Question

1. Draw the supply and demand graph for coffee below assuming the market operates at an equilibrium price of $2.40 and an equilibrium quantity of 5,000.
2. Assuming tea and coffee are substitutes, what will happen in the market for coffee if the price of tea increases? Show the effects on your market.
3. Based on this information, will producer surplus in the market for coffee increase or decrease? Explain.

Answer 1

Answer: We start by assuming that the market for coffee operates at an equilibrium price of $2.40 and an equilibrium quantity of 5000. Now as tea and coffee are perfect substitutes, an increase in the price of tea will increase the demand for coffee as consumers will switch to coffee consumption because of higher price of tea. As a result of this higher demand, the demand curve for coffee will shift rightward from D1 to D2 and as the economy moves from point A to point B, the equilibrium price of coffee rises from $2.40 to P2 and the equilibrium quantity of coffee increases from 5000 to Q2.

We know that producer surplus is measured by the area above the supply curve and below the equilibrium price level. Here as the demand curve shifts rightward due to the increased demand for coffee, the price and quantity of coffee both increases and as a result of which producer surplus increases from the area of the OAP1 to the area of the OBP2 (refer to the above diagram).