This article is about Cross Elasticity of Demand (CED).
It defines, calculates and interprets Cross Elasticity of Demand (CED) as well as explains the factors that determine Cross Elasticity of Demand (CED) and its impact on company revenue. The graphs illustrate various stages of Cross Elasticity of Demand (CED).
What is Cross Elasticity of Demand (CED)?
Cross Elasticity of Demand (CED) measures how a change in price of one product affects the quantity demanded for another product. Simply, how much demand for a product decreases or increases following an increase or decrease in the price of another product.
How to calculate Cross Elasticity of Demand (CED)?
Cross Elasticity of Demand (CED) is calculated using the following equation:
| %∆ Change in Quantity Demanded of Product B | |
| Cross Elasticity of Demand (YED) = | ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ |
| %∆ Change in Price of Product A |
Where:
| Final Value – Original Value | ||
| %∆ Change = | ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ | x 100 |
| Original Value |
NOTE: The final value of Cross Elasticity of Demand (CED) is usually either negative or positive.
Different types of Cross Elasticity od Demand (CED)
Cross Elasticity of Demand (CED) is used to show the relationship that exists between the price of one product and the demand for another product.
It measures the responsiveness of demand for one product after a change in the price of another product.
Cross Elasticity of Demand (CED) can be either:
- Negative
- Zero
- Positive
The following descriptions of elasticities start from the situation when percentage change in the price of one product has completely no effect on quantity demanded of another product until the situation when even a tiny change in the price of one product has a huge effect on quantity demanded of another product.
Cross Elasticity of Demand (CED) also gives us more information about the relationship between goods whether they are substitute goods complementary goods.
1. Negative (CED < 0)
Value of Cross Elasticity of Demand (CED) lower than 0. The product is to have negative Cross Elasticity of Demand (CED). This means a change in demand for Product B following a change in the price of Product A.
Comment: The Cross Elasticity of Demand (CED) is negative for complements to each other, or in other words, complementary goods which are often bought together. When the price of Product A decreases, the demand for Product B will increase. Because as these two products are consumed together, if the price of one of them decreases, demand should increase, it is logical that demand for another product should increase as well. And, when the price of Product A increases, the demand for Product B will decreases. Because as these two products are consumed together, if the price of one of them increases, demand should decrease, it is logical that demand for another product should decrease as well.
The negative sign means that the two products are complements. However, if the coefficient is between -1 and 0, it means that these two products are not particularly complementary. The lower the number, the stronger the relationship between two goods.
Examples of products: If the price of DVD players decreases, demand should increase, it is logical that DVD videos will increase in demand and vice versa. Purchasing a laptop computer when prices go down will often lead to the purchase of a Microsoft operating system.
How consumers behave? Consumers will respond to a change in the price of a complementary product.
Chart:
Calculations: The price of Product A (a computer) has increased by 3%. The quantity demanded of Product B (a printer) has decreased by 9%. What is the Cross Elasticity of Demand (CED) for this product?
Step 1: Calculate the percentage change in Quantity Demanded for Product B.
%∆ Change in Quantity Demanded for Product B = -9%
Step 2: Calculate the percentage change in Price of Product A.
%∆ Change in Price of Product A = 3%
Step 3: Use the CED formula:
Cross Elasticity of Demand (CED) = -9% / 3% = -3
It is now important to explain this result. A Cross Elasticity of Demand (CED) of -3 means that demand for Product B changes by -3% for every 1.0% change in price of Product A.
What should the business do? The producers and retailers of complementary products should expect higher demand when prices of other complements decrease. It is because people tend to consume them hand in hand. So, an increase in demand of one product, following the price decrease, will cause an increase in demand of another product. And, a decrease in demand of one product, following the price increase, will cause a decrease in demand of another product. For instance, if the business sell cheese and wants to figure out its future demand, it should observe what happens with the price of hamburgers as people use cheese to make hamburgers.
2. Cross Elasticity of Demand (CED) = 0
Value of Cross Elasticity of Demand (CED) equals 0. This means there is no change in demand for Product B following a change in the price of Product A.
Comment: There is no relationship between the two products. These products are not bought together nor one can be substituted for another. When the price of Product A decreases, the demand for Product B will not respond at all.
Examples of products: Any two products which are completely not related to one another will have Cross Elasticity of Demand (CED) equal zero such as fish and cars, clothes and hamburgers, bicycles and space rockets, Halloween costumes and marble flooring, etc. If the price of fish increases, it should have no impact on the demand for cars.
How consumers behave? Consumers will respond at all to a change in the price of a product.
Chart:
Calculations: The price of Product A (fish) has increased by 3%. The quantity demanded of Product B (a passenger car) has not changed. What is the Cross Elasticity of Demand (CED) for this product?
Step 1: Calculate the percentage change in Quantity Demanded for Product B.
%∆ Change in Quantity Demanded for Product B = 0%
Step 2: Calculate the percentage change in Price of Product A.
%∆ Change in Price of Product A = 3%
Step 3: Use the CED formula:
Cross Elasticity of Demand (CED) = 0% / 3% = 0
It is now important to explain this result. A Cross Elasticity of Demand (CED) of –0 means that demand for Product B changes by 0% for every 3.0% change in price of Product A.
What should the business do? The producers and retailers of unrelated products should not count on increased demand when market prices change. It is because people tend to consume them on completely different occasions, purchase them for completely different reasons, etc. So, an increase or decrease in demand of one product, following the price increase or decrease respectively, will cause not cause any change in demand of another product.
Value of Cross Elasticity of Demand (CED) higher than 0. The product is to have positive Cross Elasticity of Demand (CED). This means a change in demand for Product A following a change in the price of Product B.
Comment: The Cross Elasticity of Demand (CED) is positive for substitutes, or in other words, very similar products which are competing for customers spending. Generally, people see these goods as substitutes to one another. When the price of Product A increases causing demand for product A to decrease, demand for Product B will increase. Because as these two products can be easily replaced, if the price of one of them increases, it is logical that demand for another substitute product should increase. And, when the price of Product A decreases causing demand for product A to increase, demand for Product B will decrease. Because as these two products can be easily replaced, if the price of one of them decreases, it is logical that demand for another substitute product should decrease.
The positive sign means that the two products are substitutes. However, when the coefficient is greater than 1, it means that these two products are considered to be very close substitutes. The higher the number, the stronger the replaceability among these two goods.
Examples of products: If the price of Sony TVs increase, demand for Toshiba TVs will also increase. It is logical that when Sony TVs become more expensive, customers will buy more of Toshiba TVs. The same applies to different brands of cigarettes, tea, toothpaste, sparkling water, or newspapers.
How consumers behave? Consumers will respond to a change in the price of a substitute product.
Chart:
Calculations: The price of Product A (daily newspaper A) has increased by 5%. The quantity demanded of Product B (daily newspaper B) has decreased by 2%. What is the Cross Elasticity of Demand (CED) for this product?
Step 1: Calculate the percentage change in Quantity Demanded for Product B.
%∆ Change in Quantity Demanded for Product B = 2%
Step 2: Calculate the percentage change in Price of Product A.
%∆ Change in Price of Product A = 5%
Step 3: Use the CED formula:
Cross Elasticity of Demand (CED) = 2% / 5% = 0.4
It is now important to explain this result. A Cross Elasticity of Demand (CED) of 0.4 means that demand for Product B changes by 0.4% for every 1.0% change in price of Product A.
What should the business do? The producers and retailers of close substitutes should expect higher demand when prices of other competing products increase. It is because people tend to consume them by choosing one over another. So, an increase in demand of one product, following the price decrease, will cause a decrease in demand of another product. And, a decrease in demand of one product, following the price increase, will cause an increase in demand of another product. For instance, if The Coca-Cola Company wants to figure out its future demand for Coke, it should observe what happens with the price of Pepsi as customers tend to buy either Coke or Pepsi Cola, but very rarely both of them at the same time.
Cross Elasticity of Demand (CED) and Sales Revenue
Let’s see how to apply Cross Elasticity of Demand (CED) into real business situations to help the business increase sales.
A. For compliments:
Managers can price two close compliments in a counterintuitive way to implement the pricing strategy called Loss Leader.
While one of the goods will be priced significantly at below the cost of production, another good which is necessary to make the first good work will be sold at the very high price. The firm will make a heavy loss on the first product but a large profit on the second one. Overall, this will allow for making a decent profit.
B. For substitutes:
Managers can compare sales of the product before and after the competitors raised prices of close substitutes. The sales performance before and after the price change can be used to calculate the Cross Elasticity of Demand (CES).
This will help to find new pricing points, and then design new pricing strategies.
Generally, it would be more effective for a business in the short-term to decrease the price following any decrease in the price of competitive products. However, this may cause getting into price wars in the long-term with your competitors.
A price war is when a rival company lowers prices of comparable products to gain market share. And losing market share ultimately means losing customers and profits.
The determinants of Cross Elasticity of Demand (CED)
There are many influences on Cross Elasticity of Demand (CED):
- Closeness of complements and substitutes. This is the major determinant of Cross Elasticity of Demand (CED) as this elasticity is about the direct relationship between the two goods. The higher the values of CED (for both negative and positive results), the more sensitive the goods are to other respective goods.
- Level of competition. In highly competitive markets consumers will have many choices not only to purchase very close substitutes such as different brands of ice-cream, but they can also buy other kids of deserts such as cakes, cookies and milk-shakes. When setting prices, companies will be looking at what alternative customers have.
- Branding. Strong branding and omnipresent advertising can help firms not only to differentiate their products from competition, but also to reduce Cross Elasticity of Demand (CED). When the business has many loyal customers, they may not be willing to switch to another brand even though the price of the close substitute significantly declined. Some people religiously consume certain types of products such as marshmallows and are very loyal to their smartphone brand or sports shoes brands. Hence, weak substitutes will demonstrate low positive Cross Elasticity of Demand (CED).
- Income levels. Customers with higher income levels may decide to just pay the higher price without buying competitors’ products. This will not necessarily increase the demand for a similar product. It is because a slight price increase does not impact their monthly spending budget in a visible way.
Summary
Cross Elasticity of Demand (CED) looks at how the price change of one good affects the demand for another good.
It is useful for companies which have strong competition from very close substitute products such as Coca-Cola and Pepsi or Sony PlayStation and Microsoft Xbox.
Companies which rely on complementary goods can also use it to help set the optimum price for their products such as cars and gasoline, movie tickets and popcorn, Sony PlayStation and video games.
