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Cross Elasticity of Demand

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Degree to which demand for one product is affected by the price of another product.

Demand for frozen orange juice concentrate may increase when the price of fresh orange

juice (a substitute product) increases. Demand for hotel rooms in a ski resort may

decrease when the price of a lift ticket (a complementary product) increases. An increase

that causes an increase is the result of positive elasticity. An increase that causes a

decrease is the result of negative elasticity. Products with no impact on each other have

zero cross elasticity. Marketers need to understand the cross elasticity factors that affect

their products and competitors' products.

cross elasticity of demand

In economics, the cross elasticity of demand and cross price elasticity of demand

measures the responsiveness of the quantity demanded of a good to a change in the price

of another good.

It is measured as the percentage change in quantity demanded for the first good that

occurs in response to a percentage change in price of the second good. For example, if, in

response to a 10% increase in the price of fuel, the quantity of new cars that are fuel

inefficient demanded decreased by 20%, the cross elasticity of demand would be

-20%/10% = -2.

The formula used to calculate the coefficient cross elasticity of demand is

or:

In the example above, the two goods, fuel and cars, are complements - that is, one is used

with the other. In these cases the cross elasticity of demand will be negative. In the case

of perfect complements, the cross elasticity of demand is infinitely negative.

Where the two goods are substitutes the cross elasticity of demand will be positive, so

that as the price of one goes up the quantity demanded of the other will increase. For

example, in response to an increase in the price of fuel, the demand for new cars that are

fuel efficient hybrids for example will also rise. In the case of perfect substitutes, the

cross elasticity of demand is equal to infinity.

2

Where the two goods are independent, the cross elasticity demand will be zero: as the

price of one good changes, there will be no change in quantity demanded of the other

good. In case of perfect independence, the cross elasticity of demand is zero.

When goods are substitutable, the diversion ratio --- which quantifies how much of the

displaced demand for product j switches to product i --- is measured by the ratio of the

cross-elasticity to the own-elasticity multiplied by the ratio of product i's demand to

product j's demand. In the discrete case, the diversion ratio is naturally interpreted as the

fraction of product j demand which treats product i as a second choice,[1] measuring how

much of the demand diverting from product j because of a price increase is diverted to

product i can be written as the product of the ratio of the cross-elasticity to the ownelasticity and the ratio of the demand for product i to the demand for product j. In some

cases, it has a natural interpretation as the proportion of people buying product j who

would consider product i their `second choice.'

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