Cross price elasticity of demand is the percentage change in the demand for one product when the price of a different product changes. The formula is:
Percentage change in demand of one product ÷ Percentage change in price of a different product
If there is no relationship between the two products, then this ratio will be zero. However, if a product is a valid substitute for the product whose price has changed, there will be a positive ratio - that is, a price increase in one product will yield an increase in demand for another product. Conversely, if two products are typically purchased together (known as complementary products), then a price change will result in a negative ratio - that is, a price increase in one product will yield a decrease in demand for the other product.
Here are examples of different ratio results for the cross price elasticity of demand:
Positive ratio = When the admission price at a movie theater increases, the demand for downloaded movies increases, because downloaded movies are a substitute for a movie theater.
Negative ratio = When the admission price at a movie theater increases, the demand at the nearby parking garage also declines, because fewer people are parking there to go to the movie theater. These are complementary products.
Zero ratio = When the admission price at a movie theater increases, the demand at a nearby furniture store is unchanged, because the two are unrelated.
When there is a strong complementary relationship between two products, then a price increase for one product will have a strong negative impact on the other product. Similarly, if there are two close substitutes, a price increase for one product will have a strong positive impact on the other product.
A company can use the concept of cross price elasticity of demand in its pricing strategies. For example, the food served in a movie theater has a strong complementary relationship with the number of theater tickets sold, so it may make sense to drop ticket prices in order to attract more movie viewers, which in turn generates more food sales. Thus, the net effect of lowering ticket prices may be more total profit for the theater owner.
A business can also use heavy branding of its product line to mitigate the substitution effect. Thus, by spending money on advertising, a business can make customers want to buy its products so much that a price increase will not send them out to buy substitute products (at least not within a certain price range).