Cross Price Elasticity of Demand (XED)

1. Cross Price Elasticity of Demand (XED) IB Economics

2. 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.

3. 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.

4. Cross-Price Elasticity of demand (XED) % D Qty Demanded of good X FORMULA = % D Price of good Y Percent change in quantity demanded / Percent change in price

5. Cross Price Elasticity of Demand (XED) With cross price elasticity we make an important distinction between substitute products and complementary goods and services.

6. 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

7. Market demand for chicken Market demand (tonnes 000s) 700 Point Price (per kg) 20 A Price (per kg) A D Quantity (tonnes: 000s)

8. Market demand for chicken Market demand (tonnes 000s) 700 500 Point Price (per kg) 20 40 A B Price (per kg) B A D Quantity (tonnes: 000s)

9. Demand for beef D0 D1 Increase in the price of chicken, increases the demand for beef P Price O Q0 Q1 Quantity

10. Identify some Substitutes

11. 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

12. Increase in price of cameras D Price P2 P1 O Q2 Q1 Quantity

13. Demand for Memory Cards D1 D0 P Price O Q0 Q1 Quantity

14. Identify some Complements

15. 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

16. 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.

17. 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.

18. XED values and the strength of the relationship between products XED Value Negative Zero Positive Weak/Remote Complements Weak/Remote Substitutes Close Substitutes Unrelated Products Close Complements Relationship

19. Cross Price Elasticity for Substitutes

20. Cross Price Elasticity for Substitutes

21. Cross Price Elasticity for Substitutes

22. Cross Price Elasticity for Substitutes

23. Cross Price Elasticity for Substitutes

24. Cross Price Elasticity for Substitutes

25. Complementary Goods

26. Complementary Goods

27. Complementary Goods

28. Complementary Goods

29. 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 of Demand (XED) += Substitutes Cross price elasticity will be positive +

30. 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

31. Cross Elasticity Exercise

32. Calculate the XED and state whether the goods are complements or substitutes? • A 10% rise in the price of fish may cause demand for chicken to increase by 2%. • The fall in the price of paper by 20% causes the demand for pens to increase by 5%. • A 20% rise in the price of ice cream causes demand for sweets to increase by 4%. • A 12% fall in the price of air fares leads to a 30% rise in the demand for foreign holidays. • A 10% rise in bikes will leave the demand for cheese unaffected.

33. Answers… Positive = substitute goods Negative = complementary • 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

34. XED values and the strength of the relationship between products XED Value Negative Zero Positive Weak/Remote Complements Weak/Remote Substitutes Close Substitutes Unrelated Products Close Complements Relationship

35. 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

36. 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

37. 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 Applications of Cross Elasticity

38. Cross Elasticity Exercise Additional Exercises

39. 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. • Calculate the cross elasticity of demand between “Light-Bite” sandwiches and “Super-Snack chicken wraps. • Explain the relationship above in terms of cross elasticity of demand.

40. 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. • Calculate the cross elasticity of demand between “Super-Snack” sandwiches and the “Super-Snack” soft drinks. • Explain the relationship above in terms of cross elasticity of demand.