In this article we will discuss about the cross elasticity of demand, explained with the help of suitable diagram.

Cross elasticity provides a convenient basis for studying the relationship between two different commodities. Cross elasticity of demand is the degree to which the quantity demanded of one commodity responds to a change in the market price of another commodity.

The formula for measuring the coefficient of cross elasticity of demand is:

Cross elasticity may be positive or negative, depending on the relation­ship between the two commodities. If two commodities are substitutes, cross elasticity between them will be positive, i.e., a rise in the price of the first commodity will cause an increase in the demand for the other. For example, a 5% rise in the price of tea might result in a 6% increase in the demand for coffee, in which case cross elasticity is (+ 6/100)/ (+ 5/100) or, 1-2.

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The higher the cross elasticity, the greater is the case of substitution. If the articles are perfect substitutes (and thus essentially the same thing to the users), their cross elasticity is infinite. If the commodities are complements, cross elasticity will be negative, i.e., a rise in the price of one commodity will cause a fall in the demand for the other.

For example, if the price of milk rises, less sugar will be bought and there will be a fall in the demand for coffee also. If a 10% rise in the price of milk results in a fall of 8% in the demand for coffee, cross elasticity is (- 8/100) / (+ 10/100) or, – 0.8.

Fig.18 shows that cross elasticity of demand for substitute goods is positive and for complementary goods it is negative. Cross elasticity of demand in case of tea and coffee will be positive, because a fall in the price of tea would lead consumers to substitute it for coffee.

The relationship would be as in Fig. 18. As the price of tea falls, the demand for coffee falls, too. In contrast, cross elasticity of demand for coffee with respect to the price of sugar is likely to be negative. The reason is simple — a fall in the price of sugar would lead to an increase in the demand for coffee, as shown in Fig.18. The reason is simple: each cup of coffee will now cost less than before.