Question

Larsen E. Pulp, head of Pulp Fiction Publishing Co., just got some bad news: The price of paper, the company's most important input, has increased. a. On a supply/demand diagram, show what will happen to the price of Pulp's output (novels). b. Explain the resulting substitution and income effects for a typical Pulp customer. For each effect, will the customer's quantity demanded increase or decrease? Be sure to state any assumptions you are making.

Short answer

An increase in the price of paper results in a decrease in supply of novels, increasing their price (P2 > P1). The substitution effect and the income effect lead customers to decrease their quantity demanded of novels. Thus, both price and quantity demanded of novels are impacted.

Step-by-step solution

Diagram the Initial Supply and Demand

Draw a diagram of a supply and demand graph. Initially, the markets are at equilibrium where the quantity demanded equals the quantity supplied, at price \(P1\) and quantity \(Q1\).

Show the Impact of Increased Supply Cost

An increase in the cost of paper means the company's cost of production has increased. This will cause the supply curve to shift to the left, as the company will be less willing to supply books at any given price. This will get the market out of equilibrium and lead to a decrease in quantity of books supplied and an increase in price.

Interpret the New Market Equilibrium

The new market equilibrium occurs where the new supply curve intersects with the demand curve. The quantity of novels will decrease to \(Q2\), and the price will increase to \(P2\).

Analyze the Substitution Effect

Higher prices for novels may lead consumers to substitute away from them towards other forms of entertainment. As a result, consumers buy fewer novels, thereby decreasing the quantity demanded.

Analyze the Income Effect

The increased price of novels effectively makes consumers poorer in relative terms, as each dollar of their income now buys fewer novels. This is known as the income effect, and it leads to a further decrease in the quantity of novels demanded.

Key concepts

Supply and Demand Graph

The supply and demand graph plays a central role in economic analysis, visually reflecting how market prices are determined by the interaction of supply—the amount of goods that producers are willing to sell at various prices—and demand—the quantity of goods that consumers are willing to buy.

In the given exercise, the initial situation is depicted on the graph with supply and demand curves intersecting at equilibrium at price point \(P1\) and quantity \(Q1\). An increase in the production cost, like the rising price of paper for the Pulp Fiction Publishing Company, shifts the supply curve to the left. This represents a decrease in supply since the company is less inclined to produce novels at previous prices.

Consequently, the new equilibrium point shifts, resulting in a higher price for novels \(P2\) and a lower quantity \(Q2\). In essence, through this graph, we can see that the cost increase disrupts the market balance, leading to a rise in prices and a contraction in the output.

Substitution Effect

When the price of a good rises, the substitution effect takes place as consumers seek alternatives that fulfill the same needs or wants at a lower cost. This behavioral shift is based on the concept of relative price change. As novels become more expensive due to the increase in paper costs, the perceived value of novels relative to other forms of entertainment such as movies, e-books, or library rentals changes.

Consumers re-evaluate their choices in light of the new pricing landscape, leading them to substitute novels with more cost-effective options. The end result is a reduced quantity demanded for publisher Larsen E. Pulp's novels.

On a practical level, this could mean a trend toward purchasing second-hand novels, exploring alternative entertainment, or putting a hold on novel purchases until prices stabilize.

Income Effect

Whenever there's a change in the price of goods, the income effect steps in to quantify how this price change affects consumer purchasing power. Essentially, if the price goes up and consumers' income remains constant, they can now afford fewer goods—making them 'poorer' in relative terms.

In Larsen E. Pulp’s scenario, as the price of novels goes up, consumers feel the pinch financially. Every dollar they have can now secure fewer novels than before, diminishing their effective purchasing power. Therefore, the income effect accompanies the substitution effect, further decreasing demand for the novels.

If the Pulp Fiction Publishing Co. decides to keep novel prices high, consumers’ reduced buying capacity may force them to cut back on their overall novel consumption, turning to less expensive alternatives or entirely different purchases to maximize the utility of their limited budgets.