Cross elasticity demand, also known as XED, is the measurement of the sensitivity of quantity demanded for one good to the change in the price of another good.
Cross elasticity demand is the sensitivity of the quantity demanded for good A against the change in the price of good B.
Complementary goods are goods that are often bought together (negative XED). Substitute goods are goods that can be substituted between each other (positive XED).
Cross elasticity of demand is useful for businesses to set prices and recognize their product’s sensitivity to other products.
Complementary goods are goods that are often bought together. If the price of good B increases, both the quantity demanded for A and B will decrease. It is reflected by a negative cross elasticity demand as a result of quantity demanded for good A and the price of good B moving in opposite directions.
Substitute goods are goods that can be alternatives to each other. If consumers see that good B is on discount, there will be a switch to more consumption of good B and less of good A. Substitute goods are characterized by a positive cross elasticity demand because the numerator and denominator move in the same direction.
Scale of Cross Elasticity Demand
Different degrees of cross elasticity demand should be distinguished. On one side of the scale, there are goods that are strong complements. They are almost always bought together – such as hot dogs and hot dog buns. If hot dogs experience a small increase in price, hot dog buns will encounter a large decrease in quantity demanded.
Next, weak complements are goods that are sometimes bought together, such as peanut butter and jelly. If jelly increases in price, there may be some decline in the quantity demanded for peanut butter. However, peanut butter is used in many other recipes besides PB&J sandwiches, so there will only be a small decline in the quantity demanded for peanut butter.
The small change in quantity demanded of good A in the numerator against the relatively larger change in the price of good B in the denominator results in a low negative XED.
In the middle of the scale are unrelated goods. These two goods are not correlated at all, such as a snowboard and calculators. An increase in snowboard prices will not affect the quantity demanded for calculators. Therefore, the XED of unrelated goods is 0.
On the other hand, weak substitutes are goods that consumers sometimes substitute. For example, consumers who want to buy snacks may substitute chips for popcorn if chips go on sale. However, other consumers religiously consume popcorn and would not make the switch, even if it is more expensive. Thus, weak substitutes demonstrate a low positive XED.
Finally, strong substitutes are goods that are nearly homogenous, such as different brands of sugar. If one brand decreases its price, other brands will likely see lower quantity demanded due to consumers switching to the cheaper brand. A high positive XED is indicated by a large change in quantity demanded of good A in the numerator, relative to the change of the price of good B in the denominator.
Application of Cross Elasticity Demand
Understanding the cross elasticity demand is extremely useful for businesses in setting prices and recognizing the sensitivity of their goods to others.
Complementary goods can deliberately be priced in a counterintuitive way. In a strategy called loss leader, businesses can price one good at below cost to boost the sale of the complementary good for an overall higher profit. For example, Sony’s PlayStation consoles are sold at a loss to encourage the sale of games. Through the strategy, Sony can recover the net loss on the consoles by making a larger profit on the games.
Businesses that offer unique, non-substitutable goods are able to sell their goods at higher prices because there is no worry of consumers switching to other goods. However, keep in mind that price setting is also subject to the good’s elasticity of demand – the change in quantity demanded of the good against the price of the good.
Lastly, providers of substitute goods must be conscious of competitors to their products. They can lower their sensitivity to a competitor’s goods by creating loyal consumers. How does Budweiser stand out among other beer brands? By investing in advertisements to differentiate their product.
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