Use of Cross Elasticity of Demand in Business Decision Making
Cross elasticity of demand is a measure of degree of change in demand of a commodity due to change in price of another commodity.
Cross elasticity of demand can also be understood as the proportionate change in quantity demanded of commodity ‘X’ due to proportionate change in price of commodity ‘Y’. Cross elasticity of demand is denoted by Exy and is mathematically represented as
Cross elasticity of demand is one of the major tools that businessmen (producers) take help from in order to make correct business decisions. Described below are its few applications in business sector.
Determining nature of relationship between any two goods
We have already understood that cross elasticity of demand is the rate of change of demand for one commodity in response to change in price of another commodity. Cross elasticity of demand can only be measured between any two goods at a time, and the outcome is the representation of the relationship shared by those two goods.
Cross elasticity is greater than zero when rise in price of commodity X causes rise in demand of commodity Y. Such type of response can be observed in substitute goods such as Coke and Pepsi.
In the same way, cross elasticity is equal to zero when rise in price of commodity X does not cause any effect on the demand of commodity Y. This type of response can be seen in goods that are not related to each other such as sugar and shoe.
And, cross elasticity is lesser than zero when rise in price of commodity Y causes fall in demand of commodity X. Such type of response can be seen in complementary goods such as tea and sugar.
Forecasting change of demand
Cross elasticity can be used by a businessman (producer) to predict the future demand of his product in case when he has the idea of probable future price of substitute or complementary goods.
Let us suppose that there’s a company which manufactures Limes (cold drink) and there is another cold drink in the market called Oranges. The cross elasticity of demand between Limes and Oranges is +1.5.
Let us also suppose that the manufacturer of Limes received the information that the price of Oranges is about to fall by 10% in the upcoming month.
From the above information, the manufacturer of Limes can predict by how much the demand of its product will fall as a result of fall in price of Oranges, and thus will be able to make necessary decisions to keep up its revenue.
Classification of market
Cross elasticity of demand is also helpful in classifying the type of market.
Higher the value of cross elasticity of demand between the products, greater will be the competition in the market, and lower the value of cross elasticity, the market will be less competitive. In the same way, if cross elasticity is zero or almost zero, there is monopoly or zero competition in the market.
Price of one product can directly affect the price of another if they are related to each other. That is why large firms which produce more than one product must evaluate cross price elasticity between each of their products in order to efficiently price them.
For an example: Le t us suppose Oral-D is company which produces toothpaste as well as toothbrush (complementary goods). The rise in price of any one of these products causes fall in demand of that product as well as the other. Therefore, the company must be careful while deciding whether or not to increase the price of any product.
Determination of boundaries between industries
Concept of cross elasticity helps producers determining boundaries of their industries.
Complementary goods belong to different industries. Thus, the negative value of cross elasticity of demand indicates that the products are from different industries.
In the same way, substitute goods belong to same industry. Thus, positive value of cross elasticity of demand indicates that the products are from same industry.