Determinants of Cross Price Elasticity of Demand

In this revision video we look at a worked answer to this economics exam question. "Examine two determinants of cross price elasticity of demand."

Analysis Point (1)

Cross price elasticity of demand (XED) measures the responsiveness of demand for X in response to a change in the price of Good Y.

One determinant of XED is whether goods are substitutes or complements. Substitutes have a +ve XED whereas complements are products with a -ve cross elasticity.

For example, if the price of natural gas increases, we would expect to see an increase in demand for renewable sources of energy such as solar.

This would be caused by a substitution effect where consumers switch to the relatively low-priced energy.

Evaluation

However, this depends on the costs of substitution. Switching energy sources often involves substantial costs and time delays.

In this situation, the cross-price elasticity of demand for renewable energy would be positive but with a low coefficient (say +0.2)

Analysis Point (2)

A second determinant of cross price elasticity of demand is the strength of brand loyalty for a product.

Consider as an example different brands of sports nutrition drinks. In theory if the price of one drink increases, then we would expect to see an increase in demand for a rival drink.

If brand loyalty is weak and consumers regard the drinks as close substitutes, then the XED is expected to be highly positive (say +2.5).

However, in this type of market, drink manufacturers often spend heavily on marketing and advertising.

The effect can be to increase brand loyalty. In this way, consumers become less price sensitive. The XED will therefore fall.

Evaluation

However, many question the effectiveness of advertising spending – marketing campaigns might simply cancel each other out.