Question

QUESTION TWO [25]

2.1 As the manager of a company, explain how you would determine whether the good or service being produced by your company is a complement good or substitute good according to cross price elasticity of demand. Motivate your answer with the aid of examples. (15)

2.2 Explain your pricing decision as a manager if the good or service being produced by your company displays the following elasticity coefficients according to price elasticity of demand: 2.2.1 Price elasticity is less than one (5)

2.2.2 Price elasticity is greater than one

Answer 1

Solution 2.1: As the manager of the company, according to the value of cross-price elasticity of demand determination of whether the good or service is complement or substitute can be done by in the way explained below.

Cross-price elasticity of demand is defined as the change in the quantity of a good or service demanded when there is a change in price for another good or service. The cross-price elasticity of demand can be calculated by:

(Percent change in demand of quantity)/(Percent change in price of other good or service)

Substitute good is the good that can be used as a replacement when price of other good increases. For example if price of coffee increases people will use tea as an alternative.

The substitute goods have a positive cross-price elasticity of demand as the demand of the alternative good increases when the price of the other good increases.

Complement goods are those which are used together by the consumer. Let us take an example when we use printer for printing our documents we also need the cartridge of the printer for the ink. Therefore cartridge of the printer and printer are complement goods.

The complement goods have a negative cross-price elasticity of demand since when the price of one good increases the demand of the other good gets reduced.

As a manager the good or service can be determined as substitute or complement by identifying whether it has positive or negative value of cross-price elasticity of demand respectively.

Solution 2.2.1: As a manager it is concluded that, when cross price elasticity of demand is between 0 and 1 it is positive and the goods are substitute goods, at cross price elasticity = 0, the goods are weak substitutes to each other.

However if the cross-price elasticity of demand is negative then the goods are complement to each other which means that when price of one good gets increased the demanded quantity of other good gets decreased the cross price elasticity less than 0 indicates that the cross-price elasticity of demand is inelastic. Complement goods can be priced according to the cross-price elasticity of demand in a way such that one good can be sold at a loss so that the quantity demanded for the other complementary good gets increased

Solution 2.2.2: When the cross price elasticity of goods is more than 1, it indicates that they are strong substitute goods to each other and the cross price elasticity of demand is elastic in nature because when price of one good or service changes the demand of other substitute good or service gets increased. The increase in price of goods having substitutes can be analyzed for the purpose of determining the required demand level and the related price of the good. Those goods or services that have no substitutes are sold at high prices because cross-price elasticity is not there.