UNIT 4 : Economics
Applications of supply and demand analysis
This unit should enable you to understand and explain
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Maximum and minimum pricing
The effect of sales taxes
The effect of subsidies
How supply and demand analysis can be applied in a variety of situations
In unit 2 we saw how equilibrium prices were established by the interaction of supply
and demand. In unit 3 we saw how particular demand and supply characteristics may
influence the behaviour of those variables. We are now going to look at a number of
scenarios and put our supply and demand tools to work.
MAXIMUM AND MINIMUM PRICING
Can the government authorities or other powerful groups secure prices above
equilibrium prices if they choose?
The simple answer to the question is yes, but they must have a way to impose their
wishes on the market in such a way that normal market forces cannot work. Look at the
diagram below.
Minimum Prices
U n e m
P1
p lo y m
e n t
S
b
a
M in i m
u m
Minimum Price
Price
w a g e
P
D
0
20
21
Q u a n t it y
22
(m
Quantity
Quality
Fig 4.1
23
i ll io n s o f h o u r s p e r y e a r )
If we are unhappy at equilibrium price ‘P’ for some reason, can we shift price to ‘P1’?
As I have already said the answer is yes, but price ‘P1’ is an unstable price in a free
market. There is a surplus on the market and, if things are left to market forces, price
will tend to fall back to the equilibrium. If we want price to remain at ‘P1’ we must
have some mechanism for making it stick at this level.
Activity:
Before we go on to consider two applications, can you think of any
reasons why we might want to secure prices that are higher than
equilibrium prices?
Let’s consider some of the circumstances under which minimum prices might be
imposed. To begin with let’s look at agriculture.
Ever since the 1920’s in the UK we have tried to ensure a healthy domestic agricultural
sector by guaranteeing minimum prices to farmers for their output. Prices that would,
under a free market system, be lower. This means guaranteeing prices above
equilibrium.
As you can see from fig 12, farmers will tend to produce too much at these prices and
if we want to ensure that the market mechanism doesn’t drive prices down we must
have a way of interfering with it. One solution would be to destroy the excess produce
so that it cannot reach the market, another would be to store it or stockpile it. Either
way, the excess supply is removed and prices can stay at the higher level. Another
solution would be to pay farmers not to produce the output that they would normally
have wanted to produce in a free market system. All of these methods have been used
to ensure farmers receive prices above equilibrium for their output.
You can see from the diagram what happens to the prices consumers pay and the
quantity of foodstuff available for consumption as a result of these interventionist
policies?
The result of intervention is higher prices and smaller quantities produced and sold as
compared to those in a free market equilibrium.
For a second example (a situation when a group of people may want to secure prices
above equilibrium) we will turn to the labour market.
Would you rather work for a wage above the going rate for your job, or just work for
the going rate? I’m sure you had no difficulty in giving me an answer. I doubt if you
needed a diagram to decide either. Many groups would like to achieve wages above the
market rate. Let us focus on one such group – the drivers of traditional black taxicabs
in London.
Just refer back to fig 4.1 before reading on. The taxi drivers would like to achieve
wages at level ‘P1’ but we know there will be so many people with taxis interested in
working for this sort of money that the market would soon drive the going rate back
down to the equilibrium. To achieve rewards at the ‘P1’ level they must have a way of
keeping all those hopeful drivers and their vehicles off the market. This can easily be
achieved by a process of licensing to restrict the number of cabs and by setting
minimum standards for new drivers. The licensing authority responsible for black cabs
in London can ensure that current drivers and firms operating in the market earn
returns above the equilibrium. Of course the authorities have no control over mini-cabs
and unlicensed vehicles, which they naturally see as a threat to the way they have
manipulated the market.
Activity:
Make a list of six other organisations that try to manipulate markets to
achieve higher wages for their members.
Can the government authorities or other powerful groups secure prices below
equilibrium if they choose?
The answer is again yes, but with a similar condition to the one we met earlier. Take a
look at the next diagram.
Maximum Prices
U n e m p lo y m e n t
S
M in im u m
Price
w a g e
P
P1
Maximum Price
D
0
20
21
22
23
Q u a n t i t y ( m illio n s o f h o u r s p e r y e a r )
Quantity
Fig 4.2
Here we have a market in equilibrium at price ‘P’. We can get price in this market
down to ‘P1’ but this will be an unstable price in a free market. At this price there is a
shortage on the market and, if left to market forces, prices will tend to rise back up to
the equilibrium. If we want price to remain at ‘P1’ we must again have some
mechanism for making it stick at this level.
What are the circumstances in which a society may wish to achieve prices below
equilibrium?
If you think back to unit 1, we saw how planned economies often want to interfere
with prices to make things artificially cheap. Imagine we are in charge of the ‘Peoples
Republic of Paradise’, a highly planned economy. We are concerned that due to
inefficiencies in our agricultural sector, the price of rice is too high for many of our
citizens to be able to afford enough to survive. How can we get price down, keep it
down and continue our stay at the presidential palace?
The first possibility is that we issue a Presidential Decree that promises death by firing
squad for anyone discovered dealing in rice at more than price ‘P1’ as of midnight
tonight. This could quite easily convince buyers and sellers to take a break from their
normal market behaviour and neutralise the forces of supply and demand. More
conventionally, we will rely on some system of rationing to make sure that the excess
demand is removed so that prices stay at the lower level. A very common kind of
rationing, found in both planned and market economies, is the queue. First come first
served is a way of sharing out the scarce rice in our example. Only one kilo of rice per
person, per visit to the shop, is another possibility. Formal rationing may utilise
coupons or vouchers distributed in such a way that the scarce rice can be allocated to
consumers without market pressures building up.
Whichever method we choose, if we want to get prices down we must have a
mechanism for making them stay down.
Activity:
‘Black markets’ often occur during times of rationing. How could a
‘black market’ develop for rice in our example above?
Look at fig 4.2 again closely. Can you see for yourself what happens to the prices
consumers pay and the quantities of goods and services available to them as a result of
the interventionist policies?
The result of intervention is lower prices but smaller quantities produced and sold as
compared to those in a free market equilibrium.
Let’s extend our enquiry into market intervention and look at the most common form
of intervention of them all, taxation. For our next piece of analysis we will study the
effect of sales taxes such as VAT and customs and excise duties on the market for
goods and services.
EQUILIBRIUM PRICES AND TAXATION
A sales tax has to be paid over to Customs and Excise by the sellers of goods and
services and therefore such taxes fall initially on the supply side. If you are selling
CD players for £100 each and the government suddenly puts a tax of £10 per machine
on them would you be more interested or less interested in selling those machines at
£100?…. You would be less interested because your profit has just been cut. In fact, it
is almost as if your costs of production had just risen by £10 per copy.
The result of the imposition of a sales tax will be a decrease in supply. Supply will
shift upwards and to the left by the amount of the tax.
The Sales Tax
Price (pounds per player)
S + Tax
Tax Revenue
0
3
4
5
6
Quantity ( thousands of CD players per week )
Fig 4.3
Look at the new equilibrium price after the imposition of the tax because this will show
the impact of the tax or, to put it another way, who shoulders the burden of the tax? In
the example above it looks as if the burden of the tax falls equally on the consumer and
the seller. Price used to be £100 per machine and now it is £105, showing that £5 of the
tax is being paid by the consumer in the shape of a higher price. The remaining £5 of
taxation is being paid by the seller who suffers a reduction in profit margins as a result.
Why don’t the sellers just pass the whole of the tax on?
A closer look at the diagram will tell us the answer. If sellers passed the whole of the
tax on, price would have to go up to £110. See how many CD players people are
prepared to buy a week at that sort of price. This would cause a lot of damage to the
sellers’ sales revenues. They literally cannot afford to give up this much business so
they cannot pass all of the price increase on to the consumer.
It is the characteristics of the demand curve in this particular case that determines the
outcome. It all depends on the slope of the demand curve. In other words the price
elasticity of demand over the relevant price range.
Activity:
Try to draw two new diagrams altering the demand curve each time to
show each of the following situations:
i)
where the seller absorbs all of the tax and consumers pay
none of it.
ii)
where the consumer pays all of the tax in the form of
higher prices.
You should arrive at something resembling fig 4.4 and fig 4.5
Price
Sales Tax and the
Elasticity of Demand
Quantity
(b)
Elastic
demand
Elastic
demand
Fig 4.4
Price
Sales Tax and the
Elasticity of Demand
Quantity
Inelastic demand
Fig 4.5
In the first example, demand is completely elastic, or so sensitive to a price change that
nothing will be sold if the price rises above the present market price. Sellers are forced
to absorb the tax if they want to sell anything into this market.
In the second example, demand is completely inelastic, or insensitive to a price change.
Consumers will continue to buy the same quantity regardless of a price rise. They must
have this product at all costs. Under these circumstances it is no wonder that sellers do
not need to absorb any of the tax and why consumers end up paying it all in the form of
higher prices.
In practice, governments will aim for increased taxes on products with relatively
inelastic demand such as petrol, tobacco, wines and spirits and fuels. They would
really like to extend VAT in the UK to food since the demand for food is obviously
quite inelastic! However, it would almost certainly be political suicide for the party
who did so. In each of these cases it is almost certain that any tax increases will filter
through into higher prices. Consumers will end up paying all, or very nearly all, of
such tax increases.
EQUILIBRIUM PRICES AND SUBSIDIES
A subsidy is a negative tax. We can treat subsidies in exactly the same way as we
treated sales taxes, except in reverse.
A subsidy will be received by the producers of certain goods or services and therefore
subsidies fall on the supply side. In fact a subsidy to a producer is like a reduction in
production costs.
The result of a subsidy will be an increase in supply. It will shift the supply curve
downwards and to the right by the amount of the subsidy.
Let’s see how this would work in the leisure market.
Government believes a fit and healthy population is a national asset and so decides to
subsidise admission to leisure centres. See what happens in the diagram below.
The Subsidy
S
Tax Revenue
PP
Price
subsidy
Price
S + subsidy
Tax Revenue
P1P1
0
O
D
Q Q1Q1
Quantity
Fig 4.6
Look at the result carefully. The effect of the subsidy in my example has been to
reduce the price paid by customers of the leisure centres, but it has not resulted in
much of an increase in admissions to those centres.
The government’s aim to improve the health of the nation will not be a great success
but the people who were already using the centres are very grateful. It is the demand
and supply characteristics in my example that have produced this outcome. Demand
for admission to the leisure centre is not price elastic over the relevant range.
Governments need to give the subject of subsidies very careful consideration before
making expensive decisions. An understanding of the demand and supply elasticities is
essential in this situation.
Activity:
Under what circumstances would a subsidy for leisure services result in
increased leisure centre usage? Can you draw a suitable diagram to back
up your answer?
OTHER APPLICATIONS OF SUPPLY AND DEMAND ANALYSIS
We can close this unit by considering some other uses of demand and supply analysis.
I will begin with an example from the labour market.
A topical question in 1998, particularly for government, is: what will be the effect of a
minimum wage on the labour market in the UK?
Look at the diagram below which should look a little familiar, we used a similar one at
the beginning of this unit.
Minimum Wages and
Unemployment 1
6
Wage
s rate
(poun
ds per
hour)
S
Ss
U n e m p lo y m e n t
Unemployment
S
5
Wage rate (pounds per hour)
M in i m u m
w a g e
4
3
D
0
2 0
2 1
2 2
2 3
Q u a n t i t y ( m i l l io n s o f h o u r s p e r y e a r )
Quantity (millions of hours per year)
Fig 4.7
If the minimum wage is set at £4 then it will have no effect on the labour market at all.
Activity:
Why wouldn’t a minimum wage set at £4 have any effect?
If it is set at £5 then the result will be unemployment shown by the surplus of labour at
that price or wage. Less hours will be worked, or less people employed as a result of
the minimum wage than before its introduction.
This argument is used by those who are against minimum wage legislation.
We can easily challenge this conclusion by changing the characteristics of the labour
market.
Minimum Wages and
Unemployment 2
Unemployment
Fig 4.8
6
U n e m p lo y m e n t
Wage rate (pounds per hour)
sS
5
a
b
Minimum Wage
M in im u m
w a g e
4
3
D
0
2 0
2 1
2 2
2 3
Q u a n t i t y ( m i l l io n s o f h o u r s p e r y e a r )
Quantity (millions of hours per year)
Fig 4.8
Now, with fairly inelastic demand for labour and fairly inelastic labour supply, you can
see that the anticipated reduction in hours worked is much smaller.
This is the argument used by pro-minimum wage groups who say that the effect of a
minimum wage on the market would be negligible and that winners would far
outnumber losers.
Unfortunately economists do not have a precise grasp of current labour market
characteristics and so the question cannot be resolved through economic theory.
However, our tools of supply and demand analysis have helped us clarify the issues
behind the debate.
Activity:
Perhaps you can think of a few reasons why we do not have perfect
understanding of the way labour markets work.
Another topical question these days is: what is likely to happen to the average starting
salary for a graduate as a result of a 20% increase in the number of graduates leaving
universities in recent years?
Another easy one.
The Effects of
Change in Supply
S
S1
Su p p ly o f ta p e s
(o ld te c hno lo g y)
Wage rate
1.
Sup p ly o f ta p e s
(ne w te c hno lo g y)
W
0 .9 0
W1
0 .6 0
0 .3 0
De m a nd fo r ta p e s
Demand
0 0
2
Q4
Q1
6
8
10
12
Qua n tity (m illio ns o f ta p e s p e r we e k)
Quantity
Fig 4.9
Clearly the supply of graduate labour has increased and, if other conditions in the
labour market remain unchanged, the result is a foregone conclusion. Starting salaries
will fall.
Finally, an example from the world of finance.
A rumour goes around the City that Barclays Bank is going to take-over Natwest. What
happens to the price of Natwest shares?
If investors expect the take-over in the future they will buy Natwest shares now in the
hope of a capital gain during the take-over bidding.
The Effects of Change
in Demand
S
1. 0
8
S p p lyu
o f ta p e s
1.5
P1
0
1.2
0
P0 .9 0
Price
De m a n d fo r ta p e s
(Wa lkm a n £ 3 0 )
0 .6 0
0 .3 0
D1
De m a D
n d fo r ta p e s
(Wa lkm a n £ 1 2 5 )
00
2
Q4
6
8
10
12
Q1
Q ua n tity (m illio n s o f ta p e s p e r we e k)
Quantity
Quantity
Fig 4.10
The result is that Natwest shares do go up in price and speculators can sell at a profit
even if the take-over doesn't go ahead at all!
The power of expectations to influence markets should not be underestimated. This is
particularly true in stock markets, money markets and currency markets.
Activity:
A news item suggests that sugar prices in the stores are likely to fall
over the next few weeks as a result of lower world prices. Construct a
diagram to show the effect on the retail market for sugar this week.
I hope you agree that supply and demand analysis can help us understand the way our
market system functions. We can use it to look into the market for goods and services,
for factors of production and for money. You should now be in a position to
understand the implications of intervention in markets and to make your own decisions
about whether intervention may or may not be a good idea in certain circumstances.
You should certainly be able to look at the markets around us in a more informed and
analytical way.
CONCLUSION
In this unit we have developed the ideas first introduced in units two and three. We
have seen how governments and others try to manipulate markets preventing the
normal forces of supply and demand from taking effect. We also saw how the
imposition of sales taxes and subsidies could be analysed using our simple supply and
demand models. The nature of elasticity, both of supply and demand, was shown to be
very important in determining outcomes in tax and subsidy situations. It is perhaps
easier to understand the actions of governments in this context after having examined
the key issues.
Our supply and demand model demonstrated once more that we can analyse quite
complicated market situations and arrive at reasonable conclusions, thus proving its
usefulness
REFERENCES FOR UNIT 4
Economist, 'Schools Brief: State and Market', Feb 17 1996
Hughes, Graham and Ison, Stephen, 'Road Transport Congestion', The Economic
Review, Nov 1993
Lipsey, R and Chrystal, K, Introduction to Positive Economics, OUP, 1995, 8th
edition, Ch 6
Parkin, M et al, Economics, Addison Wesley Longman, 1997, 3rd edition, Ch 6
Sloman, John, Economics, Prentice Hall, 1997, 3rd edition, Ch 3
Smith, Peter, 'Coffee Up', The Economic Review, Sept 1997
Walter, M & Pratt, R, 'A new view on rent control', The Economic Review, Sept 1996