Cross Elasticity of Demand

Cross elasticity of demand is the ratio of percentage change in quantity demanded of a product to percentage change in price of another product. It is used to measure how responsive the quantity demanded of one product is to a change in price of another product.

Cross elasticity of demand indicates whether any two products are substitute goods, complementary goods or independent goods. A positive cross elasticity of demand means that the products are substitute goods. A negative cross elasticity of demand means that the products are complementary goods. A near zero cross elasticity of demand means that the products are independent goods i.e. quantity demanded of product A is not affected by any movement in price of product B.

Formula

Cross Elasticity of Demand EA, B =% increase in quantity demanded of A
% increase in price of product B

Percentage changes in the above formula are calculated using the mid-point formula which divides actual change by average of initial and final values.

The formula to calculate cross elasticity thus becomes:

EA, B =Qf − Qi÷Pf − Pi
(Qf + Qi) ÷ 2(Pf + Pi) ÷ 2

Where,
Qf and Qi are the final and initial quantities demanded of product A, respectively; and
Pf and Pi are the final and initial prices of product B.

Substitute Goods

When the cross elasticity of demand for product A relative to a change in price of product B is positive, it means that in response to an increase (decrease) in price of product B, the quantity demanded of product A has increased (decreased). Since A, say Coke, and B, say Sprite, are substitutes, an increase in price of product B means that more people will consume A instead of B, and this will increase the quantity demanded of product A. Increase in quantity demanded of product A relative to increase in price of product B gives us a positive cross elasticity of demand.

Complimentary Goods

When the cross elasticity of demand for product A relative to change in price of product B is negative, it means that the quantity demanded of A has decreased (increased) relative to an increase (decrease) in price of product B. As A, say car, and B, say gas, are complimentary goods, and an increase in price of B will reduce the quantity demanded of A. This is because people consume both A and B as a bundle and an increase in price reduces their purchasing power and decreases quantity demanded.

Examples

Example 1: The quantity demanded or product A has increased by 12% in response to a 15% increase in price of product B. Calculate the cross elasticity of demand and tell whether the product pair is (a) apples and oranges, or (b) cars and gas.

Cross elasticity of demand = % change in quantity demanded of A ÷ % change in price of B = 12%/15% = 0.67.

Since the cross elasticity of demand is positive, product A and B are substitute goods. They are most likely apples and oranges.

Example 2: The government of Selgina is very serious about drugs. Possession of drugs is illegal and is severely penalized. However, a black market exists which the government has failed to dismantle despite serious attempts. Khusenichho Chamling, the health minister, is worried about the situation. In early 2009, a consultant working with health ministry suggested that the government should increase the price of a pack of cigarettes from 200 Selgina dollars (S$) to S$600. A survey conducted in December 2009 suggested that over the year, the quantity demanded of marijuana decreased from 2,000 kgs per day to just 800 kgs. Calculate the cross elasticity of demand and tell why has the policy proved so effective.

Percentage increase in price of cigarettes = (600-200) ÷ {(600+200) ÷ 2} = 100%

Percentage increase in quantity demanded of marijuana = (800-2,000) ÷ {(800+2000) ÷ 2} = -85.71%

Cross elasticity of demand = % change in quantity demanded/% change in price = -85.71%/100% = -0.86

Cigarettes and marijuana have negative cross elasticity of demand which tells that they are complimentary goods.

The policy has proved effective because cigarettes and marijuana are consumed together. Increase in price of cigarettes increased the price of the whole bundle and reduced the purchasing power of people and resulted in a drop in consumption of marijuana.

Written by Obaidullah Jan