Question

1. Use demand and supply graphs to analyze and to illustrate the scenarios below. Complete demand and supply graphs will identify which market they are depicting, include labels on their axes and curves, and will clearly show how market equilibrium changes in each scenario.

a. (16 points) Assume that wine and cheese are complement goods, that wine and beer are substitute goods, and that beer and cheese are unrelated goods (i.e., neither complements nor substitutes). Suppose that we observe a decrease in the price of wine, an increase in the price of cheese, and an increase in the quantity of beer. Which of the following could have caused these changes?

• A binding price floor in the wine grapes market.

• An increase in the price of milk.

• An innovation that speeds up the production and bottling of beer.

Provide reasons for your answers.

b. (8 points) Suppose that a widely publicized medical report states that drinking a moderate amount of wine improves heart health. How will this report affect the price of wine, the price of beer, and the price of cheese? Provide reasons for your answers.

c. (8 points) Suppose that a massive infestation of pests destroys a large amount of wine grape crops. Suppose also that this change occurs at the same time as the medical report in part b. above is publicized. What is the combined effect of these two changes on the price of wine, the price of beer, and the price of cheese? Provide reasons for your answers.

Answer 1

1a. The correct answer is option b, increase in the price of milk. As price of milk rises, the cost of production and thereby price of cheese rises as well. This reduces the demand for cheese in the market. As wine and cheese are complementary goods, a fall in the demand for cheese reduces the market demand for wine as well. As people start substituting wine with beer, the demand for beer rises in the market.

1b. As a report suggests health benefits of drinking wine, more and more people will start consuming wine periodically. This will raise the market demand for wine. With supply remaining same, a higher demand for wine will push up its price. As wine and cheese are complementary goods, an increase in the demand for wine raises the demand for cheese in the market, leading to a rise in the price of cheese.

Beer on the other hand, will witness a fall in its demand, as people are switching from beer to wine. Thus, the price of beer falls as well.

1c. A large pest infestation destroying wine grapes reduces the quantity of wine supplied in the market. This, combined with higher demand fro wine following the news reports shoots up the price of wine. This increase is relatively higher than the rise in price of wine in the previous case.

In the market of cheese, the higher demand for wine leads to a higher demand and thereby higher price of cheese. This increase increase is similar to the level of rise in the previous question.

The beer market witnesses a fall in its demand and prices, owing to the rising popularity and preference of wine over cheese.