(HL Economics series) Top 3 misconceptions in Topic 5: XED

Welcome back to our lost and found series where we cover the misconceptions that we as students faced and help them get back on the right track!

This week, we will be looking at some difficulties and misconceptions within XED.

XED, is essentially a measure of how demand of a good changes when the price of a complement or substitute changes.

Basically, if the price of Coca Cola changes, how does that affect the demand for Pepsi?

OR

If the price of oil changes, how does that affect the demand for cars which use oil?

Misconception 1: Does positive or negative mean a good is a substitute or a complement?

I used to struggle with figuring this out but I found a system which I have found to be really useful.

So let’s say you’re trying to figure out if a positive XED means the goods are substitutes or complements:

I would start of by assuming that good Y, one of the goods, faces an increase in price. When a good faces an increase in price, the quantity demanded for that good, Y, will fall. If the goods are substitutes, consumers will switch from Y to X and thus an increase in demand for X.

If you recall, the formula for XED is as follows:

(Percentage change in Qd of X)/(Percentage change in price of Y)

Since Qd of X has increased, it will be a positive percentage change. Since price of Y has decreased, it will be a negative percentage change. A positive value divided by a negative value will result in a negative value. Therefore, XED in this case is a negative value, meaning that a negative XED indicates the goods are substitutes.

Yes, this is a really long process to derive this and as much as possible, you should try to commit how XED varies to memory. But, should you forget during the examination, this will prove useful.

Misconception 2: How XED is useful for businesses producing substitute products:

Once we establish that the goods are substitutes, we need to find the degree to which they are substitutes. This is because if the absolute value of XED is low, then a percentage change in price of good Y will lead to a small percentage drop in demand for good X. Thus, the sales of X will not be seriously affected. Conversely, if the absolute value of XED is high, then the sales of X will be seriously affected as a small change in price of Y will lead to a proportionately larger change in the demand for X.

The firm then would need to evaluate if it would be willing to increase the sales of Y by decreasing the price of Y. This is because it will need to consider the effect on sales of X as well. If the XED has a low positive absolute value, it might proceed to lower the price of Y as X would not be seriously affected. However, if the firm does not intend to negatively affect the sales of X too much, lowering the price of Y might not be a good idea.