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TOPIC 7: ELASTICITY Measuring Responsiveness

ECON-200 CSCC
Selloane Asiamah

3. Cross Price Elasticity


Cross Price Elasticity (Exy) Measures how much demand of Good X changes when the price of Good Y changes. How sensitive is the demand for a good to changes in the price of a related good? Changes in the price of a related good is a DEMAND SHIFTER! RECALL: When the price of a good changes, it can SHIFT the DEMAND of RELATED GOOD (this is 1 of the 5 demand shifters!) Assuming Good X & Y are related, they can either be: 1. SUBSTITUTES (can replace each other to fulfill the same want) 2. COMPLEMENTS (are used together in consumption)

ExyRELATED GOODS
HOW CONSUMERS RESPOND DEPENDS ON WHETHER THE GOOD IS A SUBSTITUTE or A COMPLEMENT GOOD!

1. SUBSTITUTE GOOD: Price of Y INCREASES then Qd for Y DECREASES (Y is relatively more expensive)
Since Good X can be substituted for Good Y, when Qd for Y decreases then people buy more X andDEMAND for X INCREASES

Py

Dx

Price of Y DECREASES

then Qd for Y INCREASES (Y is relatively cheaper than X) Since Good Y can be substituted for Good X, when Qd for Y increases, people are buying less X and .DEMAND for X DECREASES

Py

Dx

ExyRELATED GOODS
HOW CONSUMERS RESPOND DEPENDS ON WHETHER THE GOOD IS A SUBSTITUTE or A COMPLEMENT GOOD!

2. COMPLEMENT GOOD: Price of Y INCREASES then Qd for Y DECREASES. Since Good Y is used together
with Good X, when Qd for Y decreases then people will also buy less X and

DEMAND for X DECREASES Py Dx

Price of Y DECREASES

then Qd for Y INCREASES. Since Good Y is used together with Good X, when Qd for Y increases, people will also buy more X and

DEMAND for X INCREASES Py Dx

Cross Price Elasticity


To calculate how sensitive demand for X is to changes in the price of Y, we must calculate the Cross Price Elasticity using this formula:

Exy = % change in Demand for X % change in Price of Y

Calculating % Change
Again you can calculate your % changes using either the point method or Arc (midpoint) method New value Original value Original value
POINT METHOD

New value Original value New + Original 2

ARC METHOD

Calculating Exy
Try it using the point method: 1. The price of hotdogs increases from $3 to $3.60. As a result, the demand for hotdog buns decreases from 12 units to 8 units (complements).

Exy = % change in Dx = % change in Py

8 - 12 12 $3.60 - $3.00 $3.00

- 4 12 $0.60 $3.00

Calculating, you should have an Exy value = -1.67

Do not ignore the sign!!!


Unlike your Ep coefficient, do NOT ignore the negative sign on your Exy coefficient. When Exy is negative, then you have goods that are complements! When the Price of hotdogs INCREASED, people bought less hotdogs and the Demand for hotdog buns DECREASED because you use them together. *Since Py increased and Dx decreased (Negative/inverse relationship) therefore Exy is negative!

Calculating Exy
Try it using the point method:
2. Assume Burger King increased the price of their burger from $3.50 to $4.00. Down the street, Wendys realizes that they are selling more burgers. Usually they sell 70 burgers per day and now they are selling 100 (substitute goods)
Exy = % change in Dx = % change in Py 100 70 70 $4.00 - $3.50 $3.50 = 30 70 $0.50 $3.50

Calculating, you should have an Exy value = 3

Do not ignore the sign!!!


When Exy is positive, then you have substitute goods. When the Price of Burger King burgers INCREASED, people bought less burgers from BK and went down the street to Wendys. As a result, Wendys experienced an INCREASE in the Demand for their burgers because they are substitutes! *When Py increased and Dx increased (Positive relationship) therefore Exy is positive!

Interpreting Exy
What does the Exy coefficient tell us?

Example 1. Exy = - 1.67 This is the cross price elasticity of hotdog buns and hotdog buns. This means that a 1% change in the price of hotdogs leads to a 1.67% change in demand for hotdog buns! Because Exy is negative, they are complements!
Negative Exy means that the price of good Y (hotdogs) and the demand for good X (buns) move in opposite directions. When Py increases, Dx decreases (and vice versa)

Interpreting Exy
What does the Exy coefficient tell us?

Example 2. Exy = 3 This is the cross price elasticity of Burger King burgers and Wendys burgers. This means that a 1% change in the price of Burger King burgers leads to a 3% change in demand for Wendys burgers! Because Exy is positive, they are substitutes!
Positive Exy means that the price of good Y (Burger King) and the demand for good X (Wendys) move in the same direction. When Py increases, Dx increases (and vice versa)

Good Y will always be the good that has a change in price Good X is the related good its demand is reacting to the change in the price of Good Y.
Chips $3 QDc 5 Pretzels $4 QDp 4

$4

$4

Example: Initially, chips are priced at $3 and pretzels are priced at $4. At these prices, people buy 5 bags of chips and 4 bags of pretzels. The price of chips increases to $4 but the price of pretzels does NOT change! Your Exy would find the change in the demand for pretzels when the price of chips increases. FIND EXY!

SOLUTION: Py is the price of chips since it was the good with the price change. Dx is the demand for pretzels its price did not change but the demand changed (in reaction to the change in the price of chips!
Using the ARC method: 74 (7+4)/2 $4-$3 ($4+$3)/2

Exy = % change in Dx = % change in Py

0.54 0.28

= 1.92

Exy for chips and pretzels = 1.92 Since its positive, they are substitutes. Interpretation of Exy = A 1% change in the price of chips leads to a 1.92% change in the demand for pretzels.