Elasticity: The sensitivity of changes in a quantity with respect to changes in another quantity.
Cross Elasticity of Demand (XED): An economic metric that measures the responsiveness of the quantity demanded for a good to a change in the price of another good.
Substitutes: A replacement or stand-in for something that achieves a similar result or purpose.
Complements: Two goods consumed together, i.e., printers and printer ink. Hence an increase in the price of one causes a fall in demand of the other.
What is Cross Elasticity of Demand?
Cross elasticity of demand is an economics metric that measures the relationship between two products. It does this by looking at the correlation between change in price for one good in regard to the change in quantity for another. This helps us identify complements and substitutes.
How to Calculate Cross Elasticity of Demand
Cross elasticity of demand can be calculated by dividing the percentage change in quantity demanded of good Y by the percentage change in price of good X. This can be represented using the following formula:
The Cross Elasticity of Demand Values
The cross elasticity of demand values can be either positive or negative and reflect the relationship between two goods. The table below indicate the necessary values:
Example – Ties and Shirts
As an example of cross elasticity of demand, let us look at shirts (Good X) and ties (Good Y). Suppose the price of shirts decreases 5% and we see an increase in the demand for ties by 8%. If we divided the percentage change of +8% by the percentage change of -5% we get -1.6 suggesting a strong complement.
Why is Cross Elasticity of Demand Important?
Cross elasticity of demand is important as it helps firms devise pricing strategies and allows them to identify whether other products are complements or substitutes (i.e., competitors).
However cross elasticity of demand is the most unreliable out of the elasticities as it has to take into account two products increasing the unreliability more than one product. Additionally, it is important to note that elasticities are only an approximation, and also does not take into account external factors (ceteris paribus).
References/ Further Reading:
Cross Elasticity of Demand (PED) – Wikipedia - https://en.wikipedia.org/wiki/Cross_elasticity_of_demand