Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What does it mean if the cross elasticity of demand is positive?

1. The two goods are substitutes

2. The two goods are complements

3. The goods are unrelated

4. The goods have the same elasticity

The correct answer is: The two goods are substitutes

When the cross elasticity of demand is positive, it indicates that an increase in the price of one good leads to an increase in the quantity demanded of another good. This relationship signifies that the two goods are substitutes. In the context of consumer behavior, if the price of one good rises, consumers may substitute it with another good that serves a similar purpose, thus increasing its demand. For example, if the price of coffee increases, consumers might purchase more tea instead. Therefore, a positive cross elasticity suggests that the goods respond to price changes in a way that illustrates their substitutive relationship in the market. The other choices present different scenarios. Complements would exhibit negative cross elasticity, as an increase in the price of one good typically results in a decrease in the demand for its complement. Unrelated goods would demonstrate a cross elasticity of zero, meaning that changes in price do not affect the demand for the other good. Having the same elasticity pertains to the sensitivity of demand concerning price changes but does not directly relate to the direction of demand changes for two goods in relation to each other.