Essay

Explain the meaning cross elasticity of demand and discuss its importance for a producer?

CROSS ELASTITY OF DEMAND

The cross elasticity of demand (CED) is a ratio which measures the responsiveness of demand due to a change in the price of other goods. For a straight line curve, the formula % change in quantity % change in price of good Y demanded of the good X

Cross elasticity of demand =Relative change in qty demand of X Relative change in price of Y.

The CED can be either positive or negative. For substitute goods CED is positive, as there is a direct relationship between the price of the other good (Y) and the quantity demanded of the good (X). This means that as the price of good Y increases, the quantity demanded of good X also increases. For CED, the degrees of elasticity is the same as for PED. If degree of elasticity is one, it is unitary, if more than 1, it is elastic and if it is less than one, it is inelastic. If zero, it is perfectly inelastic and if infinity, it is perfectly elastic. This is regardless of whether it is a positive or negative value. If the value of CED is elastic (more than one), it can mean that the two goods are good substitutes If there are other personal computer manufacturer with lower prices, there will be an increase in quantity demanded for personal computers from these manufacturers. Therefore, there will be a fall in demand for personal computers from the manufacturer concerned. The manufacturer must also lower the price to remain competitive. However, to avoid price wars, the manufacturer concerned could use other tactics such as better services, provide personalised service and advertise the; for example coke and pepsi. If the value is small (inelastic; between zero and one); the two goods are poor substitutes; for example Bata and Nike. If CED is negative, then there is an inverse relationship between the price of good Y and the quantity demanded of good X, then the goods are complementary goods. If there is a fall in the price of complements

of personal computers such as software, microprocessor, memory chips and hard disks, more of these goods will be sold. It may increase the demand for personal computers If the value of CED for complement is more than one (elastic value) it means that the goods are strong complements; for example the price of a printer and the ink-cartridge. If the value is inelastic, then they are not good complements like computer hardware and its own software; as consumers buy other independent software or pirated ones.
Price of good X Rise %change positive quantity of good Y fall negative relation between X and Y complementary -/+ negative sign

Price of good X Rise %change positive

quantity of good Y rise positive

relation between X and Y substitute + /+

sign positive

Price of good X Fall %change negative

quantity of good Y rise positive

relation between X and Y complementary +/-

sign

negative

Price of good X Fall %change negative

quantity of good Y fall negative

relation between X and Y substitute -/-

sign positive

price of X quantity of X A

price of Y B

Quantity of Y

Interpretation of cross elasticity of demand from table: Ed x shall be at A( own price elasticity of x) Ed xy that is the percentage change in the quantity demand of X with the percentage change in the price of good Y. In the above table will be located at B.( cross elasticity of x with respect to price of y) Ed y will be at D (own price elasticity of y) Ed yx that is the % change in the Qd of Y with the % change in the price of X will be at C.(cross elasticity of y with respect to price of x) NOTE the sign with A,B,C,D determines the relationship between two variables for instance if its negative with A that means its normal good and x elasticity is negative. Meaning the price of x and quantity demanded of x are inversely related with each other. Usefulness of the concept The concept of cross elasticity of demand is relevant as its value allows him not only to identify whether his good is a complement or a substitute but also the strength of that relationship. The manager is thus able to assess the impact on sales and make better business decisions regarding price and output policy when prices of substitutes or complements change. For example, if other places of interest are complements to the holiday resort in that they are part of a holiday package, he should expand his resort if cross-elasticity of demand is elastic. If cross elasticity of demand is elastic for other competitive resorts or places of interest, it would be advisable for the manager to be as price competitive as possible. At the same time, he can also engage in non-price competition, eg. by differentiating his resorts from others in order to make the cross-elasticity of demand inelastic for competitive resorts. He could offer other related services like Jacuzzi which are closely related with resort business this way he would be able to attract more customers. For instance if cross elasticity of holiday resort and some concert or fair is high then by offering this exhibition or fair he could increase the demand by much.