Cross-elasticity of demand measures how the change in price of one product affects the change in demand for another, and can help manufacturers devise pricing and marketing strategies. The CPEoD is positive for substitutes and negative for add-ons, and industries use it to implement marketing strategies and plan responses to competitors’ moves.
Cross-elasticity of demand is a microeconomic concept that measures how the change in price of one product affects the change in demand for another. This number is arrived at by dividing the percentage change in price of 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 devise pricing and marketing strategies.
A typical example of cross-elasticity of demand, also known as cross-elasticity of demand and represented in mathematical terms as CPEoD, might involve a fast-food chain that raises the price of a hamburger from $4 to $5, which represents a 25% change. In the period when this occurs, a competing chain sees the number of hamburgers it sells rise from 100 to 200, a 50% increase. To calculate the cross-elasticity of demand in this scenario, the first hamburger chain’s percentage change in price (0.25) is divided by the demand change percentage for the second chain (0.50) to achieve a CPEoD of 2.
When two products are substitutes, as in the case above, the CPEoD should normally be a positive number. This is because an increase in the price of one brand of product must lead to greater demand for a competing brand. Likewise, if one brand lowers prices, demand for a competing brand will drop. In this case, dividing the two negatives still yields a positive number.
For add-on products, such as the example listed earlier on a video game system and the games supported by that system, the CPEoD will likely be a negative number. If the company that manufactures the video game system raises the price, it stands to reason that demand for compatible games will drop. This means that a positive number would be divided into a negative number, which produces a negative result. A CPEoD result equal to or close to zero likely means that the two products in question are unrelated.
Industries use the cross-elasticity of demand to implement marketing strategies and plan responses to competitors’ moves. For example, a company may have to decide whether to match a competitor’s price drop. You may also need to decide whether you can meet the resulting demand if another competitor suddenly raises prices, or whether it would be more profitable to raise prices in cash. Using the cross-elasticity of demand formula can help answer these questions.
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