Question

How will the cross elasticity of demand differ, depending upon whether product $\mathrm{A}$ is a complement of or substitute for product $\mathrm{B}$ ?

Short answer

The cross elasticity of demand will differ depending on whether product A is a complement or a substitute for product B. If the products are complements, the cross elasticity of demand will be negative, showing that the demand for product A decreases when the price of product B increases. In contrast, if the products are substitutes, the cross elasticity of demand will be positive, indicating that the demand for product A increases when the price of product B increases.

Step-by-step solution

Define Cross Elasticity of Demand

Cross elasticity of demand measures how the demand for one product is affected by changes in the price of another product. It is calculated using the following formula: Cross Elasticity of Demand = $\frac{\mathrm{\%}\text{Change in quantity demanded of product A}}{\mathrm{\%}\text{Change in price of product B}}$ A positive cross elasticity of demand indicates that the two products are substitutes, while a negative cross elasticity of demand indicates that the two products are complements.

Calculate Cross Elasticity of Demand for Complementary Products

Let's assume product A and product B are complementary products. When the price of product B increases, the demand for product A will decrease, as they are often consumed together (e.g., coffee and sugar). Suppose the price of product B increases by 10%, and the demand for product A decreases by 5%. Using the cross elasticity of demand formula, we have: Cross Elasticity of Demand = $\frac{-5\mathrm{\%}}{10\mathrm{\%}}=-0.5$ Since the cross elasticity of demand is negative, this confirms that product A and product B are complementary products.

Calculate Cross Elasticity of Demand for Substitute Products

Now, let's assume product A and product B are substitute products. When the price of product B increases, the demand for product A will increase, as consumers may switch from product B to product A (e.g., butter and margarine). Suppose the price of product B increases by 10%, and the demand for product A increases by 8%. Using the cross elasticity of demand formula, we have: Cross Elasticity of Demand = $\frac{8\mathrm{\%}}{10\mathrm{\%}}=0.8$ Since the cross elasticity of demand is positive, this confirms that product A and product B are substitute products.

Explain the Difference in Cross Elasticity of Demand

The cross elasticity of demand will differ depending on whether product A is a complement of or a substitute for product B: 1. If product A and product B are complementary products, the cross elasticity of demand will be negative, indicating that the demand for product A decreases when the price of product B increases. 2. If product A and product B are substitute products, the cross elasticity of demand will be positive, indicating that the demand for product A increases when the price of product B increases.

Key concepts

Substitute Goods

Substitute goods are products or services that can be used in place of each other. When the price of one substitute good increases, consumers tend to switch to the other substitute, effectively increasing its demand.

Take, for instance, tea and coffee. If the price of coffee rises, people may choose to buy more tea, reflecting a positive cross elasticity of demand. This is because the increased cost of coffee makes tea more attractive economically, leading to a change in consumer behavior.

Complementary Goods

On the other hand, complementary goods are products that are often used together, where the use of one enhances the consumption of the other. A classic example is that of cinema tickets and popcorn.

When the price for cinema tickets goes up, the demand for popcorn typically falls, resulting in a negative cross elasticity of demand. This demonstrates the natural inverse relationship between the price of one good and the demand for its complement.

As such, the presence of a negative cross elasticity is a strong indicator of a complementary relationship between two products. Making an assessment of cross elasticity helps businesses and consumers understand how a price change can ripple through related markets.

Price Elasticity

Price elasticity is a broader economic concept that measures the responsiveness, or elasticity, of the demand for a product when its price changes.

There are two main types of price elasticity:

• Price Elasticity of Demand (PED): This measures how much the quantity demanded of a good responds to a change in its price. PED can be elastic (sensitive to price changes), inelastic (not sensitive), or unitary (proportional change).
• Cross Price Elasticity of Demand: This focuses specifically on the impact of the price change of one good on the demand for another good, as explained earlier.

Understanding price elasticity enables businesses to set prices strategically and promotes a deeper comprehension of market dynamics among consumers and analysts.

Economic Concepts

Economic concepts like cross elasticity of demand, substitutes, and complements are crucial for understanding market mechanisms.

Economists and businesses use these concepts to predict market reactions and make informed decisions. For example, if two goods have a high positive cross elasticity, companies might engage in competitive pricing strategies. Conversely, if goods are strong complements, firms might bundle them, securing sales of both products.

In any economic landscape, a comprehensive understanding of these principles supports more effective marketing, pricing, and production strategies, leading to more stable and profitable business operations.