Cross price elasticity of demand

Objectives:

• Understand the basic relationships between demand and price levels for different goods.

• Be able to calculate cross elasticity of demand.

• Identify and explain the changes in demand in response to a change in price of another good.

Cross price elasticity of demand

... Is the response in quantity demanded of a good or service (at each price level) when there is a change in the price of another good.

How the price change of one good will affect demand for another will be determined by their relationship to each other.

Relationships of goods

The price of Dairy Milk rises. What is likely to happen to the demand for Galaxy (at each price level)?

Substitute goods – Where one good can be used as an alternative to another. Other examples?

What are possible substitutes for....

• Rail travel • Ford cars • Beef!

Relationships of goods

The price of chips rises. What is likely to happen to the demand for fish (at each price level)?

Complementary goods – Where one good is consumed with another. Other examples?

What are possible complementary goods for....

• Cereal • Cars • Beef!

Relationships of goods

The price of sausages rises. What is likely to happen to the demand for Volkswagen cars (at each price level)?

No relationship! – Where one good has no relationship to another. Other examples?

Cross price elasticity of demand

How to calculate cross elasticity of demand: % change in quantity demanded of Good A CPED = -------------------------------------------- % change in price of Good B

% change in quantity demanded of Good A CPED = -------------------------------------------- % change in price of Good B 10% increase in Q of good A ------------------------------------ 10 = ----- 5% increase in P of good B 5 = +2 Substitutes! (positive correlation) Higher the CPED, the closer the goods are as substitutes.

% change in quantity demanded of Good A CPED = -------------------------------------------- % change in price of Good B 10% decrease in Q of good A ------------------------------------ -10 = ----- 5% increase in P of good B 5 = -2 Complementary! (negative correlation) Further from 0 the CPED, the closer the goods are as complementary goods or services.

Cross price elasticity of demand

As with income elasticity and price elasticity, a result between 0 and 1 (or 0 and -1) is inelastic, showing less correlation between goods.

A result greater than 1 (or below -1) is elastic, and shows a higher level of correlation between the goods.

It is worth considering the relative price of the goods. Which will have the greater effect on the other?

Cross price elasticity of demand

It is worth considering the relative price of the goods, and their relationship with each other, when discussing cross price elasticity. For example, sun cream and holidays are complementary goods.

But will a 50% rise in the price of holidays affect demand for sun cream in the same way as a 50% rise in the price of sun cream will affect demand for holidays?

Explain your answer.....

Cross Price elasticity of demand

Choose 5 pairs of goods, and explain their relationship, with estimated CPED calculations.

1. Strong substitute relationship 2. Weak substitute relationship 3. Strong complementary relationship 4. Weak complementary relationship (can be pair 3 reversed) 5. No relationship Page 60 – activity box questions.