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

Negative income elasticity signifies Frosty is an inferior good, so higher consumer income will lower its demand, shifting the demand curve leftward, decreasing price and decreasing quantity. At the same time, a decrease in transportation cost will lower overall production cost, so Frosty will increase output, thus increasing market supply. The supply curve will rightward, decreasing price and increasing quantity. The net effect is a certain decrease in price. But quantity may be higher, lower or unchanged depending on whether the leftward shift in demand is less than, more than or equal to the rightward shift in supply.

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 leftward shift in demand is higher than the rightward shift in supply, Q1 is less than Q0.