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Significance of Cross Elasticity of Demand Values

Question

Explain the significance of cross elasticity of demand values that are negative, positive and zero.

Category:

Elasticity

[CIE AS level November 2018]

Preview Answer


Step ➊ : Define 'cross elasticity of demand' and state it’s formula.

Cross elasticity of demand (XED) is a numerical measure of the responsiveness of the quantity demanded for one product following a change in the price of another related product, ceteris paribus. The formula for cross elasticity of demand used is as follows :

XED =

% change in quantity demanded of product A

% change in the price of product B

The values of XED can be positive, negative and zero. This value depends on whether products are substitutes, complements or are independent.


Step ➋ : Explain what is meant by a positive, negative and zero for cross elasticity of demand. (Application)


➤ 2.1 Products that are substitutes for each other will have positive values for the XED.

A substitute good is a good that can be used in place of another, for example, cars and motorbikes. If the price of cars increase, then people can turn to motorbikes instead because of its more favourable relative price. If the price of cars fall, then consumers will start to buy cars instead of motorbikes.

Assume that the current average market price of a car is $10,000 and current sales are 100 cars per day. This is shown in Figure A illustrated below.

Following a 2% decrease in the price of motorbikes (a substitute product), demand for cars falls from 100 units to 98 units per day at the original price. The demand curve for cars shifts from D0 to D1.

The cross elasticity of demand can be calculated as follows;

XED =

2% fall in demand for cars

2% decrease in price of motorbikes

= + 1

The positive sign indicates that the products are substitutes.

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