The cross-price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It's a tool used to analyze the relationship between two products, typically categorized as either substitutes or complements.
Cross-price elasticity of demand is calculated as the percentage change in the quantity demanded of Good A divided by the percentage change in the price of Good B. The formula is:
(price₁A + price₂A) / (quantity₁B + quantity₂B) × ΔquantityB / ΔpriceA
- price1A – Initial price of product A;
- price2A – Final price of product A;
- ΔpriceA – Change in price of product A;;
- quantity1B – Initial demand for product B;
- quantity2B – Final demand for product B;
- ΔquantityB – Change in demand for product B.
You can get one of three results: a cross-price elasticity coefficient that is positive, negative, or equal to zero.
A positive elasticity is characteristic of substitute goods. It means that as the price of product A increases, the demand for product B increases, too. For example, this can be true for butter and margarine; once the price of butter goes up, more people opt for margarine, increasing the demand. This phenomenon is especially visible in situations in which only two competitors try to monopolize the market.
A negative elasticity is characteristic of complementary goods. When the price of product A increases, the demand for product B decreases. A good example would be the coffee machine, and capsules situation described earlier. If you increased the price of the coffee machine, fewer people would be inclined to buy the capsules, hence decreasing the demand.
If the elasticity is equal or very close to zero, it means that the two products are uncorrelated. The change in the price of product A does not influence the demand for product B