Question

Jennifer and Drew consume orange juice and coffee. Jennifer's MRS of orange juice for coffee is 1 and Drew's MRS of orange juice for coffee is 3. If the price of orange juice is \(\$ 2\) and the price of coffee is \(\$ 3,\) which market is in excess demand? What do you expect to happen to the prices of the two goods?

Short answer

Based on the above analysis and understanding of the Marginal Rate of Substitution and price ratios, there is an excess demand for orange juice. Hence, the price of orange juice is expected to rise while that of coffee is expected to decrease.

Step-by-step solution

Calculate Price Ratios

Calculate the ratio of the price of orange juice to the price of coffee. This is \(frac{2}{3}\) or 0.67.

Compare MRS with Price Ratios

Compare each individual's MRS with the price ratio. If MRS is greater than the price ratio, they prefer more orange juice, otherwise, more coffee. Jennifer's MRS is equal to 1 which is greater than 0.67, hence, Jennifer demands more orange juice. Drew's MRS is 3 which is also greater than the price ratio, 0.67. Hence, Drew also demands more orange juice.

Identify Excess Demand

Since both Jennifer and Drew prefer more orange juice at the existing prices, there would be an excess demand for orange juice.

Predict Price Changes

Since there is an excess demand for orange juice, we expect the price of orange juice to rise. The price of coffee would likely decrease since it is 'in excess supply'.

Key concepts

Excess Demand

Excess demand occurs when the quantity demanded of a good exceeds the quantity supplied at the current market price. This imbalance suggests that consumers are willing to purchase more of the good than what is available, often leading to upward pressure on the price. In our example with Jennifer and Drew, both individuals' marginal rates of substitution (MRS) indicate they would prefer to consume more orange juice in relation to coffee at the current price levels. This collective preference points towards an excess demand for orange juice.

When excess demand is present in a market, it typically triggers a price adjustment mechanism. Sellers, recognizing the high demand, may raise prices to achieve an equilibrium where the quantity demanded matches the quantity supplied. This self-correcting nature of markets helps to clear excess demand over time. In educational content, this concept can be emphasized with common real-world examples, such as product shortages and subsequent price surges.

Price Ratio

The price ratio in economics is the rate at which two goods can be traded based on their market prices. It is a critical measure when analyzing consumer choice and preferences. Referring to the given exercises, the price ratio between orange juice and coffee is calculated by taking the price of one good and dividing it by the price of the other, resulting in a price ratio of 0.67, or \(\frac{2}{3}\).

This ratio is essential for understanding the decision-making process of consumers. If an individual's MRS (the rate at which they are willing to give up one good in exchange for another while maintaining the same level of utility) is greater than the price ratio, it indicates a preference for consuming relatively more of the first good. In our example, Jennifer's MRS equals the price ratio, suggesting she might be indifferent to trading one for the other, whereas Drew's MRS is much greater, highlighting a strong preference for more orange juice relative to its price.

Demand and Price Relationship

The relationship between demand and price is a fundamental concept in economics, epitomized by the law of demand, which states that, ceteris paribus, there is an inverse relationship between the price of a good and the quantity demanded. Essentially, as the price of a good increases, the quantity demanded typically decreases, and vice versa.

In the context of Jennifer and Drew, both would demand more orange juice if its price remained lower relative to coffee, explaining why Marginal Rate of Substitution (MRS) is an intuitive measure of the demand and price relationship. As the price of orange juice begins to rise due to the excess demand, the quantity demanded would normally decrease, bringing the market back to equilibrium. The exercise implicitly tests the student's understanding of this dynamic and highlights the importance of prices as signals in a free-market economy. Teaching students to analyze these economic principles helps them to grasp the interplay between different factors influencing consumer behavior.