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Tutor2u - Cross Price Elasticity of Demand (XED)

Students need to be able to define cross price elasticity of demand and apply the correct formula to information on changing prices of two related products. In most questions, students are asked to apply the concept of cross price elasticity to a real world market, when there has been a change in the price of a substitute or a complementary product. Strong evaluation questions the likely relative strength of the cross price effect. For example, when consumers are willing and able to switch their demand, the substitution effect is likely to be high.

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Tutor2u - Cross Price Elasticity of Demand (XED)

1. 1. How Markets Work – Cross Price Elasticity of Demand (XED)
2. 2. How Markets Work Cross Price Elasticity of Demand
3. 3. What is Cross Price Elasticity of Demand? • Substitutes: – Substitutes are products in competitive demand – With substitutes, an increase in the price of one good (ceteris paribus) will lead to an increase in demand for a rival product – The value of XED for two substitutes is always positive • Complements: – Complements are products in joint demand – A fall in the price of one product causes an increase in demand for the complementary product – The value of Xed for two complements is always negative Cross price elasticity (Xed) measures responsiveness of demand for good X following a change in the price of a related good Y. With elasticity questions – remember to write down the correct equation for a mark
4. 4. Cross Price Elasticity of Demand (XED) Calculations Beats Studio headphones retail at approximately £200 per unit. Following a change in price of the headphones (an increase in £20), there is an increase demand for a rival brand of headphones by 5% What is the XED of this price change? • % change in demand of Y = 5% • % change in price of X = 10% • Coefficient of PED = +0.5 • The two goods are fairly weak substitute products Table shows price and quantity demanded of goods, X and Y Price of X Quantity demanded of X Quantity demanded of Y £30 400 250 £15 700 400 Calculate the XED for Y with respect to the price of X. • % change in price of X = -50% • % change in demand for Y = +60% • XED for good Y = -1.2 • The two goods are fairly close complements Changing prices and demand for Dr. Beats headphones
5. 5. Understanding the Coefficient of Cross Price Elasticity • Substitutes: – Close substitutes have a strongly positive cross price elasticity of demand i.e. a small change in relative price causes a big switch in consumer demand • Complements: – When there is a strong complementary relationship, the cross elasticity will be highly negative. – An example might be games consoles and software games • Unrelated products: – Unrelated products have zero cross elasticity e.g. the effect of changes in taxi fares on the market demand for cheese! The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand
6. 6. Cross Price Elasticity of Demand - Substitutes Close substitutes – small rise in price of X causes large rise in demand for Y Price of S Demand for T P2 P1 Q1 Price of X Demand for Y P2 P1 Q1 Q2 D D Q2 Weak substitutes – large rise in price of S leads to small increase in demand for T
7. 7. Cross Price Elasticity of Demand - Complements Close complements: A small fall in price of A causes a large rise in demand for B Price of E Demand for F P2 P1 Q1 Price of A Demand for B P2 P1 Q1 Q2 D D Q2 Weak complements: A large drop in price of E causes only small rise in demand for F
8. 8. Cross Price Elasticity – Cinema Ticket Prices Cinema ticket prices Average annual price in the UK, 2000-2013 2000 4.40 2002 4.29 2004 4.49 2006 4.87 2008 5.20 2010 5.95 2013 6.53 Online streaming Direct DVD Purchases Pay TV – Films on Demand e.g. Sky Alternative entertainments including gaming Substitute Factors Food and drink prices Apps to enhance the customer experience Discount programmes for cinema-goers Cost of parking / transport Complement Factors Total UK cinema admissions remain roughly stable, with 166m admissions in 2013 Cinema ticket prices rising – but £6- £7 is still a low price for an evening’s entertainment?
9. 9. Get help from fellow students, teachers and tutor2u on Twitter: @tutor2u_econ
10. 10. Tutor2u Keep up-to-date with economics, resources, quizzes and worksheets for your economics course.