I 4 1 Cross-Price Elasticity of Demand

Cross-Price Elasticity of Demand
A firm that produces an entire line of products has a

special interest in how a change in the price of one item
affects the demand for another.
For example, the Coca-Cola Company needs to know
how changing the price of Cherry Coke affects sales of
Classic Coke.
The company also needs to know the relationship
between the price of Coke and the demand for Pepsi and
vice versa.
Likewise, Apple needs to know how changing the price of
one iPhone model affects the demand for the other
iPhone models.
The responsiveness of the demand for one good to
changes in the price of another good is called the cross-
price elasticity of demand.
This is defined as the percentage change in the demand

of one good divided by the percentage change in the
price of another good.
Its numerical value can be positive, negative, or zero,

depending on whether the two goods in question are
substitutes, complements, or unrelated, respectively.
Substitutes
If an increase in the price of one good leads to an
increase in the demand for another good, their cross-
price elasticity is positive and the two goods are
substitutes.
For example, an increase in the price of Coke, other
things constant, shifts the demand for Pepsi rightward, so
the two are substitutes.
The cross-price elasticity between Coke and Pepsi has
been estimated at about 0.7, indicating that a 10 percent
increase in the price of one increases the demand for the
other by 7 percent.
Complements
If an increase in the price of one good leads to a decrease

in the demand for another, their cross-price elasticity is
negative and the goods are complements.
For example, an increase in the price of gasoline, other

things constant, shifts the demand for tires leftward
because people drive less and replace their tires less
frequently.
Gasoline and tires have negative cross-price elasticity and

are complements.
To Review:
The cross-price elasticity of demand is positive for
substitutes and negative for complements.
Most pairs of goods selected at random are unrelated, so

their cross-price elasticity is zero, such as socks and sushi.
What Causes a Demand Curve to Shift?
(1) Changes in the Prices of Related Goods
• Substitutes: Two goods are substitutes if a fall in the
price of one of the goods makes consumers less willing to
buy the other good. Substitutes are goods that in some
way serve a similar function: concert and opera, muffins
and doughnuts.
• Complements: Two goods are complements if a fall in
the price of one good makes people more willing to buy
the other good. Complements are goods that in some
sense are consumed together: cars and gasoline,
computer and software.
(2) Changes in Income
• Normal Goods: When a rise in income increases the

demand for a good - the normal case - we say that the
good is a normal good. Preferred, more expensive.
• Inferior Goods: When a rise in income decreases the

demand for a good, it is an inferior good. Less desirable
alternative.
• When a good is inferior, a rise in income shifts the

demand curve to the left; when a good is normal, a rise
in income shifts the demand curve to the right.
(a)Why is it that when two commodities are substitutes
for each other, the cross elasticity of demand between
them is positive while when they are complements it is
negative?
(Answer) For two commodities which are substitutes, a

change in the price of one, ceteris paribus (with other
conditions remaining the same), causes a change in the
same direction in the quantity purchased of the other.
For example, an increase in the price of coffee increases

tea consumption and a decrease in the price of coffee
decreases tea consumption.
Thus the cross elasticity between them is positive.
On the other hand, ceteris paribus, a change in the
price of a commodity causes the quantity purchased
of its complement to move in the opposite direction.
Thus the cross elasticity between them will be

negative. It should be noted that commodities may
be substitutes over some range of prices and
complements over others.
(b) How can we define an industry by using cross elasticities?
What difficulties does this lead to?
(Answer) High positive cross elasticities (indicating a high

degree of substitutability) among a group of commodities can
be (and frequently is) used to define the boundaries of an
industry.
This, however, may sometimes lead to difficulties. For

example, how high should cross elasticities be among a group
of commodities in order for us to include them in the same
industry?
In addition, if the cross elasticity of demand between
cars and station wagons and between station wagons
and small trucks is positive and very high but the cross
elasticity between cars and small trucks is positive but
low, are cars and small trucks in the same industry?
In these and other cases, the definition of the industry

adopted usually depends on the problem to be
studied.

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Cross-Price Elasticity of Demand

A firm that produces an entire line of products has a

This is defined as the percentage change in the demand

Its numerical value can be positive, negative, or zero,

If an increase in the price of one good leads to a decrease

For example, an increase in the price of gasoline, other

Gasoline and tires have negative cross-price elasticity and

Most pairs of goods selected at random are unrelated, so

• Normal Goods: When a rise in income increases the

• Inferior Goods: When a rise in income decreases the

• When a good is inferior, a rise in income shifts the

(Answer) For two commodities which are substitutes, a

For example, an increase in the price of coffee increases

Thus the cross elasticity between them will be

(Answer) High positive cross elasticities (indicating a high

This, however, may sometimes lead to difficulties. For

In these and other cases, the definition of the industry

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