Question

When the cross elasticity of demand for two services is negative, then these services are (LO4) a) complements b) substitutes c) both complements and substitutes d) neither complements nor substitutes

Short answer

The correct answer is a) complements. When the cross elasticity of demand for two services is negative, it indicates that the services are complements, meaning they are closely related and typically consumed together. This results in the demand for one service decreasing when the price of the other service increases.

Step-by-step solution

Define cross elasticity of demand

Cross elasticity of demand is a measure of how the quantity demanded of one good or service (let's call it Good A) changes in response to a change in the price of another good or service (let's call it Good B). It can be calculated by dividing the percentage change in the quantity demanded of Good A by the percentage change in the price of Good B. Mathematically, we can represent cross elasticity of demand as: \(Cross \, Elasticity \, of \, Demand = \frac{Percentage \, Change \, in \, Quantity \, Demanded \, of \, Good \, A}{Percentage \, Change \, in \, Price \, of \, Good \, B}\)

Define complements and substitutes

Complements are goods or services that are usually consumed together or are closely related. When the price of one complement increases, the demand for its complement typically decreases. In this case, cross elasticity of demand is negative. Examples include coffee and sugar, or cars and gasoline. Substitutes, on the other hand, are goods or services that can replace each other in consumption. When the price of one substitute increases, the demand for its substitute typically increases as well. In this case, cross elasticity of demand is positive. Examples include tea and coffee, or butter and margarine.

Determine the correct answer

Given that the cross elasticity of demand for the two services is negative, this indicates that when the price of one service increases, the demand for the other service decreases. This behavior is consistent with the definition of complements. Therefore, the correct answer is: a) complements

Key concepts

Complementary Goods

Complementary goods are items that people often consume together. Imagine the relationship between cars and gasoline. You need gasoline to operate a car, making them two parts of a whole. When the price of gasoline rises, the demand for cars might decrease, as the cost of using a car has indirectly increased.

Complementary goods have a special kind of connection. Their demand is intertwined, so when the price of one increases, it affects the other. This interconnectedness causes the cross elasticity of demand to be negative.

Here's why this is important to understand: in the case of complements, as the cost of one item goes up, we tend to reduce our purchase of both items. People might drive less if gasoline becomes more expensive, thus leading to fewer car purchases. This negative cross elasticity is a key indicator that two goods are complements.

Substitute Goods

Substitute goods are like stand-ins for each other. For instance, if the price of coffee rises, tea might become more popular, as people look for a similar effect at a lower cost. These goods replace each other to satisfy a similar need.

Think of them like two competitors aiming to win your preference. When the demand for one goes up due to the high price of the other, we see a positive cross elasticity of demand.

The dynamic here is opposite to that of complements. If butter becomes pricier, consumers may shift to margarine. This is an example of substitution at play. By understanding substitutes, we can better predict changes in consumer behavior based on relative pricing.

Negative Cross Elasticity of Demand

When we talk about negative cross elasticity of demand, we are referring to an indicator that shows a special kind of relationship between two goods. Specifically, when the price of one service goes up and this causes the demand for another to go down, they are said to be complements.

This negative elasticity gives us a valuable insight into consumer preferences. It suggests these goods are linked in a way that their demand moves together in the opposite direction to the price. For example, an increase in the cost of peanut butter could result in decreased demand for jelly, as both are often paired together.

The key takeaway is that negative cross elasticity helps identify complementary relationships, allowing businesses to anticipate how a change in pricing strategy for one product might impact demand for another.