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CHAPTER 2 Demand, Supply, and Market Barun Kanjilal You can make even a parrot into a learned economist – all it must learn are the two words “supply” and “demand”. Paul A. Samuelson “Econ...

CHAPTER 2 Demand, Supply, and Market Barun Kanjilal You can make even a parrot into a learned economist – all it must learn are the two words “supply” and “demand”. Paul A. Samuelson “Economics” McGraw-Hill Book Company, 13th Edition, p-55 2.1. Introduction Society has to find some way of deciding what, how, and for whom to produce. In Chapter 1, we said that, in a free-market economy, market and prices play a very important role in allocating resources between competing uses. We now examine markets in detail. The framework of analysis is very general and must be mastered by anyone who wishes to understand how our own society solves the basic economic problems. It can be applied to the market for motor cars, labour, apples, haircuts, and health care. Demand and supply are two essential ingredients of a market. In the following sections, we will thus present the fundamental tools and techniques associated with demand, supply, and their interactions in a free and a not-so-free (or, chained) market. At the end (Section 2.6), Elasticity, an important concept, especially associated with demand, will be separately discussed. 2.2. Demand and Supply Curves The Demand Curve Let us start with demand. Demand is the quantity of a good, buyers wish to purchase at each conceivable price. The starting proposition, therefore, is that the quantity of a good that people will  2.2 buy at one time depends on its price. What is the nature of the dependence? As you may have noticed in real life, the higher the price charged for a good, all other things remaining the same, the less of it people will be willing to buy. Conversely, the lower its market prices, the more units will be demanded. The above relationship between price and quantity demanded is called the demand schedule, or when translated in geometry, the demand curve. Table 2.1 presents a hypothetical demand schedule for a hospital’s luxury suites. At any price (P), such as Rs. 4000 per suite, a definite quantity of suites will be demanded by all the consumers in the market – in this case 1 suite per night. In other words, price is so high that only one patient opted for a suite. Table 2.1: Demand Schedule for luxury suites in a hospital Price (Rs.) Quantity of suites ( per suite per demanded night) P Q 4000 1 3500 3 3000 4 2000 6 At a lower price, say Rs. 3500, the quantity purchased is even greater, 3 suites. At lower P of Rs. 3000, the quantity demanded is greater still – namely, 4 suites. Thus, by lowering P enough, the hospital could coax out sales of more than 6 suites per night.  2.3 The graphical depiction of the demand schedule is called the demand curve. The demand curve presented in Figure 2.1 below shows the quantity of suites demanded at each level of the price of a suite. Note that the curve slopes downward, going from Northwest to Southeast. That means quantity and price are inversely related, Q going up when P goes down. This important property is given a name: law of downward-sloping demand. In the demand curve for luxury suites, prices are measured on the vertical axis while quantity demanded is measured on the horizontal axis. Each pair of (P,Q) numbers from Table 2.1 is plotted as a point (A, B, C, and E) and then a smooth curve is passed through the points to give us a demand curve (DD). Figure 2.1: Demand curve for luury suites in a hospital 5000 Price of a suit per night (P) 4000 D 4000 3500 3000 3000 D 2000 2000 1000 0 0 1 2 3 4 5 6 7 Quanity Demanded of Suites (Q) Why Q and P are inversely related? For two main reasons. First is the substitution effect. When the price of a good rises, I naturally try to substitute it by some other similar product. For example, if a hospital luxury suite becomes costlier, some people may switch to general cabin (thereby causing a drop in demand for luxury suites). A second factor, known as the income effect, comes into play because  2.4 when a price goes up, I find myself poorer than I was before. If hospital suites are more expensive, I have in effect less income, so I will naturally curb my consumption of luxury suites and other goods. Other determinants of demand We have, up to now, mentioned price as the only determinant of quantity demanded of a good. But there are other factors, which also weigh importantly. Majors among them are: average level of income of consumer, the size of the population, the prices and availability of related goods, individual tastes, and other special factors. Let us take them one by one. The average income of consumers is a key determinant of demand. As people’s income rise, they tend to buy more of almost everything – apples, oranges, health care, etc. The size of the market – measured say by the population – also affects the amount demanded at each price. New Delhi tends to buy 10 times more hospital care than does Jaipur (at the same price). The price and availability of related goods will also influence the demand for a commodity. There are two types of related goods: (a) substitute (such as, pens and pencils, condom and oral pill, etc.), and (b) complementary (pen and ink, doctors and medicine, etc.). Demand for good A tends to be low if the price of substitute product B is low (for example, demand for non-qualified doctors will be lower if the qualified doctors reduce their fee). In the case of complementary goods, demand for good A tends to be low if the price of complementary good B goes up (for example, demand for disposable syringe will be lower if the price of Injectable medicine goes up). In addition to these objective factors, we must add a set of subjective factors called tastes or preferences. In part, these are shaped by convenience, custom, and social attitudes. For example, the  2.5 recent emphasis on health and fitness has increased the demand for jogging equipment, health foods, and sports facilities while reducing the demand for fatty foods and cigarettes. Finally, individual goods will generally have particular factors behind their demand. For example, demand for health care depends (in addition to the above factors) on the accessibility, demographic factors (such as age and gender), information on availability of health care, and so on. Chapter 4 will discuss these factors in details. Shifts in demand curve The demand curve will have a shift when factors other than price of the commodity change. For example, even if the price of medical care remains the same over time, its demand will increase possibly due to (a) increase in average level of people’s income, and/or, (b) increase in population, and/or (c) people’s growing dependence on medical care, and/or (d) increasing burden of disease, and so on. In all cases, the demand curve will shift upwards as presented in Figure 2.2 (from DD to D’D’). In other words, at each price there will be more (or, less) demand when other factors change. Figure 2.2: Increase in demand for medical care P D’ D D’ D Q  2.6 The Supply Curve Let us now turn from demand to supply. By supply we mean the quantity of a good that businesses are willing to produce and sell at each conceivable price. Here again we relate the quantity supplied of a good to its market price, holding equal other things, such as costs of production, the prices of substitute goods and the organisation of the market. Like demand schedule we also have the supply schedule, which shows the relationship between the market price of a commodity and the amount that producers are willing to produce and sell. Table 2.2 shows a hypothetical supply schedule for luxury suites in a hospital. Figure 2.3 plots the same data as the supply curve of luxury suites. Table 2.2: Supply Schedule for luxury suites in a hospital Price (Rs.) Quantity of suites ( per suite per hospital will supply night) Q P 4000 7 3500 5 3000 4 2000 2 1000 0  2.7 Figure 2.3: Supply curve for luxury suites 5000 S Price of a suit per night 4000 4000 3500 3000 3000 2000 S 2000 1000 1000 0 0 1 2 3 4 5 6 7 8 Quantity Supplied of Suites (Q) The small squares in Figure 2.3 represents (P,Q) combinations from Table 2.2. A curve is passed through these points to give the upward- sloping supply curve (SS). The upward slope of the curve indicates that there is a direct relationship between price of a commodity and its quantity supplied. In other words, the producers will be willing to sell more only at a higher price. Why? One important reason is found in the law of diminishing returns, which states that given all other inputs fixed, if one input is increased total output will increase but less than proportionately. If society wants more hospital suite services, then more and more labour will have to be added to the same hospital infrastructure. Each new worker will – according to the law of diminishing return – be adding less and less extra product; hence the price needed to coax out additional product will have to rise. By raising the price of hospital suites, society can persuade hospital owners to produce and sell more suite services, and the supply curve for suites therefore is upward sloping.  2.8 Other determinants of supply Just as we looked behind demand to uncover its major determinants (other than price), we now examine the forces operating on supply. The fundamental point to grasp about producers’ supply behaviour is that firms supply goods for profit, not for fun or charity. As a result, a key dominant factor lying behind supply decisions is the costs of production. When production costs are very high relative to price, producers will produce little or may quit producing. Costs of production, in turn, primarily depend on two factors: technological advance and prices of inputs. Technological advance usually reduce the per unit production costs and thus increase the supply. For example, advancement of diagnostic technology in health care has been able to make diagnosis faster and thus, to reduce the cost of total treatment. Similarly, if technology does not change, but the input prices change the costs of production and thereby supply will be affected. For example, if AC machines are more expensive, hospital luxury suites will be more expensive and supply of suite services will be reduced. A second major factor affecting supply stems from the prices of production substitutes; these goods are one that can be readily substituted for one another in the production process. Hospitals produce luxury as well as ordinary (cabin) services. If the price of luxury suites increases, hospitals will have incentive to reduce the supply of ordinary services. A third factor affecting supply is the market organisation. If there is monopoly (i.e., only one seller) in the market, price will tend to rise at each level of output. For example, if there is only one hospital in the town, the supply price of luxury suites will be higher in comparison to the town where there is more than one hospital.  2.9 Finally, there are special factors. The weather exerts an important influence on farming. Similarly, government policies to encourage the growth of private hospitals will have a boosting effect on the supply of private hospital care. Opening insurance market will have a positive effect on hospital care in India. Shifts in supply curve Supply curve shifts, and supply is said to change, when any factors other than the commodity’s own price change. To consider the supply shift, take the private hospital care market. Supply of private hospitals might increase because government removed some of the regulatory burden on the market, or because the new diagnostic machines have become cheaper. As a result, the supply of private hospital care would tend to increase. As shown in Figure 2.4, at each price producers will supply more hospital care and the supply curve shifts to right. Figure 2.4: Increased supply of hospitals S S’ S S’  2.10 2.3. Equilibrium in a Market We have seen how consumers demand different amounts of a commodity (for example, hospital luxury suites) as a function of its price. Similarly, producers willingly supply different amount of this and other goods depending on their prices. What happens when suppliers and demanders meet? The answer is that the supply and demand forces in the market will produce an equilibrium price and equilibrium quantity, or market equilibrium. The market equilibrium comes at that price and quantity where the supply and demand forces are in balance. Let us work through the luxury suite example in Table 2.3 to see how supply and demand determine a market equilibrium; the numbers of this table come from the data shown in Tables 2.1 and 2.2. We want to know the exact level that price and quantity will settle on. Neither the supply schedule nor the demand schedule alone can tell us the answer. Rather the answer will depend on the interaction of both the forces.  2.11 Table 2.3: Combining demand and supply schedules for luxury suites in a hospital (1) (2) (3) (4) (5) Price (Rs.) Quantity of Quantity State of Pressure ( per suite suites of suites Market on price per night) demanded supplied P 4000 1 7 Surplus Downwar d 3500 3 5 Surplus Downwar d 3000 4 4 Equilibri Neutral um 2000 6 2 Shortage Upward To find the right level of price and quantity, proceed the way an intermediary or broker might – by trying to find a price at which the desired amounts to be bought and sold just match. Could a price of Rs. 4000 bring this balance? Clearly not, as at Rs. 4000, hospitals will be supplying 7 suites (per night) but the demanders will be hiring only 1 suite. The amount supplied at Rs. 4000 will thus exceed the amount demanded, and 6 suites will remain unoccupied. Because too many suites are chasing too few consumers, the suite rent will tend to fall, as shown in column 5 of Table 2.3. Let us try another price, say, Rs. 2000. At this price consumption exceeds production (i.e., shortage). People will scramble around for a suite, and by doing so, they will tend to bid up the suite rent. A little scrutiny of Table 2.3 will reveal that only at Rs. 3000 will the amount demanded by consumers exactly equal the amount willingly supplied by producers – in each case 4 units. At Rs. 3000,  2.12 price is at equilibrium because there is no surplus or shortage that would create upward or downward pressure on price. Everybody is satisfied at this price – demanders, suppliers, and the broker. The same story is told in Figure 2.5. Here we have placed the demand curve from Figure 2.1 right on top of the supply curve from Figure 2.3. They intersect each other at point C. At any point above C, there is surplus (i.e., supply greater than demand) which creates downward pressure on price until it converges to Rs. 3000. Similarly, at any point below C there is shortage which creates upward pressure on price until it converges to Rs. 3000. Figure 2.5: Graphical presentation of equilibrium Surplus P D S 4000 3000 C Equilibrium point 2000 Shortage D 1000 S 1 2 3 4 5 6 7 Q We see that the balance of forces or equilibrium comes at point C, where the supply and demand curves intersect. At point C, with a price of Rs. 3000 and an amount of 4 suites, the quantity demanded and supplied are equal. There are no shortages or surpluses; there is no tendency for price to rise or fall.  2.13 2.4. Demand and Supply Shifts Demand shift The demand-supply framework described above is so powerful that they can explain most of the economic events and their impacts on a particular market. Let us consider, for example, consider the market for private hospital care. In Figure 2.6, DD and SS represent the demand and supply curves of the market respectively. They intersect at point E and the equilibrium price and quantity are P 0 and Q0 respectively. Now suppose there is a change in disease profile of the population. More and more have become vulnerable to diseases, which need secondary or specialised hospital care (for example, heart diseases). Given the wretched condition of public hospitals, more and more people now want to seek private hospital care. As a result, the demand curve shifts up (from DD to DD) and a new equilibrium is reached at point E. Figure 2.6: Effect of demand shift: private hospital care P S D’ D P1 E’ E P0 S D’ D Q0 Q1 Q  2.14 We now see a change in price and quantity – price has increased from P0 to P1. Why? Because, after the demand curve shifts, at the old price (P0) consumers want more than suppliers produce. Shortages arise. A scramble for admission in private hospitals sets in. Prices are bid upward until at E supply and demand come back into balance. Supply shift We can also use our apparatus to examine the effect of forces that change supply. Consider again the case of private hospital care market. We start with the same scenario – E being the initial equilibrium point. Now suppose government relaxes some regulatory burden on the growth of private hospitals. As a result, more hospitals enter into the market leading to an upward shift of supply curve from SS to SS. This generates a new equilibrium point E and a lower price P1. Figure 2.7: Effect of supply shift: private hospital care P S D S’ E P0 P1 E’ S S’ D Q0 Q1 Q  2.15 Why price goes down when supply shifts upwards? Due to increase in number of hospitals, there is now surplus of hospital care at the old price. The result: hospitals are forced to reduce price. 2.5. Free versus Chained Market The above discussion is based on the assumption that market is free, that is prices are determined purely by the forces of supply and demand. Here, the non-market forces (such as government policy and regulations) may shift demand and supply but makes no attempt to regulate prices directly. Any deviation from this assumption or, alternatively, any intervention of forces, other than supply and demand, on prices can get the market chained. It is sometimes good for the society to chain a free dog especially when it has a potential to be a monster. The same is true for market also. As mentioned in Chapter 1, market without chain may go against a society’s interest. This is especially true when equity in consumption or production is the major concern of the society. For example, if the society perceives that P0, the price of private hospital care, is too high for the needy but poor people, the government may want to control the price by imposing some regulation on price. It may ask the hospitals not to charge more than P1 – a price much lower than the free market price, P0. The immediate impact of this decision would be emergence of an artificial shortage in the market, Q2Q0 in Figure 2.8. Why? Because, at free market situation, the hospitals were willing to supply Q0 at P0 price. Now the restriction has forced them to supply Q 2; hence the shortage.  2.16 Figure 2.8: Effect of price control: private hospital care market P S D E P0 P1 D S Q Q2 Q0 Q1 1 Chaining a market may, however, do more harm than good if it is not followed by an equitable distribution policy. It is true that the ceiling price P1 allows some of the poor to buy private hospital care they could not otherwise have afforded. But the restriction would also encourage the providers reserve supplies for selected people, not necessarily the poor. Indeed, the suppliers may even accept bribes from those who can afford to pay extra to jump the queue. We should then say a ‘black market’ or an ‘underground market’ or a “parallel market” had developed. Indeed, a restricted market always has a tendency to quickly build its underground or parallel free counterpart if restriction is not followed by a distribution policy. Take, for example, the drugs market in government hospitals. Drugs are free or very cheap at government hospitals. That means prices are kept artificially low for the poor. It is assumed that the poor will get their drugs free from the hospital. But, then why there are so many private pharmacies outside the hospital? It is also observed that most of their clients are poor who have to pay an exorbitant price for the drugs. Why? Because, the artificial restriction (that, within hospitals, prices will be lower than market prices) creates a shortage  2.17 and provides an incentive to establish a free parallel market for drugs. Since the poor are not properly identified and “drugs trafficking” from hospitals to outside are not effectively restricted, it is a common experience that poor people have to buy the drugs from outside which they were supposed to get free in the hospital pharmacy. One way to tackle this problem is to back up price regulation with government-organised rationing by quota to ensure that available supply is shared out fairly and equitably. In this case, a proportion of the existing supply (i.e., Q2) may be earmarked for poor people and the rest may be distributed, either on a first-come-first-serve basis, or equally among the rest. In the end, price control may have a strong disincentive effect on the producers. If the controlled price is consistently kept below the market price, producers may quit the market and start operating in a parallel market. One reason why government doctors get involved in private practice is that their official salaries are below their market value. Exercise The shortage of qualified nurses is a chronic problem for most developing countries. Due to social constraints, low salary, perceived hardship, etc. supply of qualified nurse is a major problem in providing good quality hospital care. Do a simple supply-demand analysis of this market. Specifically, 1. Draw a demand and a supply curve of nursing care. 2. Show and analyse the equilibrium in this market. 3. Present remuneration of a qualified nurse is less than what it should be under in a free market. What is the problem? How would you show its impact in the diagram?  2.18 4. What type of solution would you suggest to deal with this chronic problem? 2.6. Concept of Elasticity Elasticity provides a way of measuring how sensitive demand or supply is to factors such as a change in price. Take the relationship between price and quantity demanded. We know that if price rises then people will buy less but we do not know how much less. Price elasticity of demand allows us to calculate this. Price elasticity of demand (PED) The formula for price elasticity of demand (PED) is % change in quantity demanded PED = % change in price of the good So if the price of osteopathy rose by 10% and the quantity bought fell − 5% by 5% then the PED would be = –0.5. This tells us that + 10% demand for osteopathy is not particularly sensitive to changes in price. It is what economists call price inelastic. Take another example, if the price of eye tests fell by 20% and the quantity of eye tests bought rose by 30% then the value of PED + 30% would be = –1.5. In this case the demand for eye tests is price − 20% elastic, i.e. sensitive to changes in price. Notice several things about PED. First, the value of PED is always negative reflecting the inverse relationship between price and quantity  2.19 demanded. Second, PED is just a number, it is not expressed in terms of any particular units. How do we know whether demand is elastic or inelastic? The rule is: Demand is price inelastic whenever the % change in price leads to a smaller % change in quantity demanded. This gives PED values between 0 and –1. Demand is price elastic whenever the % change in price leads to a larger % change in quantity demanded. This gives PED values between –1 and –infinity. Price elasticity of demand allows us to predict what will happen to spending when price changes. Take the example of the increase in the price of osteopathy used above. As the price of osteopathy rises, people will buy fewer treatments but will they spend less? Suppose the price of a treatment rose from Rs. 200 an hour to Rs. 220 (a price increase of 10%). At Rs. 200 an hour, consumers were buying 1,000 treatments per week and spending Rs. 200,000. After the price rise they bought 950 a week (a fall of 5%) but their spending had risen to Rs. 200,900 (= 950  Rs. 22). So the answer in this case is no. People spend more on osteopathy after the price rise because the percentage increase in price is greater than the percentage fall in sales volume. Therefore, although osteopaths sell fewer treatments, the higher price of each treatment more than offsets the lost quantity of treatments sold. This gives us a general rule: If PED is inelastic, a rise in price will lead to people spending more while a fall in price will lead to people spending less. If PED is elastic, a rise in price will lead to people spending less while a fall in price will lead to people spending more. Other forms of elasticity  2.20 The concept of elasticity can be applied to the impact of both income and changes in the prices of other goods on quantity demanded. Income elasticity of demand (IED) measures how demand reacts to changes in income. The formula for income elasticity of demand is: % change in quantity demanded IED = % change in income If the result is positive then the goods are normal, if it is negative then they are inferior. All the evidence suggest that health care is not only a normal good but that it is income elastic, i.e. rising income leads to a greater % rise in demand for health care. Cross price elasticity of demand (CED) measures how demand reacts to changes in the price of other goods. The formula for cross price elasticity of demand is: % change in quantity demanded of a commodity CED = % change in the price of another commodity If cross price elasticity of demand is positive then this indicates that the goods are substitutes (e.g., two specialists in the same category). If it is negative then the goods are complements (e.g., X-ray machine and X-ray plates). Finally, the concept of elasticity can be applied to supply. Price elasticity of supply (PES) measures how sensitive quantity supplied is to a change in the price of the good. The formula for price elasticity of supply is: % change in quantity supplied PES = % change in price of the good  2.21 Price elasticity of supply is always positive, reflecting the positive relationship between price and quantity supplied. PES becomes more elastic over time. This reflects the time it takes to switch resources into a market. For instance, in health care the PES is likely to be fairly inelastic in the short run but much more elastic in the long run. Even if price rises significantly it will take time for firms to react and to produce more health care. For instance, to deliver more health care new hospitals will need to be built or existing hospitals extended and extra doctors and nurses will need to be trained. All of this takes time. The concept of elasticity has helped to make our market theory more sophisticated. However, the model still suffers from being rather static.