CROSS PRICE ELASTICITY OF DEMAND (XED)
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CROSS PRICE ELASTICITY OF DEMAND (XED): Measures the responsiveness of demand for one good to a change in price of another good; hence, the XED determines whether two goods are substitute or complementary goods:
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Substitute Goods ( XED > 0 ) : Quantity demanded for one good and price of another good changes in the same direction
Complementary Goods ( XED < 0 ) : Quantity demanded for one good and price of another good changes in the opposite direction
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The absolute value of the cross price elasticity of demand (XED) indicates the closeness of the relationship between two goods:
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Smaller Absolute Value: Weaker relationship between two goods; Smaller shift of demand curve in the event of a price change
Larger Absolute Value: Stronger relationship between two goods; Larger shift of demand curve in the event of a price change
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CROSS PRICE ELASTICITY OF DEMAND (XED): SUBSTITUTE GOODS
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SUBSTITUTE GOODS: Two goods - Good X and Good Y - are substitute goods if they fulfill a similar need to consumers (an example of substitute goods are Coca-Cola and Pepsi)
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Substitute Goods ( XED > 0 ) : Quantity demanded for one good and price of another good changes in the same direction
The larger the value of XED, the greater the substitutability between two goods, and the larger the shift of the demand curve in the event of a price change:
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Suppose the two goods - Good X and Good Y - are substitute goods that fulfill a similar need to consumers
If the price of Good X increases, consumers will switch to consuming the cheaper substitute good, Good Y; hence, the demand for Good Y will increase
Alternatively, If the price of Good X decreases, consumers of the substitute good, Good Y, will switch to consuming the cheaper alternative, Good X; hence, the demand for Good Y will decrease
In other words, quantity demanded for Good X and price of Good Y will change in the same direction
For this reason, substitute goods have a positive value of cross price elasticity of demand (XED), with a larger value of XED indicating a greater substitutability between two goods
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Example: Coca-Cola and Pepsi
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Suppose a convenience store raises the price of Coca-Cola from $10 to $12 per can, later seeing an
increase in sales of Pepsi from 1500 to 1650 bottles. Calculate the cross price elasticity of
demand.
As the value of XED is 0 < 0.5, Coca-Cola and Pepsi are Substitute Goods
CROSS PRICE ELASTICITY OF DEMAND (XED): COMPLEMENTARY GOODS
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COMPLEMENTARY GOODS: Two goods - Good X and Good Y - are complementary goods if they are used together (an example of complementary goods are DVDs and DVD players)
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Complementary Goods ( XED < 0 ) : Quantity demanded for one good and price of another good changes in the opposite direction
The larger the absolute value of XED, the greater the complementarity between two goods, and the larger the shift of the demand curve in the event of a price change:
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Suppose the two goods - Good X and Good Y - are complementary goods that are used together
If the price of Good X increases, demand will decrease; however, as Good X is consumed together with the complementary good, Good Y, the demand for Good Y will decrease correspondingly
Alternatively, If the price of Good X decreases, demand will increase; however, as Good X is consumed together with the complementary good, Good Y, the demand for Good Y will increase correspondingly
In other words, quantity demanded for Good X and price of Good Y will change in the opposite direction
For this reason, complementary goods have a negative value of cross price elasticity of demand (XED), with a larger absolute value of XED indicating a greater complementarity between two goods
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Example: Pencils and Erasers
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Suppose a stationary store raises the price of pencils from $1.00 to $1.30, later seeing a decrease in
sales of erasers from 1000 to 800 pieces. Calculate the cross price elasticity of demand.
As the value of XED is -0.67 < 0, Pencils and Erasers are Complementary Goods
APPLICATIONS OF CROSS PRICE ELASTICITY OF DEMAND (XED)
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Firms can determine whether their goods are substitutes or complements to competitors by calculating the respective cross price elasticity of demand (XED); this information can be used to better plan business strategies:
Substitute Good
Firms can determine whether their goods are substitutes to competitors by obtaining a positive value for the cross price elasticity of demand (XED); this information can be used to adjust strategies when prices of rival substitutes change:
Suppose Company A produces Good X which is a substitute to a rival good, Good Y
If the price of Good Y increases, consumers will switch to consuming the cheaper substitute, Good X; hence, Company A can better prepare for this expected increase in demand by ensuring stock availability, thereby fulfilling all potential sales to maximize total revenue
Alternatively, If the price of Good Y decreases, consumers of the substitute good, Good X, will switch to consuming the cheaper alternative, Good Y; hence, Company A can avoid this expected decrease in demand by lowering price of Good X, retaining and attracting more consumers to maximize total revenue
Complementary Good
Firms can determine whether their goods are complements to competitors by obtaining a negative value for the cross price elasticity of demand (XED); this information can be used to adjust strategies when prices of rival complements change:
Suppose Company A produces Good X which is a complement to a rival good, Good Y
If the price of Good Y increases, demand will decrease, correspondingly decreasing the demand for complementary good, Good X, as they are consumed together; hence, Company A can avoid this expected decrease in demand by lowering price of Good X, retaining and attracting more consumers to maximize total revenue
Alternatively, If the price of Good Y decreases, demand will increase, correspondingly increasing the demand for complementary good, Good X, as they are consumed together; hence, Company A can better prepare for this expected increase in demand by ensuring stock availability, thereby fulfilling all potential sales to maximize total revenue
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