Cross Price Elasticity of Demand
Cross Price Elasticity of Demand (CPED) is an economic concept that measures the responsiveness of the demand for a good to a change in the price of another good. It is an important concept in economics because it helps companies understand how changes in the price of one product can affect the demand for another product.
The formula for calculating Cross Price Elasticity of Demand is:
\(\text{CPED} = \frac{\text{% Change in Quantity Demanded of Good A}}{\text{% Change in Price of Good B}} \)
There are two main outcomes from calculating CPED:
- Positive Cross Price Elasticity of Demand: This occurs when the goods are substitutes. That is, if the price of Good B increases, consumers will buy less of Good B and more of Good A, and vice versa.
- Negative Cross Price Elasticity of Demand: This occurs when the goods are complements. That is, if the price of Good B increases, consumers will buy less of both Good B and Good A, and vice versa.
If the CPED is zero, it means that the two goods are independent, i.e., the change in the price of Good B does not affect the demand for Good A.
Understanding Cross Price Elasticity of Demand can help businesses make important decisions about pricing, marketing, and inventory management. For example, if two products are complements, a company might want to bundle them together or ensure that a price increase in one does not lead to a decrease in demand for the other. Conversely, if two products are substitutes, a company might want to monitor the pricing strategies of competitors who sell the substitute product.
Example of Cross Price Elasticity of Demand
Let’s take an example of two goods: coffee and tea. These are typically considered substitutes because if the price of one rises, consumers might switch to the other.
Let’s say that initially the price of coffee is $5 per cup, and consumers buy 100 cups of tea per day. Then, due to increased demand, the price of coffee rises to $6 per cup. As a result, consumers start buying more tea instead, with daily sales rising to 120 cups.
The percentage change in the price of coffee is \(\frac{6-5}{5} \times \text{100%} = \text{20%} \).
The percentage change in the quantity demanded of tea is \(\frac{120}{100} \times \text{100%} = \text{20%} \).
So, the cross price elasticity of demand (CPED) would be:
\(\text{CPED} = \frac{\text{% Change in Quantity Demanded of Tea}}{\text{% Change in Price of Coffee}} = \frac{\text{20%}}{\text{20%}} = 1\)
A positive CPED indicates that tea and coffee are substitute goods, as expected. If the price of coffee increases by 20%, the quantity demanded of tea also increases by 20%.
This is a simplified example and actual calculations might involve more complex factors, but it illustrates the concept of Cross Price Elasticity of Demand. By understanding this, a tea seller could strategically increase prices when the price of coffee goes up, or a coffee seller might strive to keep prices competitive to prevent customers from switching to tea.
