How does the price of complementary goods affect the demand of the commodity in question?

Demand elasticity measures how sensitive demand for a good or service is to changes in other variables. There are, in fact, many factors that are important in determining the demand elasticity for a good or service, such as the price level, the type of good or service, the availability of a substitute, and levels of consumer incomes.

Key Takeaways

• Many factors determine the demand elasticity for a product, including price levels, the type of product or service, income levels, and the availability of any potential substitutes.
• High-priced products often are highly elastic because, if prices fall, consumers are likely to buy at a lower price.
• Compared to essential goods, luxury items are highly elastic.
• Goods with many alternatives or competitors are elastic because, as the price of the good rises, consumers shift purchases to substitute items.
• Incomes and elasticity are related—as consumer incomes increase, demand for products increases as well.

Price Levels

The price level of an item affects the demand for a good or service, and the price elasticity of demand can be used to measure the sensitivity of a change in the quantity demanded of a good or service relative to a change in price. The price elasticity of demand is calculated by dividing the percent change in the quantity demanded of a good or service by its percent change in its price level.

For example, luxury goods have a high price elasticity of demand because they are sensitive to price changes. Suppose the prices of LED televisions decrease in price by 50%. The demand increases because they are more affordable to those who were unable to purchase them before.

The type of good or service affects the elasticity of demand as well. A good or service may be a luxury item, a necessity, or a comfort to a consumer. When a good or service is a luxury or a comfort good, the demand is highly price-elastic when compared to a necessary good. Conversely, the demand for an essential good, such as food, is generally price-inelastic because consumers still buy food even if the price changes.

Incomes and Alternatives

The availability of alternatives or substitute goods can affect demand elasticity. Hence, the demand for goods or services with many substitutes is highly price elastic; a small increase in the price levels of goods causes consumers to buy its substitutes. For example, the demand for soda is highly price-elastic because of a large number of substitutes. If the price of one soda rises, consumers can opt to buy the cheaper substitute.

When close substitutes are available, the quantity demanded is highly sensitive to changes in the price level and vice versa. The demand elasticity of goods with close substitutes is measured by dividing the percent change of the quantity demanded of one product by the percent change in the price of a substitute product. This formula is also known as the cross elasticity of demand.

Lastly, the level of consumer income plays a role in the demand elasticity of goods and services. The income elasticity of demand is used to measure the sensitivity of a change in the quantity demanded relative to a change in consumers' incomes. Different types of goods are affected by income levels. For example, inferior goods, such as generic products, have a negative income elasticity of demand because the quantity demanded for generic products tends to fall as consumers' incomes increase.

Complementary goods will have a negative cross elasticity of demand. If the price of one good increases, demand for both complementary goods will fall. The more closely linked the goods are, the higher will be the cross elasticity of demand.

If they are weak complementary goods then there will be a low cross elasticity of demand. For example, if the price of tea increases it will only have a marginal impact on reducing demand for tea and consumption of milk.

However, if the price of Android Phones increases, it will negatively affect sales and therefore reduce demand for Android Apps.

How firms make use of complementary goods

Increase related sales. Supermarkets will place related food items close to each other. For example, next to pasta – expensive pasta sauces. The firm hopes to increase overall sales by suggesting possible related complementary goods.

Gain loyal consumers to make related sales. Another strategy a firm can implement is to offer a base product at a low price, knowing that if consumers buy ‘base product’ they can increase sales of related (and profitable) add-on items. For example, the owners of PlayStation have an incentive to cut the price of the PlayStation itself. If they do, they know they will make increases sales of licensed games, and this increase in revenue will offset the fall in revenue from a lower price.

Reducing the price of games consoles, such as Playstation may enable the firm to make more profit on licensed games.

Many printers are sold quite cheaply because firms who manufacture printers hope to make the most profit on selling compatible ink.

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