Download Cross Price Elasticity of Demand (XED)

Cross Price Elasticity of
Demand (XED)
IB Economics
XED Learning
Outcomes:
Outline the concept of cross-price elasticity of
demand
Calculate XED
Substitute vs. Complementary goods
Value of XED
Examine the implications of XED for
businesses if prices of substitutes or
complements change.
Cross-Price Elasticity of demand
(XED)
XED is a measure of the
responsiveness of consumers of
one good to a change in the price
of a related good.
Measure of how much the demand
for a product changes when there
is a change in the price of another
product.
Cross-Price Elasticity of
demand (XED)
% D Qty Demanded of good X
% D Price of good Y
Percent change in quantity demanded / Percent change in price
Cross Price Elasticity of Demand
(XED)
With cross price elasticity we
make an important distinction
between substitute products
and complementary goods and
services.
What is a substitute good
(demand)?
Is one for which demand will increase
when the price of another good
increases.
Demand for a substitute good will
decrease when the price of its
substitute decreases.
How responsive are the consumers of
one to a change in the price of the
other?
Example: Beef vs. Chicken
Market demand for chicken
100
Point
Price
(per kg)
Market demand
(tonnes 000s)
A
20
700
Price (per kg)
80
60
40
A
20
D
0
0
100
200
300
400
500
600
Quantity (tonnes: 000s)
700
800
Market demand for chicken
100
Price (per kg)
80
Point
Price
(per kg)
Market demand
(tonnes 000s)
A
20
700
B
40
500
60
B
40
A
20
D
0
0
100
200
300
400
500
600
Quantity (tonnes: 000s)
700
800
Demand for beef
Increase in the
price of chicken,
increases the
demand for beef
Price
P
D0
O
Q0
Q1
Quantity
D1
Identify some Substitutes
What is complementary goods?
Goods that are typically consumed
together
Demand for one is decreased by
the price increase of the other
How responsive are the
consumers of one to a change in
the price of the other?
Example: Cameras vs. Memory
Cards
Price
Increase in price of cameras
P2
P1
D
O
Q2
Q1
Quantity
Demand for Memory Cards
Price
P
D1
O
Q0
Q1
Quantity
D0
Identify some Complements
Example of XED
The owners of a pizza stand find that
when their competitor, a hamburger
stand, lowers the price of a burger
from $2 to $1.80, the number of pizza
slices that they sell each week falls
from 400 to 380, because of the
lower priced burger. Calculate XED.
XED = -5% / -10% = +0.5
Range of Values of XED
XED may be positive or
negative. Sign is important
since it tells us what the
relationship between the two
goods in question is.
Range of Values of XED
If the value of XED is positive, then the
two goods in question may be said to
be substitutes for each other.
If the value of XED is negative, then
the two goods in question may be said
to be complements for each other.
If the value of XED is zero, the two
goods are unrelated.
XED values and the strength of the relationship
between products
XED
Value
Negative
Zero
Weak/Remote
Complements
Close
Complements
Relationship
Positive
Weak/Remote
Substitutes
Unrelated
Products
Close
Substitutes
Cross Price Elasticity for
Substitutes
Product
Coca Cola
Cheddar Cheese
KTX from Daejon to
Seoul
Starbucks Coffee
Apple Computer
Close Substitute Weak
Substitute
Good with no
relationship
Cross Price Elasticity for
Substitutes
Product
Close Substitute Weak
Substitute
Good with no
relationship
Coca Cola
Pepsi
Computer
Cheddar Cheese
KTX from Daejon to
Seoul
Starbucks Coffee
Apple Computer
Orange Juice
Cross Price Elasticity for
Substitutes
Product
Close Substitute Weak
Substitute
Good with no
relationship
Coca Cola
Pepsi
Orange Juice
Computer
Cheddar Cheese
Jack Cheese
Blue Cheese
Apples
KTX from Daejon to
Seoul
Starbucks Coffee
Apple Computer
Cross Price Elasticity for
Substitutes
Product
Close Substitute Weak
Substitute
Good with no
relationship
Coca Cola
Pepsi
Orange Juice
Computer
Cheddar Cheese
Jack Cheese
Blue Cheese
Apples
KTX from Daejon to
Seoul
“Slow” train
Bus ride
Soccer Ball
Starbucks Coffee
Apple Computer
Cross Price Elasticity for
Substitutes
Product
Close Substitute Weak
Substitute
Good with no
relationship
Coca Cola
Pepsi
Orange Juice
Computer
Cheddar Cheese
Jack Cheese
Blue Cheese
Apples
KTX from Daejon to
Seoul
“Slow” train
Bus ride
Soccer Ball
Starbucks Coffee
Dunkin Donut
Coffee
Nescafe
instant coffee
Pencil
Sharpener
Apple Computer
Cross Price Elasticity for
Substitutes
Product
Close Substitute Weak
Substitute
Good with no
relationship
Coca Cola
Pepsi
Orange Juice
Computer
Cheddar Cheese
Jack Cheese
Blue Cheese
Apples
KTX from Daejon to
Seoul
“Slow” train
Bus ride
Soccer Ball
Starbucks Coffee
Dunkin Donut
Coffee
Nescafe
instant coffee
Pencil
Sharpener
Apple Computer
Dell Computer
No name
brand
Movie tickets
Complementary Goods
Product
Personal Computer
DVD Player
Short Break Weekend
in Barcelona
Close
Complement
Weak
Complement
Good with no
relationship
Complementary Goods
Product
Close
Complement
Weak
Complement
Good with no
relationship
Personal Computer
Mouse
Stylus
Eraser
DVD Player
Short Break Weekend
in Barcelona
Complementary Goods
Product
Close
Complement
Weak
Complement
Good with no
relationship
Personal Computer
Mouse
Stylus
Eraser
DVD Player
DVDs (Video
Discs)
Remote
Control
Tables & Chairs
Short Break Weekend
in Barcelona
Complementary Goods
Product
Close
Complement
Weak
Complement
Good with no
relationship
Personal Computer
Mouse
Stylus
Eraser
DVD Player
DVDs (Video
Discs)
Remote
Control
Tables & Chairs
Champagne
breakfast
Toothpick
Short Break Weekend Tour Package
in Barcelona
(incl. running
with the bulls)
Cross-Price Elasticity of Demand (XED)
+ = Substitutes
Substitutes:
With substitute goods
such as brands of
razors, an increase in
the price of one good
will lead to an increase
in demand for the rival
product
Weak substitutes –
inelastic XED
Close substitutes –
elastic XED
Cross price
elasticity will be
positive
+
Cross-Price Elasticity of Demand (XED)
-=
Complements
Complements:
Goods that are in
complementary
demand
Weak complements –
inelastic XED
Close complements –
elastic XED
The cross price
elasticity of
demand for two
complements is
negative
Cross Elasticity
Exercise
Calculate the XED and state whether
the goods are complements or
substitutes?
1.
A 10% rise in the price of fish may cause demand for
chicken to increase by 2%.
2. The fall in the price of paper by 20% causes the
demand for pens to increase by 5%.
3. A 20% rise in the price of ice cream causes demand
for sweets to increase by 4%.
4. A 12% fall in the price of air fares leads to a 30% rise in
the demand for foreign holidays.
5. A 10% rise in bikes will leave the demand for cheese
unaffected.
Answers…
A 10% rise in the price of fish may cause demand for
chicken to increase by 2%.
+2% / +10% = +0.2
The fall in the price of paper by 20% causes the
demand for pens to increase by 5%. +5% / -20% = -0.25
A 20% rise in the price of ice cream causes demand
for sweets to increase by 4%.
+4% / +20% = +0.2
A 12% fall in the price of air fares leads to a 30% rise in
the demand for foreign holidays. +30% / -12% = -2.5
A 10% rise in bikes will leave the demand for cheese
unaffected.
0% / +10% = 0
XED values and the strength of the relationship
between products
XED
Value
Negative
Zero
Weak/Remote
Complements
Close
Complements
Relationship
Positive
Weak/Remote
Substitutes
Unrelated
Products
Close
Substitutes
Importance of XED for
businesses
Firms can use XED estimates to predict:
The impact of a rival’s pricing strategies on
demand for their own products:
Pricing strategies for complementary goods:
Popcorn and cinema tickets are strong
complements. Popcorn has a very high mark up
i.e. popcorn costs pennies to make but sells for
more than a $1.00
If firms have a reliable estimate for XED they
can estimate the effect, say, of a two-for-one
cinema ticket offer on the demand for popcorn
Applications of Cross
Elasticity
Effects of the national minimum
wage on demand for younger and
older workers (might younger
workers be replaced?)
Higher indirect taxes on goods such
as tobacco – the impact on demand
for nicotine patches and other
substitutes
Applications of Cross
Elasticity
Effect on demand for
different modes of mass
transport following
introduction of road pricing
schemes in urban areas
Rise in the price of natural
gas – effect on the demand
for coal used in power
generation
Cross Elasticity
Exercise
Additional Exercises
Exercise
“Light-Bites”, a sandwich shop, finds that when
its rival, “Super-Snack”, reduces the price of its
chicken wraps from $5 to $4.60, the demand
for “Light-Bites” sandwiches falls from 400
sandwiches a week to 340 sandwiches a week.
In addition, “Super-Snack” finds that following
the fall in price of their chicken wraps, the
demand for soft drinks rises from 600 cans to
630 cans per week.
1.Calculate the cross elasticity of demand
between “Light-Bite” sandwiches and
“Super-Snack chicken wraps.
2.Explain the relationship above in terms of
cross elasticity of demand.
Exercise
“Light-Bites”, a sandwich shop, finds that when
its rival, “Super-Snack”, reduces the price of its
chicken wraps from $5 to $4.60, the demand
for “Light-Bites” sandwiches falls from 400
sandwiches a week to 340 sandwiches a week.
In addition, “Super-Snack” finds that following
the fall in price of their chicken wraps, the
demand for soft drinks rises from 600 cans to
630 cans per week.
1.Calculate the cross elasticity of demand
between “Super-Snack” sandwiches and the
“Super-Snack” soft drinks.
2.Explain the relationship above in terms of
cross elasticity of demand.