Price Elasticity of Demand: Factors Affecting Cross Elasticity

This section explores the factors that influence the cross elasticity of demand, a crucial concept in understanding how changes in the price of one good affect the demand for another.

Understanding Cross Elasticity of Demand

Cross elasticity of demand measures the responsiveness of the quantity demanded of one good to a change in the price of another good. It is calculated as:

$$Cross \, Elasticity \, of \, Demand = \frac{\text{Percentage Change in Quantity Demanded of Good A}}{\text{Percentage Change in Price of Good B}}$$

The result is typically negative, indicating an inverse relationship between the prices of the two goods.

Types of Cross Elasticity

Based on the sign and magnitude of the cross elasticity, we can classify the relationship between the goods as:

• Substitute Goods: Cross elasticity is positive ( > 0). When the price of good B increases, the demand for good A increases. Examples include coffee and tea, or petrol and diesel.
• Complementary Goods: Cross elasticity is negative ( < 0). When the price of good B increases, the demand for good A decreases. Examples include cars and petrol, or printers and ink.
• Unrelated Goods: Cross elasticity is approximately zero (close to 0). Changes in the price of good B have little or no effect on the demand for good A.

Factors Affecting Cross Elasticity of Demand

Several factors can influence the magnitude of the cross elasticity of demand. These factors determine how strongly the demand for one good responds to price changes in another.

1. Availability of Substitutes:

The more available close substitutes for a good, the higher the cross elasticity of demand. If the price of good B rises, consumers can easily switch to a substitute good A. This leads to a larger increase in demand for A.

Example: If the price of Coca-Cola increases, consumers can easily switch to Pepsi, leading to a higher cross elasticity of demand between Coca-Cola and Pepsi.

2. Necessity vs. Luxury:

The cross elasticity of demand tends to be higher between luxury goods and necessities. Consumers are more likely to substitute between luxury goods when prices change. Necessities often have fewer substitutes.

Example: The cross elasticity between a luxury car and a slightly cheaper luxury car will be higher than the cross elasticity between bread and a slightly more expensive loaf of bread.

3. Proportion of Income Spent on Goods:

The higher the proportion of a consumer's income spent on two goods, the higher the cross elasticity of demand between them. A price change in a good that represents a significant portion of income will have a more noticeable impact on the demand for the other good.

Example: The cross elasticity between petrol and cars is likely to be higher than the cross elasticity between petrol and a bicycle, because petrol represents a larger proportion of the cost of owning a car.

4. Brand Loyalty:

Strong brand loyalty reduces the cross elasticity of demand. Consumers who are loyal to a particular brand are less likely to switch to a substitute good even if the price of the original good increases.

Example: Consumers strongly loyal to a specific brand of coffee might not switch to another brand even if the price of their preferred brand increases.

5. Time Horizon:

The cross elasticity of demand can change over time. In the short run, consumers may have limited options for substitutes. However, in the long run, they may be able to find alternative goods. Therefore, the cross elasticity tends to be higher in the long run.

Example: In the short run, if the price of petrol increases, people might not immediately switch to public transport. However, in the long run, they might invest in a carpool or move closer to work.

Table Summarizing Factors Affecting Cross Elasticity

Understanding these factors is essential for analyzing market dynamics and predicting how changes in the price of one good will affect the demand for other goods.