What happens when the price of a substitute good changes? - FreeEconHelp.com, Learning Economics... Solved!


What happens when the price of a substitute good changes?

This post goes over a scenario where both the demand and supply curves will shift. Sometimes when both curves shift, we are left with an ambiguous (unknown) change in either quantity or price. Let’s look at the following example:

Imagine that there is an increase in popularity of a specialty type of Soy. Suppliers currently focus on GMO (genetically modified) Soy, but there is a growing premium on Organic Soy that is driving grower interest. Because of this, growers have announced that there will be higher prices for the Organic Soy crop. The organization indicated it'll be calling on growers to increase the area planted to the variety later this year.

With markets in Canada, the UK, South East Asia, South Korea and now Russia, the growers hope the industry can triple production for Organic Soy in the next three years.

Using the above scenario...

1. The demand and supply model needs to explain the change happening in the market for Organic Soy and explain the equilibrium achieving process on prices and output of growers’ response. Is there a shortage and a surplus why?

Would the graph show the demand curve moving to the right and the supplier curve shifting to the right?

First we have to figure out why the prices are rising in the first place. Because prices are determined by the market, and supply has not changed (yet), we have to assume that there has been an increase in demand, possibly caused by a change in tastes or preferences but it is also possible that income has increased or population has grown.
Supply and demand graph depicting an increase in demand with a shortage.
 This change in demand increases Qd to a point (given fixed prices) that is larger than Qs. Therefore, we need to see an increase in price in order to avoid the resulting shortage.

An increase in supply can keep prices the same

However, once production is ramped up we will see a rightward shift (increase) in Supply which will cause quantity to rise, however the effect on price is unknown because we do not know the exact magnitude of the shifts. In the example below, we assume that both lines shift the same amount which results in the same original price level, however it is possible for price to either rise or fall depending on the magnitudes of the shifts.

2. Using the demand and supply model, explain the impact on prices and output on the GMO Soy market caused from the likely response from Soy growers and explain the equilibrium achieving process on prices and output of growers’ response. Does this change show a surplus or a shortage why?

Would the demand curve shift to the left and the supply curve shift to the right?

This market will show the opposite effect. Since demand for Organic is rising, the demand for GMO will fall (assuming that they are substitute goods) and we will see demand shift left (decrease) and since more land is being allocated to Organic Soy, we will also see supply shift left (decrease). Again, we know that equilibrium quantity will fall, but depending on the magnitudes of the shifts we could see prices rise, fall, or stay the same. In the example below, we are assuming that the decrease in supply is greater than the decrease in demand so that ultimately prices will rise a bit.