Question

Two goods have a cross-price elasticity of demand of +1.2 (a) would you describe the goods as substitutes or complements? (b) If the price of one of the goods rises by 5 per cent, what will happen to the demand for the other good, holding other factors constant?
(5 Marks)

Answer 1

• Whenever the cross elasticity of demand is more than one such as in this case where it is +1.2, this denotes that the goods under consideration are substitute goods.

• Substitute goods are those kinds of goods that can be used in place of one another. The price of one good share a direct relationship with the demand for its substitute goods.
• Holding the other factors constant, when the price of one good rise by 5%, keeping the price of its substitute good constant, the demand for its substitute also rises. Whereas the demand for the good whose price had risen falls since it has become costlier.

Answer 2

If the cross-price elasticity of demand is +1.2, then it is positive. The answers are as follows:

a) Since the cross-price elasticity is positive, therefore the goods are substitutes.

• Cross-price elasticity is positive when the demand for a commodity rises with the increase in the price of the other good. It can only happen in the case of substitute commodities.

b) If the price of one commodity rises by 5 percent, the demand for the other good increases.

• If the price of the commodity is seen to rise, its demand falls.

• The demand for substitute goods increases because it can give the same satisfaction to the customers.