Preview
IB DP Economics — Unit 2: Microeconomics | SL | 2.5 Elasticities of Demand
📋 What You Will Learn
- Define cross-price elasticity of demand (XED) and state the formula
- Explain how the sign of XED identifies substitute and complementary goods
- Analyse the magnitude of XED and what it reveals about the closeness of the relationship between goods
- Apply XED to firm pricing decisions, market definition, and competitive strategy
- Evaluate the significance of XED for businesses and governments in real-world contexts
🔍 Guiding Question How does the relationship between goods — whether they compete with or complement each other — shape the pricing strategies of firms and the market power they hold?
🌍 Why This Matters In 2023, when Netflix raised its subscription price by 25% in the UK, Disney+ reported a measurable surge in new sign-ups. Meanwhile, when petrol prices spiked globally in 2022, sales of new cars — especially large SUVs — fell sharply. Both outcomes reflect cross-price elasticity of demand: the idea that the price of one good can powerfully shift the demand for another.
What Is Cross-Price Elasticity of Demand?
Demand for a good is not only affected by its own price. When the price of coffee rises, some consumers switch to tea. When the price of printers falls, more ink cartridges are sold. These relationships between goods are captured by cross-price elasticity of demand.
📖 Definition — Cross-Price Elasticity of Demand (XED) XED measures the responsiveness of the quantity demanded of one good (Good A) to a change in the price of another good (Good B), ceteris paribus.
XED Formula
\[ \text{XED} = \frac{\%\Delta Q_d^A}{\%\Delta P^B} \] Where: \( \%\Delta Q_d^A \) = percentage change in quantity demanded of Good A; \( \%\Delta P^B \) = percentage change in the price of Good B.
Unlike PED, the sign of XED is economically meaningful — it tells us whether the two goods are substitutes or complements. The magnitude tells us how closely related they are.
Interpreting the Sign and Magnitude of XED
Positive XED — Substitute Goods
When the price of Good B rises, consumers switch away from B and toward Good A — demand for A increases. The two goods are substitutes: they satisfy the same or similar needs and can replace each other in consumption.
- XED > 0: substitute goods — price of B rises → demand for A rises (same direction)
- Higher positive XED: closer substitutes — consumers switch more readily (e.g. Pepsi and Coca-Cola, XED ≈ +0.7 to +1.0)
- Lower positive XED: weaker substitutes — goods satisfy similar but not identical needs (e.g. tea and coffee)
- Examples: butter and margarine; Uber and Lyft; Netflix and Disney+; petrol and diesel
💡 Example — Substitutes If the price of Pepsi rises by 10% and the quantity demanded of Coca-Cola rises by 6%,