Thursday, 7 April 2011

Cross Elasticity of Demand (Microeconomics)

Cross elasticity of demand, sometimes referred to as XED, measures the responsiveness of demand for one good after a change in price of another good. The theory assumes that all other factors stay the same and that only the price of one good is what's affecting the demand for another good.

As with the previous elasticity theories, there is a formula involved here too, that being:

XED = % Change in quantity demanded of product A ÷ % Change in price of product B.

The sign and size of the result given after the formula is vital:
• A positive result means that the two goods are substitute goods, so the price of one good rises then the demand of the other good also rises and vice versa. These goods tend to be bought instead of each other.
• A negative result means that the two goods are complimentary goods. Meaning if the price of one good rises then demand for the other will fall and vice versa. The two goods are normally bought together.
• If the result is 0 it means there is no relationship between the two goods.

The size of the result indicates how strong the relationship between the two goods is. If the figure is a high one (or very low if the result is negative) it shows to us that the two goods are close substitutes or have a high degree of complementarity.

An example is in need i think. So, say the price of Audi cars increased by 10%, which caused a demand increase for BMW cars of 15%. Lets work this out...

XED = 15% ÷ 10% = 1.5

Thus, with this answer we can see that these two goods are substitute goods (positive value), and quite close substitutes at that because the figure is fairly high.

Short but sweet, that's the basics. Thanks!