1 answer

Explain the cross-price elasticity of demand. Why is it negative or positive for certain types of...

Question:

Explain the cross-price elasticity of demand. Why is it negative or positive for certain types of goods?


Answers

Cross-price elasticity of demand measures the degree of responsiveness of quantity demanded of one related commodity to a change in the price of another related commodity. Related commodities are divided into substitute goods and complement goods. Hence, cross-price elasticity is the degree of relative change in the quantity demanded of a commodity due to a change in the price of its substitute or complement.

Let the two goods are X and Y, then cross-price elasticity of demand is a measure of the degree of responsiveness of quantity demanded of Y to change in the price of X.

Cross-price elasticity of demand = % change in the quantity demanded of one related good/

% change in the price of another related good

Related goods are divided into

1. Substitute goods

When goods are substitute of each other the cross elasticity of demand is positive. When the price of one substitute good increases, the quantity demanded of another substitute good also increases.

So there is a direct relationship between price of one substitute good and quantity demanded of another substitute good. In this case the cross elasticity will be positive.

2. Complementary goods

In case of complementary goods, cross elasticity of demand is negative. When the price of one complementary good increase, the quantity demanded of another complementary good also decreases. So there is an inverse relationship between price of one complementary good and quantity demanded of anther complementary good.

A proportionate increase in price of one commodity leads to a proportionate fall in the demand of another commodity because both are demanded jointly. In this case the cross elasticity will be negative.

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