Cross Price Elasticity
Cross price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It is the percentage change in demand for a good, in response to a percentage change in price of a related good. It is closely related to competitive pricing, which is setting the price of a product/service based on what the competition is charging. Businesses can decide the extent to which it lets competition influence its prices, based on the degree of cross price, or competitive price elasticity.
Broadly, there can be three types of relations between different products, which in turn influence the cross price elasticity between the products.
i) Substitute Goods: Here, the increase in the price of a good leads to an increase in the demand for another. Substitute goods face positive cross price elasticity. The more substitutable the two products are, the higher their cross price elasticity. ii) Complementary Goods: Here, an increase in the price of one good leads to a decrease in the demand for another. Complementary goods face negative cross price elasticity iii) Unrelated Goods: Here a change in the price of one good has no impact on the demand for another good. Cross price elasticity is zero.
Assumptions when calculating cross price elasticity:
- Impact of all other factors on the demand of the good, including its own price, is kept constant. - Both goods are ordinary goods, i.e. inverse relationship between quantity demanded and its own price. - Both goods are normal goods, i.e. positive relationship between demand and disposable income.
Degree of Elasticity:
- Demand is considered inelastic with respect to the price of a second product, if a 1% change in the price of the second product leads to a less than 1% change in the demand for the first. - Demand is considered elastic with respect to the price of a second product, if a 1% change in the price of the...