Question

As you’ve been studying the soft drink market, you’re quite convinced that consumer income is declining in the marketplace. At this same time, Frosty Cola’s production department has notified you that the costs of carbonated water and sugar have increased significantly. You have also come across the following data: Income elasticity of demand for Frosty Cola = -1.5

Using supply/demand analysis, what do you think is going on in the market for Frosty Cola right now? Illustrate and explain.

Answer 1

From data I have seen that the income elasticity of demand is -1.5. This means that, as income increases by 1 unit, the quantity of cola demanded decreases more than the increase in income.Colas are inferior goods, People tend to consume less of it when income decreases. However, I have the information that consumer income is decreasing in the market. If income decreases, more of an inferior good should be consumed. Thus, the demand for the Colas should rise. The demand curve should shift from D1 to D2.

However, I have one more additional information. The cost of inputs for making cola, that is, carbonated water and sugar has increased. This will increase the production costs and the supply of cola will decrease. Thus, the supply curve would hift to the left.

In both the cases, price rises but quantity increases or decreases depending on the strength of the two effects, There can be three different outcomes.

1) Supply decreases more than demand increase

Here, the quantity demanded decreases,

2) Supply decreases less than demand increase

Here, the quantity demanded increases.

3) Supply decreases equals demand increase

Here, the quantity remains unchanged.

Any of the three outcomes is possible.