2 Explain why the sign positive or negative of the cross pri

2. Explain why the sign (positive or negative) of the cross price elasticity of demand is important.

Solution

Cross price elasticity of demand is calculated by considering percentage change in the quantity demanded of one good and dividing it by the percentage change in price of the other good. It measures the responsiveness in the quantity demanded of one good when the price for another good changes. In other words, it basically measures the impact of change in price of one good on the quantity demanded of other good. The negative sign in the cross price elasticity of demand denotes that the two goods are complements while a positive sign in the cross price elasticity of demand denotes that the two goods are substitutes.

In case of complementary goods, as the price for one good increases, an item closely associated with that item and necessary for its consumption decreases because the demand for the main good has also dropped. For example, lets consider two complementary goods: printer and ink cartridges. If the price of printer increases, the quantity demanded for ink cartridges drops as consumers will buy less printer and therefore need to purchase fewer ink cartridges. In this case there will be a negative sign in the numerator (quantity demanded of ink cartridges) and positive sign in the denominator (price of printer) which results in negative cross price elasticity of demand. In case of substitute goods, the demand for one good increases when the price for the substitute good increases. For example, lets consider two substitute goods: coffee and tea. If the price of coffee increases, the quantity demanded for tea (a substitute beverage) increases as consumers switch to a less expensive yet substitutable alternative. In this case, there will be a positive sign in both the numerator (quantity demanded of tea) and the denominator (price of coffee) which results in positive cross price elasticity of demand. With the help of these examples one can easily understand the importance of positive or negative sign in the cross price elasticity of demand. This sign basically depicts the relationship between the two goods.