Answer to Question #269394 in Microeconomics for Olivera

Question

Assume that the markets for sugar cane, rum and whiskey are initially in equilibrium (i.e., supply equals demand in each case). Assume further that a good harvest impacts the world’s sugar cane crop. Sugar cane is a principal ingredient in rum, but it is not an ingredient in whiskey. Rum and whiskey are substitutes in consumption.

(i) Discuss the impact of the good harvest on each of the three markets. (6 marks)

(ii) Discuss the effect on the markets for each of the three products if the government implements a price restriction in the sugar cane market with the aim of protecting the farmers. How will this impact the revenues for sugar growers, rum producers and whiskey producers? 

Answer 1

The equilibrium price and equilibrium quantity of a good sold in the market are determined by the demand and supply. The equilibrium occurs when the quantity demanded is equal to the quantity supplied.

The changes in demand and supply can result in changes in equilibrium price and equilibrium quantity. For example, a decrease in the demand with the supply remaining the same will result in a decrease in the equilibrium price and quantity.

i)The good harvest will increase the supply of sugarcane in the market. As a result, the supply curve will shift to the right, resulting in a fall in the equilibrium price and an increase in the equilibrium quantity of sugarcane.

Sugarcane is used in the production of rum. The drop in the price of sugarcane will reduce the cost of production of rum and as a result, the supply of rum will increase. The increased supply of rum will result in a fall in the equilibrium price and an increase in the equilibrium quantity of rum sold in the market.

Whiskey and rum are substitute goods. Therefore a fall in the price of rum will result in a fall in the demand for whiskey. The demand curve for whiskey will shift to the left, resulting in a fall in the equilibrium price and equilibrium quantity of whiskey.

ii)The price restriction will increase the price of sugarcane above the equilibrium price. Total revenue is the product of price and quantity. Therefore the increase in price will increase the revenue of sugar cane producers.

The increase in the price of sugarcane will increase the cost of production for rum. As a result, the supply will fall and the supply curve will shift to the left. The leftward shift of the supply curve will reduce the equilibrium quantity and increase the equilibrium price of rum. Since the quantity has fallen and the price has increased, the change in revenue will depend on the price elasticity.

The increase in the price of rum will increase the demand for whiskey. As a result, the price of whiskey and the quantity of whiskey traded will increase. The increase in price and quantity will increase the revenue for the whisky producers.