Cross Elasticity Of Demand

Definition

Cross elasticity of demand is an economic concept that measures the responsiveness of the demand for one good to a change in the price of another good. Also known as cross-price elasticity of demand, this metric is calculated by dividing the percentage change in the quantity demanded of one good by the percentage change in the price of another good.

Origin

The concept of cross elasticity of demand originated in the late 19th and early 20th centuries as economists began to study the interrelationships between goods in a market economy. This concept helps analyze the relationships between substitutes and complements.

Categories and Features

Cross elasticity of demand is primarily categorized into positive cross elasticity and negative cross elasticity. Positive cross elasticity indicates that two goods are substitutes, meaning an increase in the price of one good will lead to an increase in the demand for the other. Negative cross elasticity indicates that two goods are complements, meaning an increase in the price of one good will lead to a decrease in the demand for the other. The magnitude of cross elasticity can help businesses and investors understand market dynamics and consumer behavior.

Case Studies

A typical case is butter and margarine. If the price of butter increases, the demand for margarine may rise as consumers opt for a cheaper substitute. Another example is coffee and sugar. If the price of coffee increases, the demand for sugar may decrease because they are complements, and consumers might reduce their coffee consumption, thereby reducing sugar demand.

Common Issues

Common issues investors face when applying cross elasticity of demand include misunderstanding the relationship between substitutes and complements and overlooking other market factors. It is important to consider the complexity of the market and the diversity of consumer preferences.