Significance of Cross Elasticity of Demand:

The study of the concept cross elasticity of demand plays a major role in forecasting the
effect of change in the price of a good on the demand of its substitutes and
complementary goods. Therefore, it helps in deciding the price of a good by determining
the change in the demand of its substitutes and complementary goods.

Apart from this, cross elasticity of demand helps in determining the nature of
relationship between two goods whether they are substitutes, complementary to each
other or totally different from each other. In addition, it also enables an organization to
anticipate the intensity of monopoly and extent and type of competition in the market

Cross Elasticity of Demand: Measurement, Types :

The study of the concept cross elasticity of demand plays a major role in forecasting the
effect of change in the price of a good on the demand of its substitutes and
complementary goods.

Therefore, it helps in deciding the price of a good by determining the change in the
demand of its substitutes and complementary goods.

The demand for a good is generally associated with the demand for another good.
Therefore, change in the price of one good produces change in the price of another good.
The extent of relationship between two related goods can be measured by cross-
elasticity of demand. In other words, cross-elasticity of demand measures the
receptiveness of quantity demanded of a good with respect to change in the price of its
substitute or complementary good.

Some of the definitions of cross-elasticity of demand are as follows:

In the words of Leibhafsky, “the cross elasticity of demand is a measure of the
responsiveness of T to change in the price of X.”

According to Ferugson, “the cross-elasticity of demand is the proportional change in the

quantity of good-X demanded resulting from a given relative change in the price of the
related good-Y.”

It should be noted that the cross-elasticity of demand would be positive, when two goods
are substitute of each other. This is because the increase in the price of one good
increases the demand for the other. On the other hand, in case of complementary goods,
the cross-elasticity of demand would be negative as increase in the price of one good
decreases the demand for the other. For example, increase in the price of tea would
result in the increase in the demand for coffee, whereas increase in the price of petrol
would cause decrease in the demand for cars.

Measurement of Cross Elasticity of Demand:

Cross-elasticity of demand expresses the ratio of percentage change in demand of good
X produced due to the percentage change in price of related good Y.

Therefore, the formula for cross-elasticity (ec) of demand is as follows:

ec = Percentage change in quantity demanded of X/Percentage change in price of Y
Percentage change in quantity demanded of X= New demand for X (∆QX)/Original
demand for X (QX)
Percentage change in price of Y= New price for Y (∆PY/Original price for Y (PY)
The symbolic representation of the formula for cross elasticity of demand is
as follows:
ec = ∆QX/QX: ∆PY/PY
ec = ∆QX/QX */PY/∆PY
ec = ∆QX/∆PY */PY/QX
∆QX can be calculated by subtracting original demand for X (QX) from increase in
demand (QX1), which is as follows:
∆QX = QX1 – QX
Similarly, PY is the difference between the new price of Y (PY1) and original price for Y
(PY).
It can be calculated by the following formula:
∆PY = PY1 -PY
Types of Cross Elasticity of Demand:
There are three types of cross price elasticity of demand: substitute goods, complimentary goods
and unrelated products.

Cross Elasticity of Demand for Substitutes

When the cross elasticity of demand for product A relative to a change in the price of product B
is positive, it means that in response to an increase in the price of product B, the quantity
demanded of product A has increased. An increase in the price of product B means that more
people will consume A instead of B, and this will increase the quantity demanded of product A.
Substitutes will always have a positive Cross Price Elasticity or greater than zero.
Cross Elasticity of Demand for Compliments

When the cross elasticity of demand for product A relative to the change in the price of product
B is negative, it means that the quantity demanded of A has decreased relative to an increase in
the price of product B. An increase in the price of B will reduce the quantity demanded of A.
Compliments will always have a negative Cross Price Elasticity or less than zero.

Cross Elasticity of Demand for Unrelated

These are goods that show no relationship. Unrelated goods will always have a Cross Price
Elasticity of Demand = 0

Uses of Cross Price Elasticity of Demand

Knowing the Cross Price Elasticity of Demand of its own and other related products
allows a firm to map out the market. The firm can then calculate how many competitors it has,
and how closely related they are. It also allows a firm to measure how important its
complementary products are to its own products.
To reduce exposure to risk, firms can develop strategies associated with price changes by other
firms, such as a rise in the price of a complement or a fall in the price of a substitute.

The numerical value of cross-elasticity of demand is not same for every related goods. It
differs for different types of goods.

The various types of cross-elasticity of demand are as follows:

i. Positive Cross Elasticity of Demand:
Implies that the cross elasticity of demand would be positive when increase in the price
of one good (X) causes increase in the demand for the other good (Y). In simple terms,
cross elasticity would be positive for substitutes. For example, the quantity demanded
for coffee has increased from 500 units to 550 units with increase in the price of tea
from Rs. 8 to Rs. 10. Calculate the cross elasticity of demand and state the type of
relationship between coffee (X) and tea(Y).

Solution:
QX1 =550 units
QX =500 units
PY1 = Rs. 10
PY = Rs. 8
Therefore, ∆QX = QX1 – QX = 550 – 500 = 50 units
Similarly, ∆PY = PY1 – PY = Rs. 2
Now ec = 50/2*8/500= 0.4
The cross elasticity of “demand is positive; therefore, X and Y are substitutes.

ii. Negative Cross Elasticity of Demand:

Refers to a situation when the rise in the price of one good (X) reduces the demand for
the other good (Y). The cross elasticity of demand would be negative for complementary
goods. For example, the quantity demanded for X decreases from 220 to 200 units with
the rise in prices of Y from Rs. 10 to 12.

Now, the cross elasticity of demand would be as follows:

QX1 =200 units
QX =220 units
PY1 = Rs. 12
PY = Rs. 10
Therefore, ∆QX = QX1 – QX = 200 – 220= – 20 units
Similarly, ∆PY = PY1 – PY = Rs. 12 – Rs. 10 = Rs. 2
Now ec = – 20/2* 12/200= -0.6
The cross elasticity of demand is negative; therefore, X and Y are complementary to
each other.

iii. Zero Cross Elasticity of Demand:

Implies that the cross elasticity of demand would be zero when two goods X and Y are
not related to each other. In other words, the increase or decrease in the price of one
good (X) would not affect the demand of other good (Y).

How to Calculate Cross Price Elasticity of Demand

Cross Price Elasticity of Demand (XED) = Percentage Change in Quantity Demanded of Good x
/ Percentage Change in Price of Good y
= (New Quantity Demanded of Good x – Old Quantity Demanded of Good x)/(Old Quantity
Demanded of Good x) / (New Price of Good y – Old Price of Good y)/(Old Price of Good y)