Lecture 14: Cross Price Elasticity of Demand
Cross price elasticity (CPed) measures the responsiveness of demand for good X following a
change in the price of good Y (a related good).With cross price elasticity we make an important
distinction between substitute products and complementary goods and services
Substitutes: With substitute goods such as brands of cereal or washing powder, an increase in
the price of one good will lead to an increase in demand for the rival product. Cross price
elasticity for two substitutes will be positive. For example, in recent years, the prices of new cars
have been either falling or relatively flat. As the price of new cars relative to people’s incomes
has declined, this should increase the market demand for new cars and (ceteris paribus) reduce
the demand for second hand cars. We can see that there has been a very marked fall in the prices
of second hand cars.
Complements: With goods that are in complementary demand, such as the demand for DVD
players and DVD videos, when there is a fall in the price of DVD players we expect to see more
DVD players bought, leading to an expansion in market demand for DVD videos. The cross
price elasticity of demand for two complements is negative.
The stronger the relationship between two products, the higher is the co-efficient of cross-
price elasticity of demand. For example with two close substitutes, the cross-price elasticity
will be strongly positive. Likewise when there is a strong complementary relationship between
two products, the cross-price elasticity will be highly negative. Unrelated products have a zero
How can businesses make use of the concept of cross price elasticity of demand?
Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use
estimates of cross-price elasticity to predict the effect on the quantity demanded and total
revenue of their own product. For exam