Significance of Cross Elasticity of Demand Values
Explain the significance of cross elasticity of demand values that are negative, positive and zero.
[CIE AS level November 2018]
Price Elasticity
Answer
Step ➊ : Define 'cross elasticity of demand' and state it’s formula.
Cross elasticity of demand (XED) is a numerical measure of the responsiveness of the quantity demanded for one product following a change in the price of another related product, ceteris paribus. The formula for cross elasticity of demand used is as follows :
XED =
% change in quantity demanded of product A
% change in the price of product B
The values of XED can be positive, negative and zero. This value depends on whether products are substitutes, complements or are independent.
Step ➋ : Explain what is meant by a positive, negative and zero for cross elasticity of demand. (Application)
➤ 2.1 Products that are substitutes for each other will have positive values for the XED.
A substitute good is a good that can be used in place of another, for example, cars and motorbikes. If the price of cars increase, then people can turn to motorbikes instead because of its more favourable relative price. If the price of cars fall, then consumers will start to buy cars instead of motorbikes.
Assume that the current average market price of a car is $10,000 and current sales are 100 cars per day. This is shown in Figure A illustrated below.
Following a 2% decrease in the price of motorbikes (a substitute product), demand for cars falls from 100 units to 98 units per day at the original price. The demand curve for cars shifts from D0 to D1.
The cross elasticity of demand can be calculated as follows;
XED =
2% fall in demand for cars
2% decrease in price of motorbikes
= + 1
The positive sign indicates that the products are substitutes.
➤ 2.2 Products that are complements will have negative values of XED.
A complementary good is a good used in conjunction with another good, for example cars and car tyres. If the price of cars go up, the quantity demanded of cars will drop and so will the complementary demand for car tyres.
Consider that the average price of car tyres (a complement to cars) falls by 5%. This encourages extra sales of cars tyres and cars as well. The demand for cars rises to 101 per day at the original price. The demand curve for cars shifts from D0 to D2 in Figure A.
The cross elasticity calculation is:
XED =
1% increase in sales of cars
5% falling price of car tyres
= − 0.2
The negative sign indicates that the products are complements.
Figure A
➤ 2. 3. Two goods that are independent have a zero cross elasticity of demand
This means that as the price of good Y rises, the demand for good X stays constant. There may be products whose change in price may not affect the cross elasticity of demand. Because the goods are not related to each other, the cross elasticity of the demand turns out to be zero. For example, jewellery and notebooks are two goods that are not related to each other, and will have a XED of 0.
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Step ➌ : Conclude
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To conclude, two products that are complements will have a negative value of XED , two products that are subtitutes will a have positive value of XED and two products that are independent have a cross elasticity of demand of 0.
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Marking scheme ♕
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For knowledge and understanding of the concept of cross elasticity of demand. What it measures i.e. the relationship between the change in the price of one product and the change in the demand for another product (1 mark) and the correct formula (1 mark) (KU: up to 2 marks)
and application to explain the relationship between goods with a cross elasticity value that is negative i.e. they are complementary (1 mark) because a rise(fall) in the price of one product leads to a fall(rise) in the demand for the other product (1 mark) (Up to 2 marks)
The candidate may provide the formula for cross elasticity, but not give an explicit explanation of what this measures. The candidate could still be awarded the mark for ‘what it measures’ if it is clear from the application that this is clearly understood
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Examiner’s report ♕
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This question was generally answered well and many candidates gained full marks. There was clear knowledge and understanding displayed of the underlying concepts and a large number of candidates were rewarded with full marks. However a number lost marks through carelessness. Some, for example, inverted the formula, while others confused the relationship between substitutes and complements stating that substitutes had a negative coefficient and complements had a positive coefficient, but generally speaking marks here were very pleasing.
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Preview:
Step ➊ : Define 'cross elasticity of demand' and state it’s formula.
Cross elasticity of demand (XED) is a numerical measure of the responsiveness of the quantity demanded for one product following a change in the price of another related product, ceteris paribus. The formula for cross elasticity of demand used is as follows :
XED =
% change in quantity demanded of product A
% change in the price of product B
The values of XED can be positive, negative and zero. This value depends on whether products are substitutes, complements or are independent.
Step ➋ : Explain what is meant by a positive, negative and zero for cross elasticity of demand. (Application)
➤ 2.1 Products that are substitutes for each other will have positive values for the XED.
A substitute good is a good that can be used in place of another, for example, cars and motorbikes. If the price of cars increase, then people can turn to motorbikes instead because of its more favourable relative price. If the price of cars fall, then consumers will start to buy cars instead of motorbikes.
Assume that the current average market price of a car is $10,000 and current sales are 100 cars per day. This is shown in Figure A illustrated below.
Following a 2% decrease in the price of motorbikes (a substitute product), demand for cars falls from 100 units to 98 units per day at the original price. The demand curve for cars shifts from D0 to D1.
The cross elasticity of demand can be calculated as follows;
XED =
2% fall in demand for cars
2% decrease in price of motorbikes
= + 1
The positive sign indicates that the products are substitutes.
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