The cross elasticity of demand tells you how your customers will react to a change in your product’s price. It is a way to mathematically measure the amount you can increase an item’s price before your sales start to fall. Some products have a high cross elasticity of demand. This means that your sales will decrease when you raise the selling price. Other products have a low cross elasticity of demand. This means that your sales are largely unaffected when you increase the product’s price. The cross elasticity of demand can help you find the optimal selling price for your products.
Calculate the Cross Elasticity of Demand
To calculate the cross elasticity of demand, divide the percentage change of the quantity purchased by the percentage change in the price of another good. For example, say your customers purchase 10 percent more tomatoes when you raise the price of cucumbers by 20 percent. Divide 10 percent by 20 percent to get the cross elasticity of demand of the two. A positive number indicates that one of the goods can be substituted for the other. A negative number indicates that the goods are complements of each other. A price increase of one good decreases the sales of a complementary good.
Availability of Substitute Goods
The availability of substitute goods affects the cross elasticity of demand. A substitute good is one that is identical or very similar to another. Goods such as loaves of bread and gallons of gasoline have a high cross elasticity of demand. Your customers can easily purchase a similar or identical product from your competitors if you raise your price. Goods that are unique, such as houses and medicines, have a low cross elasticity of demand. Your customers must buy at your price or forgo the item. The higher the cross elasticity of demand, the less leeway you have when raising the price.
With complementary goods, an increase in the price of one good results in decreased sales for the other. Complementary goods are used and frequently purchased together, such as coffee and cream or hot dogs and hot dog buns. For example, an increase in the price of hot dogs causes a decrease in your hot dog bun sales. The cross elasticity of demand is negative, because the increased price results in decreased demand. Putting your hot dogs on sale results in an increased demand for hot dog buns. However, the cross elasticity of demand is still negative, because the decrease in price results in an increase in demand.
There is no cross elasticity of demand for unrelated goods. Unrelated goods are items that do not share similar characteristics or are purchased or used together. An increase in the price of one good has no effect on the other. For example, say your store sells hamburgers and throw rugs. Your throw rug sales are unaffected if you increase the price of hamburgers. No matter how much you change your hamburger prices, the demand for throw rugs remains steady. Since the price change of one good does not affect the other, the cross elasticity of demand for unrelated goods is always zero.