Question

Typically, some factor, other than the product’s own price, is either a determinant of the quantity demanded, or the quantity supplied. When it comes to the market for ice cream, however, frozen yogurt is an exception. As you saw, frozen yogurt is both a substitute in consumption and a substitute in production (because firms that make ice cream usually also produce frozen yogurt). We examined how a change in the price of frozen yogurt affects the demand side and the supply side of the market for ice cream independently. Let us now focus on the entire picture. Starting from the equilibrium position in the market for ice cream, suppose that the price per unit of frozen yogurt rose. In a SINGLE diagram, a) illustrate graphically what will happen to the market demand curve and the market supply curve for ice cream and show the ultimate equilibrium point, equilibrium price per unit of ice cream and equilibrium quantity of ice cream after this change. b) How does the ultimate equilibrium price of ice cream compare with the original equilibrium price? How does the ultimate equilibrium quantity of ice cream compare with the original equilibrium quantity? Provide a very short explanation for your answers. If you think that, in addition to the case depicted in your diagram in part a), there may be other possibilities, illustrate each of them graphically next to the first diagram.

Answer 1

Frozen yogurt and ice cream are substitute goods in both demand and supply. So if the price of frozen yogurt increases, the supply of yogurt would increase because the sellers are willing to supply more of the good at a higher price. So the supply of ice cream would reduce.

The demand would reduce for yogurt as the price increases and the demand for ice cream increases as they are substitute goods.

Since we do not know the proportion of change or level of substitutability of the goods, there would be three cases.

This would be the first case wherein the demand and supply change by same proportion ie the supply of ice cream reduces, shifting the supply curve to left, and the demand increases, shifting the demand curve to right. The new equilibrium price is given by P*.

This is the second case wherein the demand increases by a lesser proportion than the supply decrease. The new equilibrium price and quantity is given by P' and Q'.

This is the third case wherein the increase in demand is more than reduction in supply.

The new equilibrium price and quantity is given by P' and Q'.

b) In all cases, the price would definitely rise because the demand is increasing and supply is decreasing. But due to different proportions, the equilibrium quantity could be greater, less or equal to the original one and hence is indeterminant in nature. Also the equilibrium would always be above the original equilibrium.

(you can comment for doubts)