3.7.1 An Increase in the Price of a Substitute

What happens to the price of fish when the price of chicken rises? This may sound like a riddle, but it is a serious question in economics. If the price of chicken increases, the quantity of fish demanded at every price will rise. Buyers will want to consume more fish. But the costs of producing fish will not have changed, and the quantity of fish supplied will increase only if its price rises. Thus an increase in the price of chicken will raise both the equilibrium price of fish and the equilibrium quantity of fish bought and sold.

Let us now show this graphically. Figure 3-6 adds the supply curve to Figure 3-5, which showed how an in­crease in the price of chicken shifts the demand curve for fish. Before the price of chicken increases, the demand curve is D, and equilibrium is represented by point E, with the equilibrium price equal to Po ($3 per pound) and the equilibrium quantity equal to Qo (6 million pounds per month).

Now the price of chicken rises. The effect is shown as a shift of the demand curve for fish to the right, to D’. At each price, quantity demanded on D’ is 6 (million lb) greater than on D. At the initial equilibrium price, Po, there is thus an excess demand for fish of 6. This is shown as the distance EF in Figure 3-6. If the price of fish does not change, buyers will be unable to find all the fish they want to purchase, since sellers will not be willing to supply that much. As we mentioned earlier, sellers will react to the resulting shortages by raising price.

Price will rise until quantity demanded equals quantity supplied; at that point the market is in equilibrium again. Figure 3-6 shows graphically that the new market equilibrium is depicted by point ?”, which is to the northeast of E. Sellers have raised price to Pv the new equilibrium level, and the price increase has reduced the quantity demanded from 12 (at price Po) to Q:. From Figure 3-6 we see that Px is $4 (per pound) and Q1 is 9 (million lb); after the demand curve has shifted, quantity demanded is equal to quantity supplied at a price of $4. The equilibrium price is higher than it was before the increase in the price of chicken, and the equilibrium quantity is also higher.

The price rise from Po to P1 does two things. First, it reduces the quantity of fish demanded as consumers «in effect move up along the new demand curve D’. (Box 3-1 emphasizes the importance of the distinction between a shift of a demand curve and a movement along a given demand curve.) Second, it increases the quantity supplied as producers respond to the increased price. The shift in the demand curve thus results in consumers obtaining more fish, but to do so they must pay a higher price in order to persuade suppliers to produce more.

This example hints at why economists refer to the price system: An increase in one price leads to an increase in another, suggesting—correctly—that prices in many different markets are interrelated. When the price of chicken goes up, the price of fish goes up, and so do the prices of other substitutes, such as beef and pork.

These interconnections among markets become very clear when disease or bad weather affects a major crop or foodstuff. Suppose, for example, that the price of chicken increased because a disease killed many chickens. Consumers would substitute other foods, such as fish, pizza, and beef, increasing the quantities of those goods they demanded. But this would lead to increases in the prices of substitutes for chicken. Graphically, this is depicted as shifts of the demand curves for these other foods to the right. Although the disease affected only chickens, prices would rise in many other markets as well, reflecting a general increase in the scarcity of meat.

This example also suggests how prices allocate resources. If a central planner in a command economy were faced with a reduction in the number of chickens with which to feed the population, she would use alternative food sources—and would send out orders to fishermen, ranchers, and others to increase their production to make up for the lost chicken meat. That is precisely what the price system achieves. The increased prices of substitute goods tell sellers to produce more fish, beef, and other chicken substitutes. Market prices act in exactly the same way as the orders of a central planner, but they operate without central direction, “as if by an invisible hand.”[1]

Box 3-1. Movements along the Demand Curve versus Shifts of the Demand Curve

The demand curve shifts when any of the factors that affect quantity demanded (other than the price of the good) change. Such shifts show the responses of consumers to changes in the prices of other goods, income, tastes, and so forth. Figure 3-6, for instance, shows the demand curve for fish shifting from D to D’ when the price of chicken rises.

In contrast, a movement along a demand curve shows the response of quantity demanded to a change in the price of the good itself. In Figure 3-6 the movement from F to ?” is a movement along the demand curve as consumers respond to the price increase from $3 to $4 per unit by cutting back the quantity of fish demanded.

Why does the difference matter? A shift of the demand curve causes equilibrium price and quantity to change, but movements along the demand curve are just part of the process by which the market comes into equilibrium.

Figure 3-6 shows how an increase in the price of a substitute shifts the demand curve for a good to the right, causing both its price and its quantity to increase. You should be able to show that an increase in the price of a complement is depicted as a shift in the demand curve to the left and that it causes both price and quantity to fall.

[1] As Chapter 1 noted, this famous phrase is from Adam Smith’s classic Wealth of Nations, published in 1776