2.3 SUBSTITUTE 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. Cross elasticity of demand is measured by the % change in demand of good B divided by the percentage change in price of good A.
Substitute
One relationship between goods is substitute goods. This is where individuals swap one good for another. The needs of the consumer will be fulfilled. An example would be Pepsi and Coke, The Sun Newspaper and The Mirror etc. Suppose the price of both newspapers was the same and the Sun chose to reduce their price. As the price falls, we see a movement along the demand curve and a higher quantity being demanded. For the Sun this was a change in price, but for the Mirror this price change was a change in the price of other good (p1…n). This means that now the price of the Mirror is relatively expensive in comparison to the Sun causing the demand curve to shift to the right and would increase the quantity demanded for The Mirror. If a good is now relatively cheaper compared to another similar good, it is likely that you would increase your consumption of the good that is now relatively cheaper and decrease your consumption of the good that is relatively more expensive. The extent of this reduction would depend on the responsiveness of consumers, which is the cross elasticity of demand.
One relationship between goods is substitute goods. This is where individuals swap one good for another. The needs of the consumer will be fulfilled. An example would be Pepsi and Coke, The Sun Newspaper and The Mirror etc. Suppose the price of both newspapers was the same and the Sun chose to reduce their price. As the price falls, we see a movement along the demand curve and a higher quantity being demanded. For the Sun this was a change in price, but for the Mirror this price change was a change in the price of other good (p1…n). This means that now the price of the Mirror is relatively expensive in comparison to the Sun causing the demand curve to shift to the right and would increase the quantity demanded for The Mirror. If a good is now relatively cheaper compared to another similar good, it is likely that you would increase your consumption of the good that is now relatively cheaper and decrease your consumption of the good that is relatively more expensive. The extent of this reduction would depend on the responsiveness of consumers, which is the cross elasticity of demand.
We can also work out the cross elasticity of demand for these two goods. We will use the example of The Sun and The Mirror. Suppose the Sun originally costs 50p and they decided to raise the price to 55p. This is a rise of 10% because 55-50 equals 5p and 5p divided by 50p, multiplied by 100 gives you a 10% price increase. This is associated with a rise in the number of Mirrors sold from 100k to 120k. This is a rise of 20%. To work out cross elasticity we divide the percentage change in quantity demanded of good B (the Mirror, 20%) by the percentage change in the price of good A (the Sun, 10%). This gives us a value of 2. A positive value for cross elasticity of demand indicates that these two goods are substitutes.
Close and Weak Substitutes
We can have close and weak substitutes. Close substitutes are more responsive to a change in price; a small increase in price would result in a larger increase in demand for the other good, petrol could be an example. Because petrol is a homogenous good, consumers do not generally care which company they buy the petrol from. If BP chose to raise their price of petrol, then car owners would buy petrol somewhere else such as Shell, Sainsbury’s, and Texaco etc. Weak substitutes are less responsive; a larger increase in the price of x results in only a small increase in the demand for y. An example could be newspapers because there is brand loyalty to a certain extent.
We can plot the change in price of one good (A) against the change in demand for the substitute of that good (B). As these goods are substitutes we have a positive value for the cross elasticity of demand. This is why the graph is upwards sloping. The gradient of the slope tells us how responsive the quantity demanded of good B is when a change in price A occurs. On the diagram on the left we have close substitutes. These would have a high value for cross elasticity of demand. A small increase in the price of good A is met with a large increase in the quantity demanded of good B. Alternatively, we could have weak substitutes. With weak substitutes the same increase in price (for the last example) results in a lower increase in quantity demanded of good B.
We can have close and weak substitutes. Close substitutes are more responsive to a change in price; a small increase in price would result in a larger increase in demand for the other good, petrol could be an example. Because petrol is a homogenous good, consumers do not generally care which company they buy the petrol from. If BP chose to raise their price of petrol, then car owners would buy petrol somewhere else such as Shell, Sainsbury’s, and Texaco etc. Weak substitutes are less responsive; a larger increase in the price of x results in only a small increase in the demand for y. An example could be newspapers because there is brand loyalty to a certain extent.
We can plot the change in price of one good (A) against the change in demand for the substitute of that good (B). As these goods are substitutes we have a positive value for the cross elasticity of demand. This is why the graph is upwards sloping. The gradient of the slope tells us how responsive the quantity demanded of good B is when a change in price A occurs. On the diagram on the left we have close substitutes. These would have a high value for cross elasticity of demand. A small increase in the price of good A is met with a large increase in the quantity demanded of good B. Alternatively, we could have weak substitutes. With weak substitutes the same increase in price (for the last example) results in a lower increase in quantity demanded of good B.