Cross-elasticity of demand measures how the change in price of one product affects the demand for another. It depends on whether the products are substitutes or complements. Industries use it to implement marketing strategies and plan responses to competitor movements.
Cross-elasticity of demand is a microeconomic concept that measures how the change in price in one product affects the change in demand for another. This number is reached by dividing the percentage change in price in one product by the percentage change in demand for the other. The cross-elasticity of demand depends on whether the products are substitutes, which are two different brands of the same product, or complements, which are two separate products that are related to each other, such as a video game system and its individual compatible games. Using this formula can help product manufacturers come up with pricing and marketing strategies.
A typical example of cross-elasticity of demand, also known as cross-elasticity of demand and represented mathematically as CPEoD, might involve a fast-food chain raising the price of a hamburger from $4 to $5 USD, which represents a 25 percent change. During this time, a competing chain sees the number of burgers it sells increase from 100 to 200, a 50 percent increase. To calculate the cross-elasticity of demand in this scenario, the percent change in price for the first burger chain (0.25) is divided by the percent change in demand for the second chain (0.20) to reach a CPEoD of 2.
When two products are replaced, as in the case above, the CPEoD should usually come out as a positive number. This is because an increase in the price of one brand of product should lead to higher demand for a competing brand. Similarly, if one brand lowers its prices, the demand for a competing brand will decrease. In that case, dividing the two negatives still produces a positive number.
In the case of complementary products, such as the example listed above of a video game system and the games compatible with that system, the CPEoD will most likely be a negative number. If the company that makes the video game system raises the price, it stands to reason that the demand for compatible games would drop. This means that a positive number would be divided into a negative number, which produces a negative result. A CPEoD result of zero or near zero probably means that the two products in question are not related.
Industries use the cross-elasticity of demand to implement marketing strategies and plan responses to competitor movements. For example, a company may need to decide whether to match a competitor’s price reduction. It may also need to decide whether it can meet the resulting demand if another competitor suddenly raises its prices or whether it would be more profitable to raise prices in kind. Using the cross-elasticity of the demand formula can help answer these questions.
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