Question

1. Suppose that good X and good Y are substitutes: 1) What will happen to the equilibrium prices and quantities for good X and good Y if input prices for good X increase? Explain by drawing demand and supply curves. 2) What will happen to the equilibrium prices and quantities for good X and good Y if there is improvement in production technology for good Y? Explain by drawing demand and supply curves.

Answer 1

1) lf good X and good Y are substitutes, they have negative price elasticity of demand.

>At first, Let's look at what happens to the equilibrium price and quantity of X . When input price of X Increases, then cost of production also increases. As a result, supply of good X falls.

Initial equilibrium is determined by the intersection of demand curve DD and supply curve SS. Equlibrium price is P and equlibrium quantity is Q . As a result of fall in supply , supply curve shifts to left from SS to S1S1.

*Intersection of S1S1 with DD leads to a rise in equilibrium price from P to P1 and a fall in equilibrium quantity from Q to Q1.

>Now let's look at the market for Y. We already saw that, there is an increase in the equlibrium price of X. When price of X Increases, people will prefer to buy Y instead of X since they are substitutes. As a result demand for Y increases.

Initial equilibrium price is P and equlibrium quantity is Q determined by the intersection of demand curve DD and supply curve SS. As a result of Increase in demand, demand curve shifts from DD to D1 D1.

*Intersection of D1D1 with SS leads to rise in equilibrium price of Y from P to P1 . Equlibrium quantity also increases from Q to Q1.

2)

>Now there is an improvement in production technology for good Y. So , at first let's look at the market for good Y.

Due to improvement in production technology, supply of Y increases. Supply curve shifts to right from SS to S1S1. *Intersection of S1S1 with demand curve DD leads to a fall in equilibrium price from P to P1 and a rise in equilibrium quantity from Q to Q1.

> Now, let's look at the impact of above mentioned event on the market for X.

Here, we already know that, price of Y declines. When price of Y declines , people will prefer to buy Y instead of X since they are substitutes. Demand for X falls. Demand curve shifts to left from DD to D1 D1 .

*Intersection of D1D1 with supply curve SS leads to a decline in equilibrium quantity from Q to Q1 . Equlibrium price also falls from P to P1.