Cross Elasticity Of Demand

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MICROECONOMICS

Cross Elasticity Of Demand




Introduction

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We have seen in the earlier section that in defining the demand relationship we have assumed Other things to remain constant. One of the factors which has been assumed to remain constant is the prices of other commodities. When the price of related commodities like complementary goods or substitutes Change what will be its impact on the demand? Two commodities X and Y are said to be complements if With an increase in the price of X not only the demand for X but the demand for Y also goes down. For example we can consider Pen and ink, Tea and sugar, car and petrol are complements. On the other hand two commodities X and Y are said to be substitutes if with an increase in the price of X the demand for Y increases. For example Coca-cola and Pepsi ,electricity and gas , travel by rail and travel by road are substitutes. We study impact of a change in the price of one good on account of a change in the price of another good which is a complement or substitute.


Learning Objectives
After reading this chapter, you are expected to learn about:

i. Understand the relationship between two commodities and how a change in the price of one commodity affects the demand for the other commodity.

ii. Understand how decision needs to be carefully taken with respect to changing relationship between commodities.




Definition


Cross elasticity of Demand is defined as :The degree of responsiveness of demand for commodity X on account of a change in the Price of Commodity Y .


From the definition it follows that


Exy = (Percentage change in quantity demanded of x)/( Percentage change in the price of Y)


In mathematical terms it can be represented as:

Exy == ( ∆Qx/∆py)(Py/Qx)



Numerical illustration


Let us consider an example.If the price of coffee rises from Rs.6/- to Rs.7/- per cup and as a result the consumer's demand for tea increases from 60 cups to 70 cups,then the cross elasticity of demand of tea(x) for coffee(y) can be found out as follows:
∆Qx =70-60 =10
Qx =60
∆py =7-6 =1
Py = 6


Cross elasticity of demand = Exy = ( ∆Qx/∆py)(Py/Qx)
=(10/1)(6/60)
=1
We can see that with an increase in the price of coffee(Y) the demand for tea (X) has increased.The two commodities are considered as substitutes. In this case the consumer substitutes tea for coffee.

Relationship between nature of commodities and Cross elasticity


If Exy is greater than zero, X and Y are substitutes because an increase in Py leads to an increase in Qx as X is substituted for Y in consumption. On the other hand if Exy is less than zero , X and Y are complements because an increase in Py leads to a reduction in Qy and Qx both.


Diagrammatic representation of cross elasticity of Demand Cross elasticity


The following diagram indicates the effect of change in price of good Y (Price of X remaining the same) on the demand for good X.With a decrease in the price of good Y from OP1 to OP2 the demand for good Y declines from OQ1 to OQ2 and the demand for X also declines from OM1 to OM2 . The two commodities X and Y are said to be complements.
















Note


There are certain points to be taken note of with respect to cross elasticity of demand.

  • Exy need not be equal to Eyx because the responsiveness of Qx to change in price of Y need not be equal the responsiveness of Qy to a change in the price of X.
  • A high positive cross elasticity is associated with high degee of similarity between commodities.
  • The above definition of substitutes and complements is sometimes referred to as gross definition since it refers to the market response.


Activity
1.1

a.Classify the commodities in your own consumption basket as normal goods,luxury goods and inferior goods.

b.Are the commodities mentioned below normal goods ,luxury goods or inferior goods ? Give reason for your answer.

Salt,camera,fruits,milk,Two wheeler,Cigarettes,medicines,Picasso's painting,Laptop.


Activity
1.2

Colgate sells its standard size toothpaste for Rs.30.Its sales have been on an average 8000 units per month over the past year. Recently its close competitor Binaca reduced the price of the same standard size from Rs.40 to Rs.35.As a result ,Colgate sales declined by 1200 units per month.

  • Calculate the Cross elasticity of demand between the two products.
  • What does your estimate indicate about the relationship between rhe two products?

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