How can a business make use of cross elasticity of demand to maximize revenue and stay competitive?

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Cross elasticity of demand (also referred to as cross-price elasticity) measures the change in the quantity demanded of Good A in response to a change in the price of Good B. How these goods will react depends on whether Good A and Good B are substitute goods or complements. Substitute...

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Cross elasticity of demand (also referred to as cross-price elasticity) measures the change in the quantity demanded of Good A in response to a change in the price of Good B. How these goods will react depends on whether Good A and Good B are substitute goods or complements. Substitute goods are goods that – predictably enough – can be substituted for one another, like apples and oranges. If the cost of apples increases compared to the price of oranges, you’ll probably buy oranges because they’re cheaper. Complements, on the other hand, are goods that increase or decrease in demand together, like coffee and foam cups. If there’s a higher demand for coffee, there will probably be a higher demand for disposable coffee cups. If the price of either coffee or the cups increases, then people are likely to buy fewer of both goods.

A business could use this knowledge in a couple of ways. One way it might use it is to diversify its products with substitute goods in order to protect itself from fluctuations in the market. If a firm produces coffee, it might also produce tea. That way if the demand for tea decreases, the demand for coffee will increase and the firm’s profits will stay roughly the same. Alternatively, a firm could go a different direction and attempt to maximize its profits by producing complementary goods. If, for instance, a firm thinks that bubble tea is going to become really popular in the next few years, it might choose to produce the tea, plastic to-go cups, specialized bubble tea straws, etc. If the product does do really well, the firm won’t just be getting revenue from bubble tea, but also from all the products that you need to enjoy it.

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