Cross Price Elasticity Meaning
Cross Price Elasticity refers to the change in demand of one good with change in the price of another. Why measure a change in the demand of one good when the price of another changes? This is because the two goods could be interconnected with each other. The two goods under consideration could be Substitutes, Compliments or could have no relationship with each other.
Cross price elasticity would vary depending on the relationship between the two goods. This is explained below:
- Substitute Goods are those that can be used in place of each other. Consider two very similar brands of toothpaste like Colgate and Pepsodent. If the price of Pepsodent increases, consumers will shift to using Colagte as it might suit their budget better. Thus, an increase in the price of the substitute will increase the demand of the main good in question. Vice-versa would be the case when the price of the substitute will decrease. In that case, a decrease in the price of the substitute, say Pepsodent will lead to an increase in Peposdent’s demand or a decrease in Colgate’s demand. Since the price of the substitute and demand of the main good move in the same direction, the Cross Price Elasticity would be positive in case of substitutes.
- Complementary Goods: These are those goods that go hand in-hand or are typically used together. If price of a complementary good increases, it would lead to a decrease in the demand for the main good and vice-versa. For example, tennis racquets and membership for tennis courts. Since the two of them are used together, an increase in the price of membership for tennis courts, might discourage people from playing tennis and would reduce the demand for tennis racquets. Similarly, if the membership becomes cheaper, more people might enroll for playing tennis and demand for tennis racquets will go up. Thus, the price of the complementary good and demand of the main good in question move in opposite directions. Hence, the Cross Price Elasticity in case of complements would be negative.
- No Relationship: Commodities that are are unrelated to each other, will not have an impact on each other’s demand. For example, mangoes and badminton racquets. A change in the price of mangoes, will have no impact on the demand for badminton racquets.
Formula for Cross Price Elasticity
Mathematically, Cross Price Elasticity of Good A, with respect to Good B is given as:
