Study Notes on Cross Elasticity of Demand
1. Introduction
Cross elasticity of demand (XED) measures how the quantity demanded of one good changes
in response to a change in the price of another good. It helps economists and businesses
understand the relationship between products—whether they are substitutes, complements, or
unrelated goods.
In simpler terms, cross elasticity shows how connected two products are in consumers’ minds.
For instance, if the price of tea rises and people buy more coffee instead, coffee and tea are
substitutes.
2. Definition and Formula
The cross elasticity of demand is defined as:
Exy=% change in quantity demanded of good X% change in price of good YE_{xy} = \frac{\%
\text{ change in quantity demanded of good X}}{\% \text{ change in price of good Y}}Exy
=% change in price of good Y% change in quantity demanded of good X
or equivalently,
Exy=ΔQx/QxΔPy/PyE_{xy} = \frac{\Delta Q_x / Q_x}{\Delta P_y / P_y}Exy=ΔPy/PyΔQx/Qx
where:
• ExyE_{xy}Exy = cross elasticity of demand between goods X and Y
• QxQ_xQx = quantity demanded of good X
• PyP_yPy = price of good Y
3. Types of Goods and Interpretation of XED
Type of Sign of
Interpretation Example
Relationship XED
Positive As the price of good Y increases, demand for Tea and
Substitute Goods
(+) good X increases. Coffee
Complementary Negative As the price of good Y increases, demand for Cars and
Goods (–) good X decreases. Petrol
Type of Sign of
Interpretation Example
Relationship XED
A change in the price of good Y does not Bread and
Unrelated Goods Zero (0)
affect demand for good X. Shoes
Substitutes (Eₓᵧ > 0)
When two goods compete to satisfy similar needs, they are substitutes. A higher positive value
indicates stronger substitutability.
Example: If the price of Pepsi rises and people buy more Coke, XED will be positive.
Complements (Eₓᵧ < 0)
When goods are used together, an increase in the price of one reduces the demand for the other.
Example: If fuel prices rise, fewer people may buy cars, showing a negative XED.
Unrelated Goods (Eₓᵧ = 0)
If the price of one product does not affect the other, they are independent.
Example: The price of apples has no effect on the demand for laptops.
4. Degree of Cross Elasticity
Value of XED Meaning
High positive Strong substitutes (e.g., Coca-Cola and Pepsi)
Low positive Weak substitutes (e.g., butter and margarine)
High negative Strong complements (e.g., printers and ink cartridges)
Low negative Weak complements (e.g., milk and biscuits)
5. Graphical Representation
Substitute Goods:
The demand curve for good X shifts rightward when the price of good Y rises.
Complementary Goods:
The demand curve for good X shifts leftward when the price of good Y rises.
(Graphs typically show two demand curves for good X before and after a price change in good
Y.)
6. Importance and Applications of Cross Elasticity
1. Business Pricing Strategy
o Firms identify substitutes and complements to set competitive prices.
o Example: If two smartphone brands are close substitutes, one company may lower
prices to capture market share.
2. Market Definition and Competition Policy
o Regulators use XED to determine if firms are in the same market.
o High positive XED implies close competition.
3. Product Line Decisions
o Companies assess whether adding a new product will cannibalize (reduce sales
of) existing ones.
o Example: A car manufacturer introducing a new model similar to an existing one
must consider internal substitution.
4. Complementary Pricing
o Firms selling complementary goods (like printers and ink) may price one product
low and the other high to maximize profits.
5. Public Policy and Taxation
o Governments assess how taxes on one good (like fuel) might affect demand for
related goods (like cars).
7. Factors Affecting Cross Elasticity of Demand
1. Degree of Substitutability or Complementarity
o The stronger the relationship, the higher the XED (positive or negative).
2. Time Period
o Substitution takes time; XED may increase in the long run.
3. Consumer Preferences and Habits
o Loyal customers may show low XED even between similar products.
4. Availability of Alternatives
o The more alternatives available, the higher the XED between close substitutes.
5. Proportion of Income Spent
o Goods that take a large share of income show more elastic relationships.
8. Limitations of Cross Elasticity of Demand
• Data Availability: It is often difficult to collect accurate data on price and quantity
changes across different products.
• Assumption of Ceteris Paribus: XED assumes other factors (income, tastes, etc.)
remain constant, which is unrealistic.
• Dynamic Preferences: Consumer preferences change over time, making elasticity
unstable.
• Non-linearity: The relationship between goods is not always constant; elasticity can vary
at different price levels.
9. Summary
• Cross elasticity of demand measures how the demand for one product responds to the
price change of another.
• It helps identify substitute and complementary relationships between goods.
• A positive XED indicates substitutes, a negative XED indicates complements, and zero
XED indicates unrelated goods.
• Businesses, policymakers, and economists use it for pricing strategies, competition
analysis, and understanding market behavior.
