Q. Cross-elasticity of demand
(May’11, May’12, and Dec’12)
In economics,
the cross elasticity of demand or 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 measured as the percentage change in demand for the first good
that occurs in response to a percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of fuel, the demand of
new cars that are fuel inefficient decreased by 20%, the cross elasticity of
demand would be: -20%/10%=-2
A negative cross elasticity
denotes two products that are complements, while a positive cross elasticity
denotes two substitute products. These two key relationships may go against
one's intuition, but the reason behind them is fairly simple: assume products A
and B are complements, meaning that an increase in the demand for A is
caused by an increase in the quantity demanded for B. Therefore, if the price
of product B decreases, then the demand curve for product A shifts to the
right, increasing A's demand, resulting in a negative value for the
cross elasticity of demand. The exact opposite reasoning holds for substitutes.
The formula used to calculate the
coefficient cross elasticity of demand is
EA,B=%Change in quantity demand of
product A/%Change in price of product B
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