ECO 1003- Microeconomics

LECTURE 8
Cross-price elasticity of demand
Outline
• Define cross-price elasticity of demand
• Measure the cross-price elasticity of demand using
the mid-point method
• Show the importance and significance of cross-
price elasticity of demand
Cross-Price elasticity of Demand
• The cross-price elasticity of demand (XED) answers a
question like this one:
• What is the expected reaction of consumers when the price of
Pepsi Cola decreases?
• Will they increase their demand for Coca Cola?
• Will they Buy more straws?
• If the price of butter goes up, will consumers increase their
consumption of alternative goods such as margarine?
• If the price of cashew or pistachios or almonds goes up, will
consumers increase their consumption of alternative goods such
as peanuts?
• The law of demand states that “ when the price of cashews go up,
consumers respond by reducing the quantity demanded of cashews, but
increasing the demand for substitutes such as peanuts ”.
Cross-Price Elasticity of Demand
• XED is measured by the ratio of the percentage change in the quantity
demanded of a good A (QA) to the percentage change in the price of a
good B (PB).
• XED is calculated:
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴 % ∆ 𝑄 𝐴
𝑋𝐸𝐷= = =¿
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐵 % ∆ 𝑃𝐵

• XED can be positive or negative

• A percentage change is the difference is expressed as a

percentage:
( 𝑵𝒆𝒘 𝒗𝒂𝒍𝒖𝒆 − 𝑶𝒍𝒅 𝒗𝒂𝒍𝒖𝒆 )
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆=% ∆= 𝑥 100
(𝒏𝒆𝒘 𝒗𝒂𝒍𝒖𝒆+ 𝑶𝒍𝒅 𝒗𝒂𝒍𝒖𝒆 )/ 2
 Practice
• A restaurant sells two goods: pizzas and burgers.
• The restaurant decided to sell more of its pizzas by
offering 25% discount. Consumers responded by
buying more pizzas.
• However, consumers also responded by reducing their
demand for burgers by 30%.
• The XED for burgers with respect to the change in
price in pizzas
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑏𝑢𝑔𝑒𝑟𝑠 % ∆ 𝑄 𝐴 −30 %
𝑋𝐸𝐷= = = =+ 1.20
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑖𝑧𝑧𝑎𝑠 % ∆ 𝑃𝐵 −25 %

• The “+” sign means that the price of pizza and the quantity demanded of burgers move in
the same direction
• The value of “1.20” means that 1% increase (decrease) in the price of pizza causes a 1.2%
increase (decrease) in the quantity demanded of burgers.
• Burgers and pizzas are substitutes
 XED using the mid-point formula
• XED is calculated:
𝐗 𝐄 𝐃=
% ∆𝑄 𝐴
=
[( 𝑄 𝐴2 −𝑄 𝐴1
𝑄 𝐴 1+𝑄 𝐴 2 )]
[( )]
% ∆ 𝑃𝐵 𝑃 𝐵2 − 𝑃 𝐵1
𝑃 𝐵1 + 𝐵 𝐵2

• The owner of a shop notices that he reduced the

price of pizza from AED 65 to AED 40, the demand
for burgers decreased from 400 to 350. sue the mid-
point formula to calculate the XIE

𝐗 𝐄 𝐃=
% ∆𝑄 𝐴
=
[( 𝑄 𝐴2 −𝑄 𝐴1
𝑄 𝐴 1+𝑄 𝐴 2 )] [(
=
3 50 − 4 00
4 00 +3 50 )] = [(− 50
750 )] = 0.28
[( )] [( 6 5 + 4 0 )] [( 1 05 )]
% ∆ 𝑃𝐵 𝑃 𝐵2 − 𝑃 𝐵1 4 0 −6 5 − 25
𝑃 𝐵1 + 𝐵 𝐵2
Interpretation of the XED
Possible values of XED

XED > 0 or positive XED = 0, XED < 0 or negative

“Substitutes” “Independent” “Complements”
A zero or near
An increase (decrease) in the price of A zero An increase (decrease) in the price of
causes an increase (decrease) in the A causes an decrease (increase) in
quantity of good B the quantity of good B
Peanuts and
watermelons
An increase in the price of AL Ain water An increase in the price of Cinema
causes consumers to buy more Mai Dubai tickets causes consumers to buy less
water, resulting in a positive XED popcorn, resulting in a negative XED
 Concept check
• A 2% increase in the price of milk causes a 4% reduction in the
quantity demanded of chocolate syrup.
• Calculate the cross-price elasticity of chocolate syrup with
respect to the price of milk using the base formula?
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴 % ∆ 𝑄 𝐴 + 4 %
𝑋𝐸𝐷= = = =−2
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐵 % ∆ 𝑃 𝐵 −2 %
• Interpret the value of the cross-price elasticity of syrup
• The sign “-” shows a negative relationship between change in price of
milk and change in quantity demanded of chocolate syrup.
• The value of “2” says that a 1% increase (or a decrease) in the price of
milk causes a 2% decrease (or increase) in the quantity demanded of
chocolate syrup.
• Are the two goods complements or substitutes?
• The value of -2 is negative, the goods are complements
Importance of cross-price elasticity of
demand
• Assume that Coca cola is considering whether to
lower the price of its Sprite to increase its
revenues. Coca cola is interested to know whether
increasing sales of Sprite will impact sales of other
drinks such as Coke Zero.
• Coca Cola would want to know how sensitive the sales of
Coke are to a change in the price of Sprite
• If they are substitutes, Coca cola wants to know by how
much the sales of Sprite will increase and by how much
will the sales of Cole decrease?
Concept check
• Assume Tinsel Town Videos • If the cross-price
lowers the price of its movie elasticity of demand for
club membership by 10% and
as a result, CineArts Videos computers and software
experienced a 16% decline in is negative, this means
its movie club membership. the two goods are
What is the value of the cross- _________.
price elasticity between the
two movie club memberships? A. Substitutes
A. -1.6 B B. complements
B. -0.625 C. Inferior
C. 0.625 D. normal
D. 1.6