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Essay question for Economics getting top marks...

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IB DIPLOMA ECONOMICS: 1.6 CROSS-PRICE ELASTICITY OF DEMAND Cr osspr i ceel ast i ci t yofdemand( XED)measur est he r espons i v enessoft hequant i t ydemandedf oragoodt o achangei nt hepr i c eofanot hergood,cet er i spar i bus.

CROSS-PRICE ELASTICITY OF DEMAND – TOPICS:  Ca l cul at i ngc r osspr i c eel ast i c i t yofdemand( XED)  I nt er pr et i ngXEDv al ues  A ppl i cat i onsofXED

CROSS-PRICE ELASTICITY OF DEMAND Learning objectives  Outline the concept of cross-price elasticity of demand, understand responsiveness of demand for one good (and hence a shifting dema the price of another good.  Calculate XED using the percentage change formula.  Show that substitute goods have a positive value of XED and com negative value of XED.  Explain that the (absolute) value of XED depends on the closeness between two goods.  Examine the implications of XED for businesses if prices of substi change.

CROSS-PRICE ELASTICITY OF DEMAND Cr osspr i ceel ast i ci t yofdemand( XED)measur est he r espons i v enessoft hequant i t ydemandedf oragoodt o achangei nt hepr i c eofanot hergood,cet er i spar i bus. I neconomi cs,t her ear et wot ypesofgoodswher et he demandwi l l changei nr esponset ot hechangei npr i ce ofanot hergood–subs t i t ut egoodsandcompl ement goods.Bycal c ul at i ngXED,wecanmeasur et he r espons i v enessanddet er mi nei ft hegoodsar e subst i t ut es ,c ompl i ment s,ornotr el at edt oeachot her . Wecanal s odet er mi net hes t r engt hoft her el at i onshi p; i . e. ,whet hert hegoodsar est r ongcompl ement ss uc has bur ger sandchi ps ,st r ongs ubst i t ut essuchasPepsi ® andCok e®.

COMPLEMENTARY GOODS Compl ementgood:Thi smeansagood' sdemandi s i nc r easedwhent hepr i c eofanot hergoodi sdecr eased. Conv er sel y ,t hedemandf oragoodi sdec r easedwhen t hepr i ceofanot hergoodi si ncr eas ed.I fgoodsAandB ar ecompl ement s ,ani nc r easei nt hepr i c eofAwi l l r esul t i nal ef t war dmov emental ongt hedemandcur v eofA

andcaus et hedemandc ur v ef orBt os hi f ti n;l essof eac hgoodwi l l bedemanded.Adecr easei npr i ceofA wi l l r esul ti nar i ght war dmov emental ongt hedemand cur v eofAandcaus et hedemandc ur v eBt os hi f t out war d;mor eofeachgoodwi l l bedemanded.Basi cal l y t hi smeanst hats i nc et hedemandofonegoodi sl i nk ed t ot hedemandofanot hergood,i fahi gherquant i t yi s demandedofonegood,ahi gherquant i t ywi l l al sobe demandedoft heot her ,andi fal owerquant i t yi s demandedofonegood,al owerquant i t ywi l l be demandedoft heot her . Thepr i cesofc ompl ement ar ygoodsar er el at edi nt he sameway :i ft hepr i c eofonegoodr i ses ,sowi l l t hepr i ce oft heot her ,andv i cev er sa.Wi t hsubst i t ut egoods, howev er ,t hepr i ceandquant i t ydemandedofonegood i sr el at edi nv er sel yt ot hepr i ceandquant i t ydemanded ofasubs t i t ut egood,meani ngt hati ft he pr i ceorquant i t ydemandedofonegoodr i ses ,t hepr i c e orquant i t ydemandedofi t ssubst i t ut ewi l l f al l . Whent wogoodsar ecompl ement s ,t heyexper i encej oi nt demand.Forex ampl e,t hedemandf orr az orbl adesmay dependupont henumberofr az or si nuse;t hi si swhy r az or shav es omet i mesbeensol dasl ossl eader s,t o i nc r easedemandf ort heas soci at edbl ades.

Abov e,pr i ceandquant i t ydemandedi nf or mat i oni nf or ms ust hatgoodAandBar est r ongcompl ement s.An i nc r easei nt hepr i ceofgoodAl eadst oal ar gedec r ease i ndemand( andquant i t ydemanded)f orgoodB.

Abov e,pr i ceandquant i t ydemandedi nf or mat i oni nf or ms ust hatgoodAandBar eweakcompl ement s.An i nc r easei nt hepr i ceofgoodAl eadst oas mal l decr eas e i ndemand( andquant i t ydemanded)f orgoodB.

SUBSTITUTE GOODS Subst i t ut egood:s ubst i t ut egoodsorsubs t i t ut esar e pr oduct st hataconsumerper cei v esassi mi l aror compar abl e,sot hathavi ngmor eofonepr oductmak es t hem desi r el es soft heot herpr oduct .For mal l y ,AandB ar esubst i t ut esi f ,whent hepr i c eofAr i s es ,t hedemand f orBr i ses. Pot at oesf r om di ffer entf ar msar eanex ampl e:i ft he pr i ceofonef ar m' spot at oesgoesup,t heni tcanbe

pr esumedt hatf ewerpeopl ewi l l buypot at oesf r om t hat f ar m andsour cet hem f r om anot herf ar mi nst ead. Ther ear edi ffer entdegr eesofs ubst i t ut abi l i t y .For exampl e,acarandabi cy cl emays ubst i t ut et osome ext ent :i ft hepr i ceofpet r ol i ncr easescons i der abl y ,one mayexpec tt hatsomepeopl ewi l l swi t cht obi cy cl es. Essential statement: If two goods are substitutes, an increase in the price of one good causes a decrease in the quantity demanded for it – a movement up and along its demand curve. At the same time, demand for the other good will increase causing the demand curve to shift right. The opposite will occur when the price of one of the substitute goods decreases.

Abov e,pr i ceandquant i t ydemandedi nf or mat i oni nf or ms ust hatgoodAandBar est r ongsubst i t ut es.An i nc r easei nt hepr i ceofgoodAl eadst oal ar gei ncr eas e i ndemand( andquant i t ydemanded)f orgoodB.

Abov e,pr i ceandquant i t ydemandedi nf or mat i oni nf or ms ust hatgoodAandBar eweaksubst i t ut es.An i nc r easei nt hepr i ceofgoodAl eadst oal ar gei ncr eas e i ndemand( andquant i t ydemanded)f orgoodB.

CALCULATING XED Exampl ecal cul at i on: I ti sobs er v edt hatwhent hepr i c eofat r ai nt i c k et r i dest ak eni nc r eas esby7%. XED=7÷10=0. 7

Unl i k epr i c eel as t i c i t yofdemand,pos i t i v eandne c al c ul at i ngXED.Wedonott ak et heabsol ut ev a per cent agechangeswi l lpr ov i dev al uabl ei ns i gh whet hert heyar es ubs t i t ut eorcompl ementgood I nt hecaseofs ubs t i t ut est het wogoodsar epos pr i ceofAwi l ll eadt oani ncr ease( +)i nQDf orB

pr i ceofAwi l ll eadt oadecr ease( –)i nQDf orB → +/ +=posi t i ve → –/ –=posi t i ve I fpr i ceandquant i t ydemandedi nf or mat i oni sgi v c onv er tt hi si nf or mat Ther ei sanot herf or m t hati nt heI BEconom was t ement alener gymemor i s i ngacompl exf or m Exampl ecal cul at i on: Thepr i c eofgoodAdec r eas esf r om $10t o$9,a f r om 1000uni t st o1300. → % changei npr i ce=[ ( $10-$9)÷$10]x100 → % changei nQd=[ ( 1000-1300)÷1000]x1 → XED=+30÷–10=–3

CALCULATING XED FROM DEM

Example calculation: A decrease in the supply for Good A, causes a decrease in demand for good B., as shown below.

→ % cha → % cha → XED =

INTERPRETING CROSS-PRICE ELASTIC

OF DEMAND Focusont heabsol ut ev al uet ogauget he st r engt hoft her el at i onshi p;e. g. ,XED=– →| 0. 65|

XED=posi t i vev al ue=subst i t ut esgoo Thehi ghert hev al ue,t hehi ghert hedegr subst i t ut abi l i t y . Forex ampl e,t wogoodswi t hXED=0. 8 st r ongersubst i t ut est hant wogoodswi t h =0. 3,andapr i cechangeofast r ong subst i t ut ewi l lr es ul ti napr opor t i onal l yl a changei nt hequant i t ydemandedf ort he good.

HOW CROSS-PRICE ELASTICITY OF DEMAND AFFECTS FIRMS

SUBSTITUTES SOLD BY A SINGLE FIRM I fafir m pr oducesal i neofpr oduct st hatar esi mi l ari t essent i al t hatt hefir m consi der scr oss pr i ceel ast i ci t yof demandwhent heymak epr i ci ngdeci si ons .For exampl e,Gener alMot or s,aUSc armanuf act ur i ng company ,pr oducesmanydi ffer entmodel sofmot or v ehi c l esunderavar i et yofbr ands.I fi tdec i dest o di s countt heChevr ol etVol t ,f orex ampl e,t heni tneedst o knowhowsal esofi t sChevr ol etBol t ,Cadi l l acCT6, Bui ck/ OpalCas cada,et c . ,wi l l beaffect ed. I ti snotenought oknowt hatt hedi ffer entpr oduct swi t hi n al i neofgoodsorser v i c esar es ubst i t ut esf oreachot her , whi chi nt hecaseofGener alMot or sv ehi c l est he di ffer entpr oduct sundoubt edl yar e.I ti sal s onecessar y t oknowt hest r engt hoft hes ubst i t ut abi l i t y . Di ffer entpr oduct swi t hi nal i neofpr oduct swi l l of t en hav edi ffer entpr ofitmar gi nsass oc i at edwi t heach.Thus, i fdi sc ount i ngt hel owmar gi nChevr ol etBol tr es ul t si na st eepdecl i nei nhi ghmar gi nGM car ss uc hast he Cadi l l acCT6,t henGM c oul dr eas onabl yexpecti t st ot al r ev enuesand/ orpr ofit abi l i t yt odec r ease.Conv er sel y ,i f GM di s count st heChevr ol etBol tandknowsi twi l l not affec ti t shi ghpr ofitmar gi ncar s( SUVsandpr emi um br andv ehi cl es) ,t heni ti smuchmor el i k el yt oi ncr ease t ot al r ev enuesandov er al lpr ofit abi l i t y .

Ess ent i al l y ,i nc r easi ngsal esf r om onepr oductby dec r eas i ngs al esi nanot herpr oducti ssomet hi ngfir ms woul dpr obabl yav oi di ft heycanhel pi t .

SUBSTITUTES SOLD BY RIVAL FIRMS Fi r mswi l l bek eenl yi nt er est edi nt hec r os spr i ce el ast i ci t yofdemandbet weent hei rownpr oduct sand t hatofr i v al fir ms.Forex ampl e,Gener alMot or s,an Amer i cancarmanuf act ur er ,woul di nt er es t edi nknowi ng t heXEDbet weeni t sbr andsandmodel sandt hoseof r i v al ssuchasToy ot aandNi ss an,Japanesecar manuf act ur er s. I fGener al Mot or shasst r ongpr oductdi ffer ent i at i onand t hus,r el at i v el yl owsubs t i t ut abi l i t ybet weeni t spr oduct s andi t sr i v al s,t heni tmayber el at i v el yunaffect edby pr i cedecr easesi nr i v alpr oduct s .Howev er ,i ft heXEDi s hi gh,t henGener alMot or swoul dneedt oqui ckl yr evi ew i t spr i ceswhenacompet i t orsuchasToy ot al ower si t s pr i cesi nor dert opr ot ectt hefir m’ sshar eoft hemar ket .

SUBSTITUTES AND MERGERS AND

ACQUISITIONS BETWEEN FIRMS Amer geri sadeal t ouni t et woexi st i ngc ompani esi nt o onenewcompany .Anacqui si t i oni sacor por at eact i on i nwhi chacompanybuysmos t ,i fnotal l ,oft het ar get company ' sowner s hi ps t ak esi nor dert oassumecont r ol oft het ar getfir m. Fi r mst hathav er i v alpr oduct st hatar ec l os esubs t i t ut es maybei nt er est edi nacqui r i ngar i v al fir m ormer gi ngt he t wofir msi nt oonefir m.Thi sr educest hecompet i t i onand al l owst hefir mt oi nc r easepr i c est oi ncr easet ot al r ev enuesandpr ofit s .Anexampl ewoul dbeFi at ’ s( an I t al i ancarmanuf act ur er )acqui si t i onofChr y s l er( aUS carmanuf act ur er ) .

COMPLEMENT GOODS I ti sus ef ul f orfir mst oknowt hecr oss pr i c eel ast i c i t yof demandr egar di ngcompl ementgoodswhenmaki ng pr i ci ngdec i si ons .Goodst hathav eweakXEDbec ause t heyar enotst r ongl yr el at edwi l l hav el i t t l ei nt er est . Howev er ,goodsandser v i cest hathav east r ong negat i v eXEDr el at i ons hi pmeanst hatdec r easi ngt he pr i ceofonegoodorser v i cewi l l st r ongl yboostsal esof t heot hergoodorser v i c e.

Somefir mswi l l pr oducear angeofgoodsandser v i ces t hatar est r ongcompl ement st oeac hot her( e. g. ,t he VI BEEducat i onI BEconomi cst eacher ’ smember shi ps andi t ss t udentcl assr oom member shi ps ) .Pr obabl yt he bes texampl ear er az or sandr az orbl ades.Gi l l et t eand Schi ckknowt hati ft heycans el l mor eoft hei rr az or st o consumer s ,t hent hosesamec onsumer swi l l bev er y l i k el yt opur chaset heas soci at edr az orbl ades.Bot hof t hesecompani essel l t hei rr az or satal oss( al oss l eader )t oi ncr eas et hedemandf ort hei rhi ghpr i c ed r az orbl ades. Somefir mswi t hst r ongl ycompl ement ar ygoodswi l l of t encooper at ewi t heachot her–bank sandi ns ur anc e compani esar ecl assi cexampl es.Forex ampl e,abank sel l i ngnewcarl oanswi l l i nv ar i abl yhav eadeal wi t han i ns ur ancec ompanyt oal s osel l cari nsur ancet ot he samec us t omer s....