question_answer

X and Y are complementary goods. The price of Y falls. Explain the chain of effects of this change in the market of X.

Or

Explain the chain of effect of excess demand of a good on its equilibrium price.

Answer:

If X and Y are complementary goods, then a fall in the price of good Y will lead to a rise in the demand of good X. Graphically, the effect of this change can be seen as follows

Here, suppose \[{{D}_{1}}{{D}_{1}}\] and \[{{S}_{1}}{{S}_{1}}\] are the initial market demand curve and market supply curve, respectively. The initial equilibrium is established at point\[{{E}_{1}}\], where the market demand curve and the market supply curve intersects each other. Accordingly, the equilibrium price is \[O{{P}_{1}}\] and the equilibrium quantity demanded is\[O{{q}_{1}}\].

Now, as the market demand of good X increases, this shifts the market demand curve parallely rightwards to \[{{D}_{2}}{{D}_{2}}\] from\[{{D}_{1}}{{D}_{1}}\], while the market supply curve remains unchanged at\[{{S}_{1}}{{S}_{1}}\]. This implies that at the initial price\[O{{P}_{1}}\], there exist excess demand equivalent to (\[Oq{{'}_{3}}-O{{q}_{1}}\]) units. This excess demand will increase competition among the buyers and they will now be ready to pay a higher price to acquire more units of good. This will further raise the market price. The rise in   the price will continue till the market price becomes\[O{{P}_{2}}\]. The new equilibrium is established at point\[{{E}_{2}}\], where the new demand curve\[{{D}_{1}}{{D}_{1}}\] intersects the supply curve\[{{S}_{1}}{{S}_{1}}\] Observe that, at the new equilibrium both market price and quantity demanded are more than the initial equilibrium. The new equilibrium quantity supplied \[O{{q}_{2}}\] and the new equilibrium price is\[O{{P}_{2}}\]. Hence, an increase in demand with supply remaining constant, results in rise in the equilibrium price as well as the equilibrium quantity.

Or

Suppose \[{{D}_{1}}{{D}_{1}}\] and \[{{S}_{1}}{{S}_{1}}\] are the initial market demand curve and market supply curve, respectively. The initial equilibrium is established at point\[{{E}_{1}}\], where the market demand curve and the market supply curve intersects each other. Accordingly, the equilibrium price is \[O{{P}_{1}}\] and the equilibrium quantity demanded is\[O{{q}_{1}}\].

Now, assume that market demand increases (may be due to an increase in the consumer?s income). This shifts the market demand curve parallely rightwards to \[{{D}_{2}}{{D}_{2}}\] from\[{{D}_{1}}{{D}_{1}}\], while the market supply curve remains unchanged at\[{{S}_{1}}{{S}_{1}}\]. This implies that at the initial price\[O{{P}_{1}}\], there exist excess demand equivalent to (\[Oq{{'}_{3\,}}-O{{q}_{1}}\]) units. This excess demand will increase competition among the buyers and they will now be ready to pay a higher price to acquire more units of good. This will further raise the market price. The rise in the price will continue till the market price becomes\[O{{P}_{2}}\]. The new equilibrium is established at point\[{{E}_{2}}\], where the new demand curve \[{{D}_{2}}{{D}_{2}}\] intersects the supply curve \[{{S}_{1}}{{S}_{1}}\]. Observe that at the new equilibrium both market price and quantity demanded are more than the initial equilibrium.

The new equilibrium quantity supplied \[O{{q}_{2}}\] and the new equilibrium price is\[OP2\]. Hence, an increase in demand with supply remaining constant, results in rise in the equilibrium price as well as the equilibrium quantity.

To summarise,

Excess demand at the existing \[\Rightarrow \] Competition among the buyers \[\Rightarrow \] Rise in the price level \[\Rightarrow \] new equilibrium \[\Rightarrow \] Rise in both quantity demanded as well as price.