What Is Cross Elasticity of Demand?

Cross elasticity of demand is an economics term that refers to the relationship between two products’ prices and the effect that change in one product’s price has on the demand for the other product. In general, if two products’ prices move in the same direction (i.e., when one product’s price increases, so does the other product’s price), then they are said to have a positive cross elasticity of demand. If, however, the two products’ prices move in opposite directions (i.e., when one product’s price decreases, the other product’s price increases), then they are said to have a negative cross elasticity of demand. The concept of cross elasticity of demand is important for businesses because it helps them understand how changes in their prices may affect demand for their products.

There are a few things to keep in mind when considering cross elasticity of demand:

1. The degree of cross elasticity of demand between two products depends on how close substitutes they are for each other. For example, if two products are perfect substitutes (i.e., they are exactly the same from the consumers’ perspective), then a change in price of one product will have a 100% impact on the demand for the other product. On the other hand, if two products are not close substitutes (i.e., they are not at all the same from the consumers’ perspective), then a change in price of one product will have very little impact on the demand for the other product.

2. The direction of the cross elasticity of demand between two products also depends on the nature of the products. For example, if one product is a necessity and the other product is a luxury, then a decrease in price of the necessity will lead to an increase in demand for both products (i.e., a positive cross elasticity of demand). However, if a decrease in price of the luxury leads to an increase in demand for the necessity, then we would say that there is a negative cross elasticity of demand between the two products.

3. The magnitude of the cross elasticity of demand between two products can be affected by other factors besides price. For example, if income increases, this may lead to a change in the demand for both products (i.e., an increase in demand for the luxury and a decrease in demand for the necessity).

4. The concept of cross elasticity of demand is also important for businesses when considering pricing strategies. For example, if two products are close substitutes, then a business may want to consider lowering the price of one product in order to increase the demand for both products. However, if the two products are not close substitutes, then a business may want to keep the prices of both products the same in order to avoid any negative impact on demand.

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