Question 11: How will a change in the price of coffee affect the equilibrium price of tea? Explain the effect on equilibrium quantity also through a diagram.
Answer:
Coffee and tea are substitute goods, i.e. they are used in the place of each other. An increase or a decrease in the price of coffee will lead to an increase or a decrease in the demand for tea respectively. The figure depicts the equilibrium of the tea market. The initial demand and supply of tea is depicted by D1D1 and S1S1 respectively. The initial equilibrium is at E1 with the equilibrium price (pe) and equilibrium quantity (qe). Now the price of coffee increases, which will lead to an increase in the demand of tea (being a substitute good), the demand curve of tea will shift rightward parallelly. At the equilibrium price (Pe), there will be an excess demand for tea, consequently, the price of tea will rise. This will form the new equilibrium at E2 with the new equilibrium price P2 and the new equilibrium output q2. Hence, an increase in the price of coffee will lead the equilibrium price of tea to rise (due to excees demand). Further the increase in the price of coffe will also lead to the increase in demand for tea as tea is the substitute good and coffee. Now, if the price of coffee decreases, there will be a decreases in the demand for tea. The demand curve for tea will shift leftward parallelly to D2D2. At the equilibrium price (Pe) there will be an excees supply. Consequently, the price of tea will fall, which will form the new equilibrium at E2 with new equilibrium price P2 and the new equilibrium output q2. Hence a decrease in the price of coffee will lead to a decrease in the price of tea and a decrease in the demand for tea as people will switch over to consumption of coffee.
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