A Canny, Domican and Flannery Ltd. has calculated the following Cross Elasticity

Question

A Canny, Domican and Flannery Ltd. has calculated the following Cross Elasticity of Demand values for a number of its products as follows:

Cross Elasticity of Demand between Good A and Good B = + 5
Cross Elasticity of Demand between Good A and Good C = - 0.3
Cross Elasticity of Demand between Good A and Good D = + 0.6
Cross Elasticity of Demand between Good A and Good E = -2.9

What is the significance of the above figures? Include in your answer an explanation of Cross Elasticity of Demand and the formula by which it is measured.

Explanation / Answer

Cross Elasticity of Demand measures the percentage change in the demand for one good caused by the percentage change in the price of other goods. The formula is

?? Q x P1 + P2

?? P Q1 + Q2

Q = Quantity of one good

P = Price of another good

?? = The change in

1 Cross Elasticity of Demand for substitute goods is always positive – the greater the positive value the closer the substitutes. When the price of butter rises, consumers switch from butter to margarine and the demand for margarine rises. Both demand and price move in the same direction (upwards in this case). When the figures are inserted into the formula we end up with a positive value. Goods B and D are both substitutes for Good A, with B being the closest substitute.

2 Cross Elasticity of Demand for complementary goods is always negative e.g. if the price of cars rise the demand for cars (eventually) falls and as a result the demand for petrol falls. Therefore the demand for petrol and the price of cars move in opposite directions. When inserted into the formula we end up with a negative value. Goods C and E are complementary to A.

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