How is cross-price elasticity of demand used to determine whether two goods are substitutes or complements?
What will be an ideal response?
If the cross-price elasticity of demand for two goods is negative, then the two goods are complements. Two goods are considered substitutes if the cross-price elasticity of demand for the two goods is positive. Consider the following examples. Coffee and tea are substitutes. If the price of tea rises, I will buy more coffee and therefore, the cross price elasticity for tea and coffee is positive (the price of tea and the quantity of coffee always move in the same direction). Peanut butter and jelly are complements. If the price of peanut butter rises, I will eat fewer peanut butter and jelly sandwiches and therefore buy less jelly. This implies that the cross price elasticity for peanut butter and jelly is negative (the price of peanut butter and the quantity of jelly always move in opposite directions).
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