Question

There is a market of candy. Consumers allocate their income only on candy and milk. The consumers have diminishing marginal utility for both products. The candy market is perfectly competitive. The candy companies use labor and capital (raw materials) to produce candy. The market is in a state of long term equilibrium.

1. Consumers experience an income increase. Illustrate with GRAPHS how the income increase affect the market short term equilibrium

a. How the income increase affects demand of candy

b. How the demand change affects market equilibrium in short run. What is going to happen in the long run?

Answer 1

If the income of the consumers increase, then their demand for candies will also increase. This increase if brought about by a factor other than the price, and hence, it causes the demand curve to shift to the right.

In the short run, the supply curve remains constant as it is not possible for the producers to change the quantity in the short run. However, since the demand curve shifts to the right, as can be seen from the diagram, the resulting market price and market quantity both will increase.

In the long run, the producers can also manage the supply. Since they will be earning higher profits due to the increase in the demand, their supply will also increase, which will cause the supply curve to shift to the right. As a result, the price will be driven down to the level which will only give them normal profits, but the resulting market quantity will be more, as seen in the diagram.