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Answer to Question # 2 on Last Month’s Pop Quiz

Posted By Don Boudreaux On June 1, 2011 @ 3:39 pm In Competition,Complexity & Emergence,Economics,Prices | Comments Disabled

The 2nd question on the pop quiz [1] was this:

Suppose that engineers at BMW invent a new machine that dramatically increases BMW’s efficiency at producing automobiles and, thus, causes BMW’s production costs to significantly fall.  As a result, BMW expands its output and lowers its prices.  But also, BMW patents this new machine; only BMW can use it.  What is the most likely consequence of this particular invention on the prices that General Motors, Ford, Toyota, and other auto makers charge for the automobiles they produce?
a. no change in the prices of non-BMW automobiles
b. the prices of non-BMW automobiles will fall
c. the prices of non-BMW automobiles will rise
d. there’s insufficient information to answer this question

…..

The correct answer is b – the prices of non-BMW automobiles will fall.

Even though BMW invented the new, cost-reducing machine and even though BMW patents it (and, hence, BMW alone is allowed to use this machine), because BMW automobiles are substitutes in many people’s minds for automobiles produced by companies such as G.M. and Toyota, G.M., Toyota, and other automakers will have to reduce their prices in response to BMW’s lower prices.

The economic rule in play here involves that of substitute goods, which states that good B is a substitute for good A if, as the price of good A changes, the demand for good B changes in the same direction.  So if B is a substitute for A, if the price of good A falls, the demand for B will fall, causing the price of B also to fall.

When the price of A falls (in this example, because of a cost-reducing new technique used by A‘s producer), the quantity demanded of A rises; consumers buy more units of A than they did before the price of A fell.  With consumers shifting into A, they shift away from buying other goods and services; those goods and services whose demands noticeably fall as a result of the fall in the price of A are substitutes for A.

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