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Cross elasticity of demand (XED)

XED measures the effect of a change in the price of one good (good X) on consumer demand for another good (good Y). XED can be calculated by using the following formula:

Examples

The following table is a demand schedule showing how demand for good Y responds to different prices of good X.

If we apply the formula to a specific price change 10 to 12. We can calculate the XED result (co-efficient).

In this case, there is a negative relationship, which signifies that two goods are complementary goods.

The fact that XED is less than 1 (at 0.5) means that they are closely related to each other. The higher the co-efficient the more complementary the products are. In the real world there will be many example of complementary products, including breakfast cereal and milk, air flights and hotels, and smartphones and apps.

Alternatively, goods may be related in terms of being substitutes for each other. Again, there will be many examples of this in the real world. Consumer the following schedule for substitute goods.

In the case of substitutes the cross elasticity will be positive - as the price of one substitute rise, demand for the other also rises. Over the price range 10 to 12 for good X, demand for Y rises from 15 units to 20 units. The XED value is:

In this case, the positive sign indicates the goods are substitutes, and the value of 1.67 is greater than one, suggesting that they are fairly close substitutes.

As an example, we can consider research on smokers from New Zealand who looked to establish how closely demand for e-cigarettes was affected by the price of tobacco cigarettes. Researchers estimated that the cross-price elasticity for e-cigarettes was (+) 0.16, indicating that e-cigarettes were only partially substitutable for regular cigarettes.

The significance of cross elasticity of demand

Given that most firms sell goods and services which have both complements and substitutes it is unsurprising that firms conduct research into various cross elasticities.

The ultimate aim of this research is to gather data that will enable them to make rational decisions about their prices, and other policies that they may adopt to either increase revenue and profits, or to make strategic discussions.

For example, data on cross elasticities indicates the relative 'strength' or closeness of substitutes as well as the significance of complements. Firms are ultimately vulnerable to the policies of other firms, especially when they operate in oligopolistic markets.

For example, airlines are vulnerable both to an increase in the price of aviation fuel, and to reductions in the ticket prices of a rival airline. This can inform other decisions, such as stockpiling fuel reserves and merging or forming an alliance with rival airlines.

Hence, if a firm can map out the cross elasticities of firms in its market it can reduce information failure and take steps to minimise risks associated with the decisions of other firms, including decisions on pricing.

Questions

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