When it comes to Cross-elasticity of demand, we must first illustrate the concept of elasticity of demand. We can say that elasticity of demand is the foundation of the theory of cross-elasticity of demand because elasticity of demand is related to only one good while cross-elasticity of demand is about the relation of two goods. We should first compare the elasticity of demand with the cross-elasticity of demand.
Elasticity of demand is sometimes referred to as the own-price elasticity of demand for a good, such as the elasticity of demand with respect to the good’s own price. Elastic demand reflects that consumers are very price sensitive. This concept is understandable because we all know price is one of important determinant of quantity, and the quantity demanded of a good is negatively related to its price. We can suppose: for a seller, lower price promotes sales; for a buyer, higher price constraints their desire of purchase. Take the example from the textbook, suppose that a 10% increase in the price of an ice-cream cone causes the amount of ice cream you buy to fall by 20%. According to the formula, ee calculate your elasticity of demand as 20%/10%= 2. This result can be explained as the elasticity 2 reflects the change in the quantity demanded is proportionately twice as large as the change in the price. This result owes to reasons as follows: First, market for ice cream is very competitive instead of monopolistic. Second, consumers have choices of other substitutes such as other desserts. Third, when the price of ice cream rises, consumers can buy cakes, milk-shake or other desserts.
The above formula usually yields a negative value, due to the inverse nature of the relationship between price and quantity demanded, as described by the “law of demand” but economists often refer to price elasticity of demand as a positive value (i.e., in absolute value terms).
Based on the theory mentioned above about price elasticity of demand, we can go further to find out the relation of two goods. Cross-elasticity of Demand, is a type of elasticity which measures the degree by which a change in the price of one commodity affects the change in demand for another commodity. In arithmetic terms, it is the percentage change in quantity demanded of one commodity, Y, divided by the percentage change in the price of one commodity, X. The resulting coefficient of elasticity shows how sensitive the demand for one commodity is to the changes in the price of another commodity.
The cross-price elasticity of demand is often used to see how sensitive the demand for a good is to a price change of another good. The major determinant of cross-elasticity of demand is the closeness of the substitute or complement. A high positive cross-price elasticity indicates that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods.
Examples of two substitutes are butter and margarine. These two cannot be consumed at the same time. Therefore, if the price of butter rises, by the law of demand, the quantity demanded will fall. Further, consumers will prefer to consume more of the substitute, which is margarine. In the case of substitutes, when the price of one commodity increases, then the quantity demanded of the best alternative, that is, the substitute increases. In this case, the value of the cross-price elasticity is positive. Complementary goods are consumed together.
Examples of two complementary goods are rice and chicken. If the price of chicken goes up, then by the law of demand, its quantity demanded will drop. Since rice complements chicken, then its quantity demanded rice will also drop. Based on the analysis above, if the cross-price elasticity is zero, then it implies that the two commodities being analyzed are not related. Further, if the value of elasticity for the commodities is less than one (negative), then it indicates that the two products are complementaries. Finally, if the elasticity is greater than zero (positive), then it shows that the two commodities being analyzed are substitutes. In the United States, the cross elasticity between cantaloupe and watermelon is 0.6. This shows that they are substitutes. Further, the cross-price elasticity between chicken and rice is -0.1309. This implies that they are complementaries. Thus, the study of cross-price elasticity helps in monitoring market trends.
For a Firm, it needs to know the cross-elasticity of demand for their product when considering the effect on the demand for their product of a change in the price of a rival’s product or a complementary product. If the quality and appearance is almost the same (regardless of the factors of affection location, and loyalty, etc.) but the price of Firm A is higher than that of Firm B, most consumers will choose the products of Firms B. Among theories of marketing, “pricing” is not only difficult but technical. These are vital pieces of information for firms when making their production plans.
However, for goods those complement each other, a firm is supposed to promote the sales of both the products and their complements. Nowadays, the price of petroleum is constantly high and it will continuously get higher in the near future. This is definitely a disaster for automotive industry. Some of the automobile companies adopt the strategy of reduction but gets an unsatisfactory feedback. What affects the decision of a consumer is mainly the price of petroleum instead of the automobile, so some companies think out of a promotional tactic: buy car get petro discounted (though the price of a car may be very expensive), and this may be to some extent cater to the consumers’ psychology.
Another application of the concept of cross-elasticity of demand is in the field of international trade and the balance of payments. What’s more, for different industries and fields, the concept of cross-elasticity of demand can be used to measure the closeness of relation of each other. For those monopoly enterprises, they are the unique suppliers in market and they are powerful enough to control the whole market, so they won’t suffer the pressure from others. However, for some industries, such as Ministry of Railway, if it decides to raise the price in a large scale, many passengers will prefer other transportation, which will make aviation industry or highroad industry prosperous. This will undoubtedly lay itself in an unadvantageous position.