Uses or Importance of Cross Elasticity of Demand

Uses or Importance of Cross Elasticity of Demand

The concept of cross elasticity is very useful to producers & businessmen to make a pricing decision. The major importance of cross elasticity of demand is given as follows: 

1. Classification of goods: Goods are classified into substitute & complementary. If the cross elasticity of demand between any two goods is positive, the goods may be considered as substitutes for each other. If the cross elasticity is greater, the goods are closer substitutes. If it is infinite, they are the perfect substitute. If the cross elasticity of demand for any two related goods is negative, the two goods may be considered complementary to each other. If the negative cross elasticity of demand is high, the degree of complementarily is also high.

2. Classification of the market: Market structure has been classified by Prof. Bain on the basis of cross elasticity of demand. If the cross elasticity of demand is infinite, the market is perfectly competitive. If the cross elasticity is zero or almost zero, the market structure is a monopoly. If the cross elasticity is high there is an imperfect market.

3. Pricing policy: Large firms produce different related goods. For example, Nepal Liver Limited produces various brands of toothpaste & toothbrush. They are complementary goods. Similarly, Nepal Dairy Limited produces ice cream of different flavors. They are substitutes. Cross elasticity of demand helps firms to decide whether to increase the price of related products or not.

4. Determination of boundaries between industries: The concept of cross elasticity of demand is useful in order to decide which product should include in which industry. If related goods having negative cross elasticity (complementary goods), they belong to different industries. If the related goods having positive cross elasticity (substitute goods), they belong to one industry.