XED for substitutes
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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.
Example: cars and motorbikes.
If the price of cars increases, then people can turn to motorbikes instead because of their more favourable relative price. If the price of cars falls, 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 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;
2% fall in demand for cars
2% decrease in price of motorbikes
= + 1
The positive sign indicates that the products are substitutes.