cross-elasticity of demand

cross-elasticity of demand

cross-elasticity of demand

Products may be regarded by consumers as substitutes for one another, in which case a rise in the price of good B (tea, for example) will tend to increase the quantity demanded of good A (coffee, for example). Here the cross-elasticity of demand will be positive since as the price of B goes up the quantity demanded of A rises as consumers now buy more A in preference to the more expensive B.

Alternatively, products may be regarded by consumers as complements that are jointly demanded, in which case a rise in the price of good B (tea, for example) will tend to decrease not only the quantity demanded of good B but also another good, C (sugar, for example). Here the cross-elasticity of demand will be negative since a rise in the price of B serves to reduce the quantity demanded of C.

The degree of substitutability between products is reflected in the magnitude of the cross-elasticity measure. If a small increase in the price of good B results in a large rise in the quantity demanded of good A (highly cross-elastic), then goods B and A are close substitutes. Likewise, the degree of complementarity of products is reflected in the magnitude of the cross-elasticity measure. If a small increase in the price of good B results in a large fall in the quantity demanded of good C (highly cross-elastic), then goods C and B are close complements.

Cross-elasticities provide a useful indication of the substitutability of products, so helping to indicate the boundaries between markets. A group of products with high cross-elasticities of demand constitutes a distinct market, whether or not they share common technical characteristics; for example, mechanical and electronic watches are regarded by consumers as close substitutes. See MARKET.