What Is Cross Elasticity of Demand?
Cross Elasticity of Demand Explained
Cross elasticity of demand is an economic principle that measures demand for one good when the price of another one changes.
Learn how cross elasticity of demand works.
What Is Cross Elasticity of Demand?
Sometimes referred to as cross-price elasticity of demand, this guiding formula measures how a consumer responds to a complementary or substitutive product or service when the price of another product or service changes.
The equation divides the change (whether it went up or down) in the percentage for the quantity demand of a product by the price change percentage of a specific product with consistent demand. In short, the cross elasticity of demand is calculated with the following:
XED = Percentage change in quantity demand for substitute product / Percentage change in price of original product
For example, if the price of cow’s milk goes up, it will likely spark an increase in demand for non-dairy milk substitutes like soy milk, almond milk, or oat milk. If the price for gasoline increases during the summer, it is likely to spark demand for more car ride-sharing services and monthly passes for public transportation.
A cross elasticity of demand analysis can provide the exact figure to express how much the demand for a substitute or complementary product or service is affected by a price increase or decrease.
How Cross Elasticity of Demand Works
If the cross elasticity of demand equals a negative number, the two products measured are complementary. In other words, if the price increase in a specific product causes a decrease in the quantity demand for another product, the two goods are connected in a complementary relationship. For example, an increase in the cost of food often causes a decrease in the quantity demand for entertainment.
However, if the cross elasticity of demand equals a positive number, the two products measured are substitutive. For instance, if one coworking company’s rates increase, a competing coworking company may suddenly see an increased demand for their office space. Consumers simply substituted one product or service for the other after the price increased.
The substitutive outcome is the typical relationship analyzed by this economic principle, but complementary relationships aren’t infrequent. Also, if the cross elasticity of demand equals zero, then the two products are said to be independent, and a change in the price of one product will have no effect on the demand for the other.
Using Cross Elasticity of Demand
Cross elasticity of demand is a valuable tool for small business owners entering a market for the first time or hoping to expand their current product or service line. Analyzing the effects of price changes in your product or service along with the quantity demand of substitutes allows you to determine the best price point for your business model. Products or services without a substitutive competitor are free to establish or raise their prices at a much higher rate than products or services with a market rival.
Complementary products and services are often priced at a rate that reflects the understanding that any change in availability or price of a complementary product will need to be addressed with a new or updated product or service.
For example, if Apple decided to release its newest iPhone at twice the price of its previous one, developers who create apps exclusively for Apple’s iPhone would see a decrease in the quantity demand for their app. The app developers’ products are complementary to the iPhone operating system. Their response could be to fast-track a version of their app that ran on the Android mobile operating system to help offset the financial loss caused by the increase in the iPhone's price.
Remember, when using the cross elasticity of demand formula for your business, you’re measuring the effect of price changes on quantity demand for a product, not on the pricing of that product.
If your business provides a product or service that appears to have no current or affordable competitors as substitutes, it’s important to remember that cross elasticity of demand can still affect your customers. A decrease in the price of a complementary product may decrease the demand for your business’ product.
A business plan that analyzes the industry market thoroughly with an eye toward cross elasticity of demand will leave you in a stronger position to determine if launching a new business or expanding your enterprise is the best course of action for your company at this time.
- Cross elasticity of demand is an economic principle that measures demand for one good when the price of another one changes.
- If the cross elasticity of demand equals a negative number, the two products measured are complementary.
- If the cross elasticity of demand equals a positive number, the two products measured are substitutive.
- Cross elasticity of demand can help you decide on the best price point for your products or services.