Question

1. Consider the markets for pharmaceutical-grade pain killers and over-the-counter pain relievers. Evaluated at the market equilibrium, the estimated price elasticities of demand are 0.2 for the former and 1.8 for the latter. Assume the price elasticity of supply is 1.0 in each market.

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 fall in input prices increases the supply of both products proportionately. Illustrate the impact of the increase in supply 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

1. First notice that the demand for grade pain killers are inelastic (0.2) while counter pain reliever is elastic (1.8) in nature. While the supply curve is unit elastic.

a. The inelastic demand curve is represented as a steep demand curve Dg while the elastic demand curve is represented as Dc. The supply being unit elastic would start as a ray from origin and is represented as S0. The equilibrum in both markets is at e0 where price is P0 at quantity Q0. (diagram at the end)

b. When input prices fall, the cost incurred by the firms decreases. The decrease will enable the firms to supply more at the previous prices. This causes supply to increases and so supply curve in both markets shift to the right. The new supply curve is S1 in both the markets. The result is a fall in price level to P1 and a rise in equilibrium quantity to Q1. As supply rises and prices fall, quantity demanded increases along the demand curve - leading to rise in quantity.

c. From the two graphs we can see that prices fall relatively more in the inelastic market of grade pain killers than in the elastic market of counter pain killers. While quantity rises relatively more in the elastic market than in the inelastic market. The reason is that in the inelastic market responsiveness of demand is less and so quantity rises only a little due to a bigger fall in price. While in elastic market, the quantity responsiveness is more for a relatively smaller fall in price.

d. Let consider the inelastic market - here, prices fall proportionately more than the rise in quantity. Total revenue is given by P*Q. So as fall in price > rise in quantity, TR will decrease. This happens as demand does not increase enough to mitigate for the fall in prices. While for the elastic market, fall in price is proportionately less than the increase in quantity. So the increase in quantity does more than just mitigate the fall in price. So TR rises in this case. In other words, for inelastic market, negative price effect > positive quantity effect and so TR falls. For elastic market negative price effect < positive quantity effect and so TR rises.