Question

Include a calculation of the cross-price elasticity of the alternative energy source and oil. Assume the current price of oil is $50/gallon of crude oil. If the price increases to the profit-maximizing price, $57.50, the quantity demanded of the alternative energy source increases by 20%. Explain if these goods are complementary goods, substitute goods, or non-related goods. If there is a relationship, indicate whether the relationship is weak or strong. Justify your answer with an explanation based on the elasticity figure.

Answer 1

Cross price elasticity of demand is the degree of change in quantity demanded of one good due to a given change in the price of another good. The cross price elasticity between alternative energy source and oil is

Proportionate change in quantity demanded of alternative energy source

                                Proportionate change in price of oil

%∆change in quantity demanded of alternative energy source= Q2-Q1/Q1×100

Q2 is the new quantity and Q1 is the initial quantity.

%∆change in price of oil = P2-P1/P1×100.

Percentage change in quantity demanded of alternative energy source =20%

Percentage change in price of oil= $57.50-50/50×100= 15%

Cross price elasticity of demand = 20/15= 1.33

The cross price elasticity of demand may be positive, negative or zero depending on the nature of goods. The complementary goods have negative cross price elasticity of demand. The increase in price of one leads to the decrease in the demand for other. The substituted goods have positive cross price elasticity of demand. The increase in price of one of such goods increases the demand for another. Independent goods have zero cross price elasticity of demand.

The increase in price of oil increases the demand for alternative energy source. Thus oil and alternative energy source are substituted goods. If the products are weak substitute they have positive but low cross elasticity of demand. In case of close substitute the relationship between the two goods is stronger and the cross elasticity of demand will be greater than 1. Here oil and alternative energy sources are close substitute and their relation is strong since the cross elasticity of demand is greater than 1.