Q. What is Cross-elasticity of
demand (May’11, May’12, and Dec’12, Dec'13)?
Cross-elasticity of demand:
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 demanded of product A/% Change in price of product B
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