Question

Consider the markets for Milky Way and Snickers candy bars. Evaluated at the market equilibrium, the estimated price elasticities of demand are 1.6 and 0.7, respectively. Assume the price elasticity of supply for each good is 1.0.

a. Construct side-by-side diagrams in which the prices of both goods are assumed to be equal. Identify the equilibrium price and quantity in both markets.

b. Suppose a rise in input prices reduces the supply of both goods proportionately. Illustrate the impact of the supply reduction on the equilibrium price and quantity.

c. Using the graphs drawn to answer (b), which good experiences a relatively larger change in price, and which good experiences a relatively larger change in quantity?

d. What happens to consumer spending (i.e. total revenue) in each market? Explain your answer by identifying and explaining the price and quantity effects.

Answer 1

From the given information we can see that the demand for milky way is more elastic (1.6) than demand for Snickers (0.7). Supply is unit elastic (1)

a. In the diagram, both the supply curves are unit elastic and is a ray from the origin -S0. For milky way demand curve is Dm and is flatter because it is elastic in nature while for Snickers demand is Ds and it is steeper because of being inelastic. The initial equilibrium is given at e0 where equilibrium price and quantity is P0 and Q0 in the two markets.(diagram at the end)

b. A rise in input prices raises the cost of production. This reduces quantity supplied at the initial price levels. Hence supply curve shifts to the left at S1. This causes equilibrium price to rise and quantity to fall. As prices rise to P1, the quantity demanded decreases along the demand curve and equilibrium quantity is Q1 at e1 equilibrium.

c. From the graphs it can be observed that prices rise relatively more in the Snickers market which has inelastic demand. While the fall in quantity is relatively more in the Milky Way market. The reason is the responsiveness in the two markets. In the Snickers market, customers respond less to a rise in price and so quantity falls less and price rises more. While in the Milky way market the responsiveness is more to a smaller price rise and quantity falls relatively more.

d. In the Milky Way market, price change is positive while quantity change is negative. Total revenue is given as a product of price and quantity. So we can see from the graph that proportional fall in quantity is more than the proportional rise in price. So the rise in price cannot compensate enough for the fall in quantity and so TR will decline. In the Snickers market the rise in price is proportionally more than the fall in quantity. Here the price rise more than compensates for the fall in quantity. This is why TR rises in this case. Another way of stating this would be - In elastic market positive price effect < negative quantity effect, so TR falls. In inelastic market positive price effect > negative quantity effect, so TR rises.