Cross-Price Elasticity

Definition

Cross-price elasticity is a measure of the responsiveness of the demand for one good to a change in the price of another good. It quantifies the relationship between the demand for two related, but distinct, products.

5 Must Know Facts For Your Next Test

1. Cross-price elasticity is calculated as the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good.
2. The sign of the cross-price elasticity coefficient indicates whether the goods are substitutes (positive) or complements (negative).
3. The magnitude of the cross-price elasticity coefficient reflects the strength of the relationship between the two goods, with higher values indicating a stronger relationship.
4. Cross-price elasticity is an important concept in pricing and marketing strategies, as it helps businesses understand how changes in the price of one product can affect the demand for related products.
5. Understanding cross-price elasticity can also help policymakers assess the potential impact of taxes or subsidies on related goods.

Review Questions

• Explain how the sign of the cross-price elasticity coefficient indicates whether two goods are substitutes or complements.
  • The sign of the cross-price elasticity coefficient indicates the relationship between two goods. If the coefficient is positive, the goods are considered substitutes, meaning an increase in the price of one good leads to an increase in the demand for the other good. Conversely, if the coefficient is negative, the goods are considered complements, meaning an increase in the price of one good leads to a decrease in the demand for the other good. The magnitude of the coefficient reflects the strength of the relationship, with higher values indicating a stronger substitution or complementary effect.
• Describe how businesses and policymakers can use cross-price elasticity to inform their pricing and policy decisions.
  • Businesses can use cross-price elasticity to understand how changes in the price of one product can affect the demand for related products. This information can be used to set optimal pricing strategies, such as adjusting the price of one product to capitalize on the cross-price elasticity with a complementary product. Policymakers can also use cross-price elasticity to assess the potential impact of taxes or subsidies on related goods. For example, if a tax is placed on a good with a high cross-price elasticity with a substitute, the policy may have unintended consequences, such as a significant decrease in demand for the substitute good.
• Analyze how the concept of cross-price elasticity is related to the topics of price elasticity of demand, price elasticity of supply, and constant elasticity.
  • $$\text{Cross-price elasticity} = \frac{\% \Delta \text{Quantity Demanded of Good A}}{\% \Delta \text{Price of Good B}}$$ Cross-price elasticity is a related, but distinct, concept from price elasticity of demand and price elasticity of supply. While price elasticity measures the responsiveness of quantity demanded or supplied to changes in the own-price of a good, cross-price elasticity measures the responsiveness to changes in the price of a related good. Additionally, the concept of constant elasticity, where the elasticity coefficient remains the same regardless of the level of price or quantity, can apply to both own-price and cross-price elasticity. Understanding the relationships between these elasticity concepts is crucial for analyzing consumer behavior and designing effective pricing and policy strategies.

Related terms

Substitute Goods: Goods that can be used in place of one another, such as Coke and Pepsi, where an increase in the price of one good leads to an increase in the demand for the other.

Complementary Goods: Goods that are used together, such as printers and printer ink, where an increase in the price of one good leads to a decrease in the demand for the other.

Elasticity of Demand: The measure of the responsiveness of the quantity demanded of a good to a change in its own price.