2.4. COMPLEMENTARY GOODS
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A change in the price of other goods depends on the relationship between the goods. Cross elasticity of demand measures the responsiveness of demand for one good following a change in the price of another good. The cross elasticity of demand is measured by the % change in demand of good B divided by the percentage change in price of good A.
Complements
Another type of relationship between goods is compliments. Compliment goods provide higher utility when combined with another good or service, compared with being consumed on its own. An example would be bread and butter, burgers and burger rolls and wine and cheese. The cross elasticity of demand would be negative if the goods are complements because if the price of one of the goods increased the demand for the other good would decrease.
Suppose that the price of bread rose making it more expensive to consume bread. This causes a movement along the demand curve for bread and results in less bread being demanded. As less bread is demanded in the economy there is less demand for butter because there is less bread to spread it on. Butter and bread are complements and the increase in the price of bread results in an inward shift of the demand curve for butter.
Another type of relationship between goods is compliments. Compliment goods provide higher utility when combined with another good or service, compared with being consumed on its own. An example would be bread and butter, burgers and burger rolls and wine and cheese. The cross elasticity of demand would be negative if the goods are complements because if the price of one of the goods increased the demand for the other good would decrease.
Suppose that the price of bread rose making it more expensive to consume bread. This causes a movement along the demand curve for bread and results in less bread being demanded. As less bread is demanded in the economy there is less demand for butter because there is less bread to spread it on. Butter and bread are complements and the increase in the price of bread results in an inward shift of the demand curve for butter.
Suppose that this time the price of bread fell. This would have the opposite effect. More bread would be consumed in society and there would be an increase in the demand for butter. This is represented by an outwards shift.
We can have a numerical example of this. We will look at the effect of a price rise of wine on the quantity demanded of cheese. Suppose that wine increased in price by 20%. This results in the demand for cheese to fall from 50k to 35k, which is a decrease in demand of 30% (-30%). To work out cross elasticity demand we divided the % change in the quantity demanded of good A (-30%) and divide it by the % change in price of good B (20%). This gives us a value of -1.5. As we have observed the negative sign it means that these two goods are complements. As the price of one increases the consumption of the other one decreases.
We can have a numerical example of this. We will look at the effect of a price rise of wine on the quantity demanded of cheese. Suppose that wine increased in price by 20%. This results in the demand for cheese to fall from 50k to 35k, which is a decrease in demand of 30% (-30%). To work out cross elasticity demand we divided the % change in the quantity demanded of good A (-30%) and divide it by the % change in price of good B (20%). This gives us a value of -1.5. As we have observed the negative sign it means that these two goods are complements. As the price of one increases the consumption of the other one decreases.
Close and Weak Complements
Like substitutes we can have close and weak compliments. A close complement will experience a larger fall in demand for y if the price of x falls. A weak substitute will experience a small rise in demand for good B with respect to a larger fall in price of good A. The diagrams below map out weak and close complements. Here the slopes are negative because the goods are complements.
Like substitutes we can have close and weak compliments. A close complement will experience a larger fall in demand for y if the price of x falls. A weak substitute will experience a small rise in demand for good B with respect to a larger fall in price of good A. The diagrams below map out weak and close complements. Here the slopes are negative because the goods are complements.
Unrelated Products
We can also have unrelated products. A change in the price of carrots will have no effect on the demand for hockey sticks. Therefore the coefficient for the cross price elasticity of demand will be zero.
We can also have unrelated products. A change in the price of carrots will have no effect on the demand for hockey sticks. Therefore the coefficient for the cross price elasticity of demand will be zero.
Why Does a Firm Want to Know their CED?
Knowing the cross elasticity of demand enables the firm to map out its market, which allows the firm to see how many rivals it has and how close the goods they produce are to their goods (this would be important for substitute goods). Also, the firm can see how many complement goods it has and monitor the market for complement goods to see how changes in that market will affect change in demand for your good. By knowing this information about other products, it allows the firm to plan a strategy to reduce their exposure to risks of changes in prices.
Knowing the cross elasticity of demand enables the firm to map out its market, which allows the firm to see how many rivals it has and how close the goods they produce are to their goods (this would be important for substitute goods). Also, the firm can see how many complement goods it has and monitor the market for complement goods to see how changes in that market will affect change in demand for your good. By knowing this information about other products, it allows the firm to plan a strategy to reduce their exposure to risks of changes in prices.