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Cross price elasticity

1) Consider a firm selling two products, A and B, that substitute for each other. Suppose that an entrant introduces a product that is identical to product A. What factors do you think will affect (a) whether a price war is initiated, and (b) who wins the price war?

2) The following table reports the distribution of profits (on a per-disc basis) for different steps in the vertical chain for music compact discs:

Artist: $ .60
Record company: $1.80
Retailer: $ .60

Use the five forces to explain this pattern. (Note: There are about half a dozen major record companies, including Warner, Sony, and Polygram. They are responsible for signing up artists, handling technical aspects of recording, securing distribution, and promoting the recordings.)

3) Consumers often identify brand names with quality. Do you think branded products usually are of higher quality than generic products and therefore justify their higher prices? If so, why don't all generic product makers invest to establish a brand identity, thereby enabling them to raise price?

Solution Preview

1) Consider a firm selling two products, A and B, that substitute for each other. Suppose that an entrant introduces a product that is identical to product A. What factors do you think will affect (a) whether a price war is initiated, and (b) who wins the price war?

Sometimes the price of one good will influence the demand for another good. We measure this by the cross-elasticity of demand:
If the cross elasticity is positive then the two goods are substitutes. If it is negative, then they are complements.
So if the two products that is the new product and the product A are identical then there is a strong cross elasticity between the product and the A and so a price war will commence between the two companies. In addition if the cross elasticity between A and B is a large positive number, that is there is a strong cross elasticity between the two products the price competition will also affect product B.

Cross price elasticity measures the responsiveness of demand for one product to a change in price of another. This allows predicting how much the demand curve for the first product will shift with a price change for the second product.
Cà¥D = % Change in Quantity Demanded of Good A / % Change in Price of Good B Substitutes: If good b is a substitute, the demand will rise for good a as the price for good b increases. Cross elasticity will be positive. The greater the number, the bigger the effect. Compliments: If good b is a compliment to good a, the demand will fall for good a as the price for good b increases. The cross elasticity will be negative.

Uses of Elasticity
Prices: (i) To determine pricing policy. If the demand is inelastic, firms are able to raise their prices to receive greater revenue, (ii) To estimate the impact of a price change, (iii) to plan the change in quantity and the firms cost, and lastly (iv), the government can use this for planning indirect taxes.
Cross Elasticity: (i) Firms can estimate the effect of a competitor's price cut on their demand and (ii) firms can estimate the effect of a change in price of a compliment (e.g computers and software). Income: (i) To determine what type of goods to produce and stock (e.g as GNP rises, firms may want to avoid giffen goods) and (ii) to help estimate potential changes in demand (as income grows overseas, new markets may emerge).Cross-price elasticity, often simply called just cross-elasticity, measures whether goods are substitutes or complements. It looks at the response of people in buying one product when the price of another product changes. The formula for cross-price elasticity is
Cross-Price Elasticity = (percentage change in amount of A bought) divided by (percentage change in price of B).
If goods are complements, cross-price elasticity will be negative. For example, if the price of gasoline rises, the sales of large cars will decline. The positive change in the denominator (bottom) is matched with a negative change in the numerator (top) of the equation. The result is therefore negative. If cross-price elasticity is positive, B is a substitute for A. For example, sales of Coke will fall if the price of Pepsi falls because some Coke drinkers will switch from Coke to Pepsi.
In this case the question clearly mentions that A and B are substitute products and so in the newly introduced product. Substitutes are Products that are "reasonably interchangeable" with each other in buyers' eyes. If two products are sufficiently "close" substitutes that changes in the price of one cause substantial changes in the volume of sales of the other, they are said to belong in the same Relevant Market. If, however, they are only "remote" substitutes, ie, if a change in the price of one has little or no effect on the other's sales volume, then they are in different markets. Any products whose demand varies directly with a change in the price of a similar product is also called substitute product.
Why substitute products matter?
Competitively priced substitutes can place ceiling on prices industry can charge for its product
Price ceiling can place lid on profits industry members can earn
Availability of substitutes invites customers to make quality & performance comparisons as well as price comparisons
The lower the switching costs, easier it is for customers to shift to substitute products

Substitutes Matter When Products Of Firms In Another Industry Enter The Market Picture
Eyeglasses Vs. Contact Lens
Sugar Vs. Artificial Sweeteners
Plastic Containers Vs. Glass Vs. Tin Vs. Aluminum
Aspirin Vs. Other Types Of Pain Relievers
References:
www.csuchico.edu
https://www.inderscience.com/search/index. php?mainAction=search&action=record&rec_id=4889
www.marketingpower.com/mg-dictionary-view3093.php - 50k
william-king.www.drexel.edu
www.tutor2u.net/economics/content/ topics/elasticity/cross_elasticity.htm
www.mtco.com/~mdobra/econ.htm - 6k

2) The following table reports the distribution of profits (on a per-disc basis) for different steps in the vertical chain for music compact discs:

Artist: $ .60
Record company: $1.80
Retailer: $ .60

Use the five forces to explain this pattern. (Note: There are about half a dozen major record companies, including Warner, Sony, and Polygram. They are responsible for signing up artists, handling technical aspects of recording, securing ...

Solution Summary

Use the five forces to explain this pattern.

$2.19