Positive Cross Elasticity of Demand: The World of Substitutes
The Foundation: What is Cross Elasticity of Demand?
Imagine you are at a snack bar. You usually buy a chocolate bar for $1. Today, you see its price has jumped to $1.50. Right next to it is a pack of cookies that still costs $1. What do you do? Many people would choose the cookies instead. This simple decision illustrates a powerful economic idea: the demand for one product (cookies) can change because of a price change in another product (the chocolate bar). Economists measure this relationship using a number called the Cross Elasticity of Demand (XED).
Formula for Cross Elasticity of Demand (XED):
The formula calculates how sensitive the quantity demanded of Good B is to a change in the price of Good A.
Let's break down the formula:
- Good A: This is the product whose price changes first.
- Good B: This is the product whose quantity demanded we are observing for changes.
- The result is a number (positive, negative, or zero) that gives us the relationship type.
Interpreting the XED Number: The Sign Tells the Story
The most important part of the XED result is its sign—positive (+) or negative (-). The sign reveals the fundamental nature of the relationship between the two goods.
| XED Value | Interpretation | Type of Goods | Simple Example |
|---|---|---|---|
| Positive (XED > 0) | Price of A goes up, demand for B goes up. They move in the same direction. | Substitute Goods | Butter and Margarine |
| Negative (XED < 0) | Price of A goes up, demand for B goes down. They move in opposite directions. | Complementary Goods2 | Hot dogs and Hot dog buns |
| Zero or Near Zero (XED ≈ 0) | Price change in A has no effect on demand for B. | Unrelated Goods | Books and Car Tires |
This article focuses on the first row: Positive XED. When XED is positive, the two goods are classified as substitutes. They compete for your wallet.
Substitute Goods: From Perfect to Imperfect
Not all substitutes are created equal. Economists often categorize them based on how close the competition is, which is reflected in the magnitude of the positive XED value.
Close (or Strong) Substitutes: These are products that serve almost the exact same purpose for consumers. If the price of one rises, consumers will quickly and easily switch to the other. The XED for close substitutes is a large positive number.
- Example: Different brands of bottled water, like Aquafina and Dasani. If Aquafina's price increases by 10%, many people will simply buy Dasani instead, leading to a significant increase in Dasani's demand.
Weak (or Distant) Substitutes: These goods fulfill a similar need but are not identical. Consumers might switch, but only if the price change is large, or they might not see them as perfect replacements. The XED for weak substitutes is a small positive number.
- Example: Butter and olive oil. Both can be used for cooking, but they have different tastes and uses. If butter becomes very expensive, some people might use olive oil for frying, but they won't use it on their toast. The switch is partial and limited.
Numerical Example: Calculating Positive XED
Let's say the price of Brand A cola (Good A) increases from $2.00 to $2.20 per bottle. This is a 10% price increase. As a result, the quantity demanded for Brand B cola (Good B) increases from 1,000 bottles per week to 1,200 bottles per week. This is a 20% increase in quantity demanded.
The XED is +2.0, a positive number, confirming they are substitutes. The value of 2.0 means that for every 1% increase in the price of Brand A, the demand for Brand B increases by 2%.
Real-World Market Dynamics and Competition
Understanding positive XED is not just an academic exercise; it's vital for real-world business strategy and market analysis.
For Businesses: Companies constantly monitor the prices of their competitors' substitute products. If a competitor raises its price, a company might decide to keep its price low to attract all the new customers looking for an alternative. Conversely, if a major competitor lowers its price, a company might feel pressured to do the same to prevent losing customers.
For Consumers: Positive XED is the engine of choice and competition. It means you have options. If one product becomes too expensive, you can exercise your power as a consumer and switch to a cheaper alternative. This competitive pressure helps keep prices in check across the market.
Market Definition: Antitrust regulators3 use the concept of positive XED to define relevant markets. If two products have a high positive XED, they are considered to be in the same competitive market. For example, if a company that makes video game consoles tries to buy a competitor, regulators will check the XED between their consoles and others to see if they are close substitutes and if the merger would reduce competition.
A Walk Through Everyday Substitute Scenarios
Let's apply the concept of positive XED to familiar situations to see how it works in daily life.
| Good A (Price Rises) | Good B (Demand Rises) | Consumer Logic | Estimated XED |
|---|---|---|---|
| Movie Theater Ticket | Streaming Service Subscription (Netflix, etc.) | "Going to the movies is getting too expensive. I'll just stay home and watch something online." | Medium Positive |
| Brand Name Cereal | Store Brand (Generic) Cereal | "This generic version looks the same and costs much less. I'll try it." | High Positive |
| Gasoline for Cars | Electric Vehicles (EVs) | "Gas prices are crazy. My next car will be electric to save on fuel." | Low Positive (Long-term) |
| Taxi Ride | Ride-Sharing App (Uber, Lyft) | "The taxi meter is running up too fast. Let me check the price on the app." | High Positive |
Important Questions
Q1: If two goods are substitutes, does a positive XED mean they are exactly the same?
No, not necessarily. A positive XED simply means they are alternatives in the eyes of consumers. They can be very different but serve a similar purpose. For example, a bicycle and a bus are both substitutes for getting to school, but they are not the same product. The strength of the substitution (the size of the XED number) tells us how similar consumers perceive them to be.
Q2: Can the XED between two goods change over time?
Yes, absolutely. Technology, consumer habits, and new products can alter relationships. For instance, smartphones and digital cameras were weak substitutes initially. As smartphone cameras improved dramatically, they became much stronger substitutes for point-and-shoot digital cameras, increasing the positive XED between them. Eventually, smartphones largely replaced that market.
Q3: How do businesses use knowledge of positive XED?
Businesses use it for pricing, marketing, and strategic planning. If a company knows its product has a high positive XED with a competitor's product (they are close substitutes), it will watch the competitor's prices closely. It might launch marketing campaigns like "Why pay more for Brand X when you can get the same quality with us?" to attract customers sensitive to the competitor's price increases.
Conclusion
The concept of a positive Cross Elasticity of Demand is a clear and powerful lens through which to view the competitive landscape of markets. It quantifies the simple, intuitive idea of substitution: when one option becomes less attractive (more expensive), people turn to alternatives. From the choice between cola brands to the long-term shift from gasoline cars to electric vehicles, positive XED shapes consumer behavior, business strategies, and even government policy. Understanding that a positive XED signifies substitute goods is a fundamental step in grasping how interconnected and dynamic our economy truly is.
Footnote
- Cross Elasticity of Demand (XED): A measure in economics that shows the responsiveness of the quantity demanded for one good (Good B) to a change in the price of another good (Good A).
- Complementary Goods: Goods that are typically used together. An increase in the price of one leads to a decrease in the demand for the other (negative XED). Examples include printers and ink cartridges, or computers and software.
- Antitrust Regulators: Government agencies responsible for enforcing laws that promote fair competition and prevent monopolies or business practices that could harm consumers. In the United States, the main agencies are the Federal Trade Commission (FTC) and the Department of Justice (DOJ).