Question

If something occurs in an economy that produces “Good X” that will decrease people’s income in the economy. Assume that this is a competitive market, what will happen to that equilibrium price and quantity of “Good X” As well use supply and demand analysis to demonstrate your answer and provide the rationale behind what is happening and any interesting observations or outcomes. As well as what in real life events that relates to each thing affecting “Good X” above. Important to know that the magnitude of any supply and/or demand shifts in this example are not specified; you may want to consider the magnitude of any shifts in your analysis.

Answer 1

According to the question, we are hypothesizing a situation in an economy which produces Good X. Although the reasons for decline in income of the people can be many, falling aggregate income leads to decline in aggregate demand. Naturally, the demand for Good X falls.

One of the important characteristics of the competitive market is that the price and output is decided by the market players. So given that free market prevails, the decline in demand is corresponded by excess supply at first, and later declining output to reach a new equilibrium. Consider the following diagram.

Picha Exces supply tak DD, DO2 ) 88,83 -Goodx Quantity

DD₁ and SS₁ are demand curve and supply curve of Good X respectively. E₁  is the equilibrium at price P₁ and quantity Q₁ . A fall in income levels would shift DD₁ to the left to DD₂ where the quantity demanded is Q_2. At Q₂ , the price is P₃  which is not only greater than P₁ but also P₂ which is the price the consumers are willing to pay for current quantity supplied Q_2. At price P_3, there is excess supply of Good X in the economy (Q₃ - Q₂). Thus, the sellers will revise their prices downwards to appeal to the consumers as they move along the supply curve to reach a point E₁. However, E₁ will not serve as the equilibrium since P₂ < P₁. The supply curve movement will continue till the new equilibrium is achieved at E₂ at price P₂ and quantity Q₂.

Coming to the second part of the question, the change or the magnitude of changes in demand will depend on the number of factors like elasticity of demand, type of good (necessary or luxury good), intensity of demand shock etc. For instance, if the elasticity of Good X was low, implying that Good X might have been a necessary commodity, the magnitude of change would be less.