What Is Cross Elasticity of Demand?
Running a small business comes with a host of concepts, strategies, and formulas you have to consider if you want your company to succeed. Some ideas are fairly straightforward and easy to implement, while others are more difficult to grasp and leave you feeling as if you need to take a course in entrepreneurial finance.
One economic principle that may cause business owners to stumble is the cross elasticity of demand. Yet, with a few solid examples, savvy entrepreneurs can understand how this concept works and, more importantly, make it work for them.
Cross Elasticity of Demand
Sometimes referred to as cross-price elasticity of demand, this guiding formula measures how the 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 a consistent demand. In short, the cross elasticity of demand is calculated with the following:
COD = Percentage change in quantity demand for substitute product/ Percentage change in price of original product
Common examples used to illustrate this principle can be found in our everyday lives. For instance, 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 a 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.
What It Means to Be Complementary or Substitutive
If the cross elasticity of demand equals a negative number, this means 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, this means the two products measured are substitutive. For instance, if the price of one co-working company’s rates increases, a competing co-working 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.
What Cross Elasticity of Demand Means for Small Businesses
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 have 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.
Using Cross Elasticity of Demand in Your Business
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. Many entrepreneurs focus on the effects of price changes on their substitutive competitor's prices or the pricing of their complementary market items. Cross elasticity of demand measures the demand for that specific product’s quantity, regardless of its pricing.
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 result in a decrease in 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.