Introduction
Cross elasticity of demand (XED) measures the responsiveness of the demand for one good to a change in the price of another good. It is calculated as the percentage change in the quantity demanded of good A divided by the percentage change in the price of good B. XED is a crucial tool for understanding the relationship between goods, specifically whether they are complements or substitutes.

Complementary Goods
Complementary goods are those that are consumed together. Examples include coffee and sugar, cars and petrol, and printers and ink cartridges. If two goods are complements, a decrease in the price of one good will lead to an increase in the demand for the other good. This is because the lower price of one good makes the combination of the two goods more attractive to consumers. A negative XED value indicates that two goods are complements. This means that as the price of one good increases, the demand for the other good decreases. For instance, if the price of coffee increases, the demand for sugar is likely to decrease as consumers are less willing to consume coffee at the higher price.
Businesses selling complementary goods can leverage this relationship to their advantage. By strategically pricing their products, they can increase overall demand. For example, a car manufacturer might offer a discount on a car purchase that comes bundled with a free set of tyres. This pricing strategy encourages consumers to purchase both products, increasing overall sales for the manufacturer. Furthermore, joint marketing efforts, such as advertising campaigns that highlight the benefits of using both products together, can also contribute to an increase in demand.

Substitute Goods
Substitute goods are those that can be used in place of each other. Examples include Coca-Cola and Pepsi, butter and margarine, and public transportation and private cars. If two goods are substitutes, a decrease in the price of one good will lead to a decrease in the demand for the other good. Consumers will switch to the cheaper option. A positive XED value indicates that two goods are substitutes. This means that as the price of one good increases, the demand for the other good increases. For example, if the price of Coca-Cola increases, consumers are likely to switch to Pepsi, leading to an increase in the demand for Pepsi.
The degree of substitutability between two goods can be measured by the elasticity of XED. A high XED value indicates that the two goods are highly substitutable, while a low XED value indicates that they are weakly substitutable. The degree of substitutability has a significant impact on the competitive environment and pricing strategies employed by businesses. If two goods are highly substitutable, businesses will need to be more competitive in their pricing and marketing efforts to maintain market share. However, if two goods are weakly substitutable, businesses may have more pricing power and less pressure to compete aggressively.

Limitations of XED
While XED is a valuable tool for analyzing the relationship between goods, it is important to recognize that it is a static concept. As such, it may not capture dynamic changes in the market. For instance, the introduction of new technologies or changes in consumer preferences could significantly alter the relationship between goods, even if their XED remains unchanged. Other factors influencing the relationship between goods include consumer preferences, income levels, and availability of substitutes.

Conclusion
XED is an essential tool for understanding the relationship between complementary and substitute goods. By analyzing the direction and magnitude of XED, businesses can make informed decisions regarding pricing, marketing, and product development. For complementary goods, businesses can leverage joint marketing efforts and price bundling to increase overall demand. For substitute goods, businesses need to consider the degree of substitutability and adjust their pricing and marketing strategies accordingly. While XED is a valuable tool, it is important to acknowledge its limitations and consider other factors that may influence the relationship between goods.

Sources:
Mankiw, N. G. (2014). Principles of microeconomics. Cengage Learning.
Perloff, J. M. (2013). Microeconomics. Pearson Education.
Lipsey, R. G., & Chrystal, K. A. (2012). Economics. Oxford University Press.