Question

As the manager of a factory that is producing Good X, you have been studying the macroeconomy for some time and have also been examining other markets, such as that of Good Y. You’ve jotted down the following notes:

                        Consumer income: estimated to increase over the next year

                        Income elasticity of demand for Good X = -0.75

                        Cross-price elasticity of demand for Good X (with Good Y) = -1.9

The CEO asks you to analyze what might happen to the equilibrium price and quantity of Good X under the following scenarios (treat each scenario separately using supply/demand diagrams; in the blanks below, write “increase”, “decrease”, or “indeterminate”):

a) the impact on the market for Good X with the increase in consumer income at the same time that production costs for Good X have risen significantly

Equilibrium Price _______________ Equilibrium Quantity _______________

b) the impact on the market for Good X with an increase in the price of Good Y

Equilibrium Price _______________ Equilibrium Quantity _______________

c) the impact on the market for Good X if production costs for that product decrease, at the same time the number of suppliers is increasing in the market for Good Y

Equilibrium Price ________________   Equilibrium Quantity ______________

Answer 1

a) Negative income elasticity of demand means that good is an inferior good whose demand will fall when income rises. It will shift demand curve to its left from demand to new demand. At the same time, production cost have decreased significatly which will raise supply of good X and shift supply curve from supply to new supply. It will result in decrease in equilibrium price while indeterminate change in equilibrium quantity.

b) Negative cross price elasticity of demand means that goods are complements to each other. If the price of good Y increases, it will leave less money with consumer to spend on good X and reduce demand of X which will decrease equilibrium price of X and decrease equilibrium quantity of X.

c) Decrease in production cost will induce producers to produce more which will shift supply curve to its right and decrease its equilibrium price and increase equilibrium quantity.