What is the Cross Elasticity of Demand?

The cross elasticity of demand is a microeconomic concept that measures how the change in price in one product affects the change in demand of another. This number is reached by dividing the percentage change of price in the one product into the percentage change of demand for the other. Cross elasticity of demand depends on whether the products are substitutes, which are two different brands of the same product, or complements, which are two separate products that are related to each other, like a video game system and its compatible individual games. Utilizing this formula can help the makers of products devise pricing and marketing strategies.

A typical example of cross elasticity of demand, also known as cross-price elasticity of demand and represented in mathematic terms as CPEoD, might involve a fast-food chain raising the price of a hamburger from $4 US Dollars (USD) to $5 USD, which represents a change of 25 percent. In the time period when this occurs, a competing chain sees the quantity of hamburgers it sells rise from 100 to 200, for a rise of 50 percent. To calculate the cross elasticity of demand in this scenario, the percentage of price change for the first hamburger chain (.25) is divided into the percentage of change of demand for the second chain (.50) to reach a CPEoD of 2.

When two products are substitutes, as in the case above, the CPEoD, should usually turn out to be a positive number. That's because a raise in price of one brand of the product should lead to a higher demand for a competing brand. By the same token, if one brand drops prices, the demand for a competing brand will drop. In that case, the dividing the two negatives still produces a positive number.

In the case of products that are complements, such as the example listed earlier of a video game system and the games compatible with that system, the CPEoD will most likely be a negative number. If the company that makes the video game system raises the price, it stands to reason that demand for the compatible games would drop. That means that a positive number would be divided into a negative number, which produces a negative result. A CPEoD result at or near zero likely means that the two products in question are unrelated.

Industries use cross-price elasticity of demand to implement marketing strategies and plan responses to the moves of competitors. For example, one company might have to decide whether to match the price drop of a competitor. It may also have to decide whether it can meet the resulting demand if another competitor suddenly raises prices or if it would be more profitable to raise prices in kind. Using the cross elasticity of demand formula can help to answer these questions.