier to understand, cross elasticity of demand graph is drawn for both the cases and the trend in changes of demand for substitute and complementary products can be visualized. The graphical representation enables us to understand and predict the trend of the behaviour of demands of various interrelated products.

Hence, cross elasticity of demand example problems and understand the two types of effects of price rise. Start identifying the substitute and complementary products for a given item and analyze the results using the mathematical representation along with the cross elasticity graph.