Homework 2_AK

# A we observe that both the equilibrium price of cream

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a. We observe that both the equilibrium price of cream cheese and the equilibrium quantity of bagels have risen. What could be responsible for this pattern - fall in the price of flour or a fall in the price of milk? Illustrate and explain your answer. Because flour is an ingredient in bagels, a decline in the price of flour would shift the supply curve for bagels to the right. The result, shown in the figure, would be a fall in the price of bagels and a rise in the equilibrium quantity of bagels. Because cream cheese is a complement to bagels, the fall in the equilibrium price of bagels increases the demand for cream cheese, as shown in the figure. The result is a rise in both the equilibrium price and quantity of cream cheese. So, a fall in the price of flour indeed raises both the equilibrium price of cream cheese and the equilibrium quantity of bagels. What happens if the price of milk falls? Because milk is an ingredient in cream cheese, the fall in the price of milk leads to an increase in the supply of cream cheese. This leads to a decrease in the price of cream cheese, rather than a rise in the price of cream cheese. So a fall in the price of milk could not have been responsible for the pattern observed.

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b. Suppose instead that the equilibrium price of cream cheese has risen but the equilibrium quantity of bagels has fallen. What could be responsible for this pattern - rise in the price of flour or a rise in the price of milk? Illustrate and explain your answer. In part (a), we found that a fall in the price of flour led to a rise in the price of cream cheese and a rise in the equilibrium quantity of bagels. If the price of flour rose, the opposite would be true; it would lead to a fall in the price of cream cheese and a fall in the equilibrium quantity of bagels. Because the question says the equilibrium price of cream cheese has risen, it could not have been caused by a rise in the price of flour. What happens if the price of milk rises? From part (a), we found that a fall in the price of milk caused a decline in the price of cream cheese, so a rise in the price of milk would cause a rise in the price of cream cheese. Because bagels and cream cheese are complements, the rise in the price of cream cheese would reduce the demand for bagels, as the figure shows. The result is a decline in the equilibrium quantity of bagels. So a rise in the price of milk does cause both a rise in the price of cream cheese and a decline in the equilibrium quantity of bagels.
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