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Chapter 16: Problem 4

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

Expert verified
Considering the MRS of Jennifer and Drew compared to the price ratio, there is an excess demand for coffee in this market. Consequently, it's expected that the price of coffee will increase and the price of orange juice will decrease until equilibrium is reached.

Step by step solution

01

Calculate the price ratio

First, calculate the price ratio of orange juice to coffee. The price of orange juice is \$2 and the price of coffee is \$3, so the ratio is \(2/3\) or approximately 0.67.
02

Compare the MRS with the price ratio

Next step is to compare the MRS values of both individuals to the price ratio. The MRS for Jennifer is 1, and the MRS for Drew is 3. Both MRS values are greater than the price ratio of 0.67.
03

Determine the market with excess demand

Since the MRS of both individuals is greater than the price ratio, it implies that they are both willing to give up more units of orange juice for each unit of coffee than what it actually costs. This leads to excess demand for coffee.
04

Predict the change in prices

When there is an excess demand in the market, it usually puts upward pressure on the price of that good. Here, expect the price of coffee to increase. This will continue until the price ratio equates the MRS. Conversely, you can expect the price of orange juice to decrease due to its excess supply.

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