This article discuss the concept of cross price elasticity odf demand and its usefulenss to business and government in a microeconomic sense.
Definition of Cross Elasticity of Demand
Cross Elasticity of demand means if a product price is changed what is the effect in demand in response to changes in price of the first product if other things are being equal. For example if the price of butter goes up what is the effect on another substitute or complementary product due to changes in the price butter.
Cross elasticity of substitutes
In real world some products are substitutes. However, there are few products that are perfect substitutes. If a product is a close substitute the cross elasticity will be elastic. For substitutes the cross elasticity is positive. This is, because if the price changes for the original product the demand for the substitute will be in the same direction. That is if the Price of the original product is reduced the demand for the substitute will be reduced as customers will shift to the original product. Some products are not close substitutes and there fore their cross elasticity of demand is inelastic.
Cross Elasticity of Complementary products
In contrast to substitutes complementary products have negative cross elasticities. For example, if the price of furniture is reduced then the demand for the furniture will increase if other things are being equal and there fore it will increase the demand for wood products and other materials used in the manufacture of furniture. The cross elasticity of demand for a complementary product is a downward sloping curve like a demand curve as opposed to the cross elaticity curve of substitutes, which as a upward sloping curve.
Importance of Cross Price Elasticity of Demand for Business
If a business can accurately estimate cross elasticity of demand then it can evaluate the impact of the pricing strategies of their rivals on their products. In the same time, they can be useful in formulating pricing strategies of complementary products. For example a firm can formulate pricing strategies if they have complementary products depending on the cross elasticities of demand to increase sales and improve profitability by analyzing the cross elasticities of demand.
The cross elasticity of demand is also useful in analyzing wage policies on different groups. For example if cross elasticities for different groups of young people say male and female then it may show the impact of setting wage levels on the replacement by females by men and the degree they are replaced.
It is also useful for government to study the impact of indirect taxes on the complementary and substitute products. For example if say government say introduces and indirect tax on tobacco then it can study the price changes on complementary and substitute products and there fore evaluate the effectiveness of indirect taxes to curb tobacco products and reduce health problems.
Another application is to the pricing strategies to reduce congestion and to promote public mass transport in peak hour by charging or increasing tolls at peak hour and its impact of reducting in congestion on major roads.
The concept of cross price elasticity of demand is also useful in power generation. For example, one can study the impact of the price of one source of enery on the other sources if cross elasticity of demand can estimated fairly accurately.
As discussed above the concept of cross price elasticity of demand is an important concept in microeconomics. The concept is useful for business and government in formulating pricing strategies and their micro effects. In addition, it also useful to classify products in to substitutes and complimentary products so that it can be studied separately. In summary, the concept of cross elasticity of demand with other concepts related to elasticity of demand is useful to buisness and government in a micro economic sense to formulate policies and to study their impact on demand patterns and evaluate policy effectiveness.