Question

As you’ve been studying the soft drink market, you’re quite convinced that consumer income is rising in the marketplace. At this same time, Frosty Cola’s shipping department has notified you that the costs of transportation of the product have decreased significantly. You have also come across the following data: Income elasticity of demand for Frosty Cola = -1.5 Using supply/demand analysis, what do you think is going on in the market for Frosty Cola right now? Illustrate and explain.

Answer 1

Since income elasticity is negative, Frosty is an inferior good, so rising consumer income will decrease its demand, shifting its demand curve leftward, lowering price and lowering quantity. At the same time, decrease in transportation cost will decrease production cost, causing Frosty to increase production and increase market supply. This will shift supply curve rightward, decreasing price and increasing quantity. The net effect is a definite decrease in price. But quantity may increase, decrease or stay the same on basis of whether the rightward shift in supply is higher than, lower than or equal in magnitude to the leftward shift in demand.

In following graph, D0 and S0 are initial demand and supply curves intersecting at point A with initial price P0 and quantity Q0. As D0 shifts left to D1, and S0 shifts right to S1, they intersect at point B with lower price P1 and new quantity Q1. Since rightward shift in supply is lower than the leftward shift in demand, Q1 is lower than Q0.