Question

The market for coffee is perfectly competitive, has a large number of identical firms, and is in LONG-RUN equilibrium. The market demand curve is downward sloping, and the cost schedules have their usual shapes. Market price for a unit of coffee is $10. There is a decrease in the price of tea, a substitute for coffee. [A] In the SHORT RUN, in appropriate diagrams, show what happens to price, industry output, and the output and profits of a representative firm in the coffee industry. [B] In the LONG RUN, what will be the market price of coffee? Explain your answer. (A diagram is not required and is not an explanation.) [C] In the LONG-RUN, what will be the market price of coffee if the government provides a subsidy of $2 for each unit of coffee produced? Explain your answer. (A diagram is not required and is not an explanation). +

Answer 1

In the given question,there is change in the price of substitute and we have to find the effect of this change on the given good.

A substitute good is a good which can be used in place of other good.For example ,tea and coffee.

If there is a change in the price of substitute,it will affect the demand of given good,it is called cross price effect.

(A) If there is decrease in the price of tea( substitute),there will be decrease in the demand for coffee because people will demand more for the substitute tea.So,in the short run ,the firm selling coffee will have to reduce its market price from $10.when ,the demand for coffee reduces, the profits of this firm will definately decrease.

B)In the long run,the price of a perfectlly competitive firm is determined by the industry on the basis of demand and supply forces.so, when the decrease in the price of tea affects femand for coffee,the new forces of demand and supply will definately change price of coffee in the long run.

C) If the govt provides a subsidy of $ 2 on coffee, the price of coffee will decrease by $ 2 in the long run.because, a perfectly competitive firm,in the long run,earns only normal profits.