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Supply & Demand Practice Question

By Mike Moffatt, About.com

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Supply & Demand Practice Question - Part D

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Supply & Demand - Part D

Illustrate each of the following events using a demand and supply diagram for bananas:

The price of oranges falls.

There are a couple of different things that could happen here. We will assume that oranges and bananas are substitute goods. We know that people will buy more oranges because the price is lower. This has two effects on the demand for bananas:

We should expect that consumers switch from buying bananas to buying oranges. Thus the demand for oranges should fall. Economists call this "the substitution effect"

There is a second less obvious effect here, though. Since the price of oranges has fallen, they will now have more money in their pocket after purchasing the same quantity of oranges as before. Thus they can spend this extra money on other goods, including more oranges and more bananas. So the demand for bananas could actually rise due to what economists call "the income effect". It is called this because the price drop allows consumers to purchase more, similar to when they have a rise in income.

Here I have assumed that the substitution effect overpays the income effect, thus causing the demand for bananas to fall. It is not incorrect to assume the opposite, but you should indicate in writing why you drew the curve where you did.

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