Skip to main content

XED and business decisions

Cross elasticity of demand: relevance for firms

Cross elasticity of demand (CED) is the responsiveness of demand for one good (good X) to a change in the price of another (good Y). Can you write down the FORMULA? Follow the link to check your answer.

The numerical value of the XED will depend on the relationship between the goods in question. If the goods are substitutes or complements, the numerical value of the XED will be much larger than if the two goods bear little relation to each other; i.e. a change in the price of one good will have a significant impact on the demand for the other good. This will be important for business decision making.

For example, consider two manufacturers of different brands of cola, for example (Coke and Pepsi). Let's call them Brand X and Brand Y, which are close substitutes for each other. The decision by the manufacturer of Brand X to lower price will, other things being equal, lead to an increase in the consumption of Brand X cola. If the manufacturer of Brand Y cola leaves the price unchanged, he/she is likely to experience a decrease in demand as Brand X will become relatively, and possibly absolutely, more expensive than Brand Y. The manufacturer of Brand X is faced with an important pricing decision in order to compete effectively with the rival. Can you think of any other goods or services where such close substitutes can be found?

Conversely, consider the case of two goods that are complements, strawberries and cream. A very British example, but very true! A good harvest will increase the supply of strawberries (the supply curve will shift to the right) and lower their price. As a result, there will be a movement along the demand curve for strawberries, an extension of demand. Given that people like to pour cream on their strawberries to give extra taste, manufacturers of cream will have to make important output decisions if they are to meet the potential increase in demand for cream arising from higher consumption of strawberries. Cows cannot suddenly increase their supply of milk so producers may have to switch production from other dairy products to that of cream or choose to keep cream output at the same level forcing the price of cream to rise in the market.