IB Economics - Cross price elasticity of demand and its determinants

This study note for IB economics looks at cross price elasticity of demand and its determinants

Definition

• Cross Price Elasticity of Demand (XED): Measures the responsiveness of the quantity demanded for one good (Good X) to a change in the price of another good (Good Y).

Formula

• XED = (% change in quantity demanded of Good X) / (% change in price of Good Y)

Interpretation

• Substitute Goods:
  • Positive XED: When the price of Good Y increases, the demand for Good X also increases.
  • Example: Tea and coffee in India. If the price of tea rises, more consumers might switch to coffee, increasing its demand.
• Complementary Goods:
  • Negative XED: When the price of Good Y increases, the demand for Good X decreases.
  • Example: Cars and petrol in Germany. If petrol prices rise, the demand for cars may decrease.

Relationship Closeness

• Absolute Value of XED: Indicates the strength of the relationship between two goods.
  • High absolute value: Strong relationship (close substitutes or complements).
  • Low absolute value: Weak relationship (distant substitutes or weak complements).
  • Example: In the UK, butter and margarine have a high XED because they are close substitutes, whereas bread and jelly have a low XED as weak complements.

Implications of XED for Businesses

Strategic Pricing

• Substitute Goods:
  • Pricing Decisions: Firms need to monitor competitor pricing closely. If a competitor lowers prices, they might need to adjust their prices to retain market share.
  • Example: In South Korea, Samsung monitors Apple's iPhone prices closely to adjust its Galaxy smartphone prices accordingly.
• Complementary Goods:
  • Bundling Strategies: Firms can bundle complementary goods to boost sales. If the price of a complementary good rises, they might reduce the price of their good to maintain demand.
  • Example: In Japan, game console manufacturers might bundle consoles with games at a discount if game prices rise.

Marketing and Product Development

• Substitute Goods:
  • Differentiation: Firms may focus on differentiating their products to reduce the substitutability and make demand more inelastic.
  • Example: In France, perfume brands differentiate through unique scents and branding to reduce cross-elasticity with competitors.
• Complementary Goods:
  • Joint Promotions: Firms can collaborate with producers of complementary goods for joint promotions.
  • Example: In Italy, coffee machine manufacturers might partner with coffee pod producers for co-promotions.

Real-World Examples

• Tea and Coffee in India: When the price of tea increases, the demand for coffee rises.
• Smartphones and Apps in China: A decrease in smartphone prices can lead to increased demand for mobile apps.
• Automobiles and Fuel in Germany: Rising fuel prices can decrease the demand for automobiles.
• Printers and Ink Cartridges in Brazil: If the price of printers drops, the demand for ink cartridges may increase.

Glossary of Key Terms

• Complementary Goods: Goods that are often used together; an increase in the price of one leads to a decrease in the demand for the other.
• Cross Price Elasticity of Demand (XED): Measures the responsiveness of the quantity demanded for one good to a change in the price of another good.
• Substitute Goods: Goods that can replace each other; an increase in the price of one leads to an increase in the demand for the other.

Related Topics for Further Exploration

• Income Elasticity of Demand: How quantity demanded changes with income variations.
• Price Elasticity of Demand (PED): How quantity demanded changes with price variations.
• Supply Elasticity: How quantity supplied responds to price changes.
• Market Structures: Understanding how different market structures influence pricing and output decisions.
• Consumer Behavior: How consumers make purchasing decisions based on preferences and constraints.

Multiple Choice Questions

1. If the cross price elasticity of demand between two goods is positive, the goods are:
   • A) Complements
   • B) Substitutes
   • C) Unrelated
   • D) Inferior
   • Answer: B) Substitutes
2. Which of the following pairs of goods is most likely to have a negative cross price elasticity of demand?
   • A) Butter and margarine
   • B) Tea and coffee
   • C) Cars and petrol
   • D) Smartphones and tablets
   • Answer: C) Cars and petrol
3. If the price of Good Y increases by 10% and the quantity demanded of Good X decreases by 5%, what is the cross price elasticity of demand?
   • A) -0.5
   • B) 0.5
   • C) -2
   • D) 2
   • Answer: A) -0.5
4. A firm produces printers and ink cartridges. If the price of printers decreases, what is the likely effect on the demand for ink cartridges?
   • A) Demand for ink cartridges will decrease.
   • B) Demand for ink cartridges will increase.
   • C) Demand for ink cartridges will remain unchanged.
   • D) The effect on ink cartridge demand is unpredictable.
   • Answer: B) Demand for ink cartridges will increase.
5. Which of the following is an example of a pair of substitute goods?
   • A) Bread and butter
   • B) Smartphones and apps
   • C) Coffee and tea
   • D) Shoes and socks
   • Answer: C) Coffee and tea

IB Economics Essay-Style Questions

1. Discuss the importance of cross price elasticity of demand for a firm when developing its pricing strategy.
2. Evaluate how a change in the price of a complementary good can impact a firm's sales and revenue.
3. Analyze the significance of cross price elasticity of demand in the context of competitive market structures.
4. Examine how businesses can use cross price elasticity of demand to identify potential threats and opportunities in the market.
5. Explore the role of cross price elasticity of demand in shaping government policies on taxation and subsidies.

Model Essay Answer

Question: Discuss the importance of cross price elasticity of demand for a firm when developing its pricing strategy.

Cross price elasticity of demand (XED) is a critical concept for firms to understand when developing their pricing strategies. XED measures how the quantity demanded for one good (Good X) responds to a change in the price of another good (Good Y). This concept is particularly important for firms dealing with substitute or complementary goods.

For substitute goods, XED is positive, meaning that an increase in the price of Good Y leads to an increase in the demand for Good X. Firms producing substitutes must be vigilant about competitors' pricing. For instance, in South Korea, Samsung monitors Apple's iPhone prices to adjust its Galaxy smartphone prices. If Apple lowers its prices, Samsung might need to follow suit to avoid losing market share. Conversely, if a competitor raises prices, a firm might capitalize by slightly increasing their prices or maintaining them to attract price-sensitive customers.

In the case of complementary goods, XED is negative, indicating that an increase in the price of Good Y leads to a decrease in the demand for Good X. Firms producing complementary goods can use this information to develop bundling strategies or joint promotions. For example, in Japan, coffee machine manufacturers often bundle their products with coffee pods. If the price of coffee pods increases, they might offer discounts on coffee machines to sustain demand. This strategy can help mitigate the adverse effects of price changes in complementary goods.

Understanding the absolute value of XED is also vital, as it indicates the strength of the relationship between goods. A high absolute value signifies a strong relationship, meaning the goods are close substitutes or strong complements. For example, in the UK, butter and margarine have a high XED due to their substitutability. Firms in such markets need to focus on differentiation to make their products less substitutable, reducing the impact of competitors' pricing.

Additionally, firms can use XED to identify potential threats and opportunities. If a firm notices that a new product in the market has a high positive XED with its product, it might consider strategic actions such as innovation, marketing campaigns, or even partnerships. On the other hand, understanding XED can help firms anticipate changes in demand due to price fluctuations in complementary goods and adjust their production and inventory accordingly.

In conclusion, cross price elasticity of demand is an essential tool for firms in developing effective pricing strategies. By understanding the relationships between goods, firms can make informed decisions to optimize pricing, maximize revenue, and maintain competitive advantage. This understanding helps firms navigate market dynamics more effectively, ensuring long-term success.