“Who would be a leader must be a bridge” Colega Consulting Ltd

Bridgend, Wales © Dr Charles Smith, Director

Applied micro-economics:

simple tools for complex problems

Dr Charles Smith

Colega Consulting Ltd

&

University of Wales

Supply & Demand Analysis

• Remember: AS and A2 are SYNOPTIC. AS topics are not “finished with” at A2; they are built upon, and you have to step up a gear.

• Generally speaking S & D analysis• … at AS deals with cases where market equilibrium is

ACHIEVED• … at A2 deals with cases where market equilibrium is

PREVENTED

Equilibrium prevented:Equilibrium prevented:

Maximum and minimum price controlsMaximum and minimum price controls

I have deliberately used diagrams which, with practice, can be reproduced BY YOU under exam conditions.

Often in economics, “a picture is worth a thousand words” - if it is used properly.

Let’s look at a versatile diagram which we can use to help analyse some important economic issues, and answer a variety of exam questions.

Maximum and minimum price controlsMaximum and minimum price controlsThe diagram on this page looks complicated at first sight, but DON’T PANIC, because…

S

EPE

PMIN

PMAX

O

X

Z S2

S1

D1

D2

W

Y

Q1Q1 QE Q2

PRICE

QTY

D

• you’ll rarely (probably never) need the whole diagram

• you can use a part of the diagram depending on the issue that you are discussing

• the crucial features are points w, x, y and z, which we will discuss in detail

Maximum price controlsMaximum price controls

This diagram shows the effect of a CEILING PRICE or a MAXIMUM PRICE CONTROL.

The maximum price is shown as the horizontal line Pmax

QTY

PRICES

E

PMAX

O Q1 Q2

D

Maximum price controlsMaximum price controlsTo avoid an excess demand of Q1Q2 the price fixing authority must

EITHER• Reduce demandOR• Increase supply

QTY

PRICES

E

PMAX

O Q1 Q2

D

Maximum price controlsMaximum price controlsIn other words, the price fixing authority must

EITHERShift the demand curve to D1 (aim at equilibrium point ‘w’)ORShift the supply curve to S1 (aim at equilibrium point ‘x’)

Unless the authority can influence either supply or demand, the maximum price CANNOT be held and the market will revert to equilibrium point ‘E’

QTY

S

E

PMAX

O

xD1

w

Q1 Q2

PRICE

D

S1

Minimum price controlsMinimum price controls

This diagram shows the effect of a FLOOR PRICE or a MINIMUM PRICE CONTROL.

The minimum price is shown as the horizontal line Pmin

QTY

E

PMIN

O Q1 Q2

PRICE

D

S

Minimum price controlsMinimum price controlsTo avoid an excess supply of Q1Q2 the price fixing authority must

EITHER• increase demand

OR• reduce supply

QTY

E

PMIN

O Q1 Q2

PRICE

D

S

Minimum price controlsMinimum price controlsIn other words, the price fixing authority must

EITHER• Shift the demand curve to D2 (aim at equilibrium point ‘y’)OR• Shift the supply curve to S2 (aim at equilibrium point ‘z’)

Unless the authority can influence either supply or demand, the minimum price CANNOT be held and the market will revert to equilibrium point ‘E’

QTY

S

E

PMIN

O

y

D2

z

Q1 Q2

PRICE

D

S2

Table of outcomes

New equil-ibrium

point

Price, compared with market equil-ibrium

Quantity, compared with market equil-ibrium

ww lowerlower lowerlower

xx lowerlower higherhigher

yy higherhigher higherhigher

zz higherhigher lowerlower

ALL POSSIBILITIES ARE EXHAUSTED

S

EPE

PMIN

PMAX

O

x

z S2

S1

D1

D2

w

y

Q1Q1 QE Q2

PRICE

QTY

D

New equil.point

Price, compared with market equil-ibrium

Qty. compared with market equil-ibrium

EXAMPLE(S) METHOD(S)

ww lower lower Rationing•Ration books,•Queues, etc

xx lower higher Merit goods Subsidy

yy higher higherBuffer stocks

Intervention buying

zz higher lowerDe-merit goods Tax

Problem:

Traffic congestion

Road-space strategies

EXCESS DEMAND AT ZERO PRICE

E

S

Qty

Price

D

QE Q1O

THE MARKET

FOR

ROAD-SPACE

Road-space

strategies (continued)

S

QTY

PRICE

D

QE Q1O

POLICY

OPTIONS

F G

S1

D1D2

PEE

S2

Road pricing : key issues

•Negative externalities• Road traffic a demerit good

•Elasticities• Alternatives (eg public transport) needed for a

substitution effect to take place• Public vs. private transport

•Average versus marginal prices• Decisions made on the margin are generally better

than decisions based on averages

•Political will

Problem:

Side effects of tobacco, sugar and alcohol

consumption (“externalties”)

• Tobacco & alcohol are already heavily taxed & regulated.

• New proposals:–A tax an sugary drinks;–A minimum price for alcoholic drinks.

• WHY a tax on one but minimum price on the other?

Minimum price controlsMinimum price controls

QTY

E

PMIN

O Q1 Q2

PRICE

D

S

Z Y

Minimum price controlsMinimum price controlsSHIFT OR MOVEMENT ALONG?SHIFT OR MOVEMENT ALONG?

A TAX aims to reach point Z by shifting the supply curve to the left (the tax in effect raises the costs of production)

A MINIMUM PRICE aims to reach point Z by imposing a price on consumers which causes them to MOVE ALONG their demand curve from E to Z

QTY

E

PMIN

O Q1 Q2

PRICE

D

SZ

S2NEITHER does what arguably really needs to be done, which is shift the demand curve to the left.

To do this, it would be necessary to influence consumer tastes and preferences, e.g. through education – a long term process

Possible matters to consider:

* Elasticities; impact and incidence of indirect taxes

* Legislation – raising minimum age, banning* Grey markets and smuggling, need for POLICING of policies* Education linking in to time lags*Negative externalities as to reasons why the government might want to intervene.

*Government failure… How do they know the right minimum price, or the correct level of tax

*Asymmetric information.

*Impact on jobs etc for the industry

* Distributional issues (effects on rich & poor)

Particularly evaluative points…•Minimum price gives a windfall to producers; taxes give a windfall to the government, depending on price elasticities of demand AND supply •Is the ideal state ZERO consumption? In which case there is NO windfall for anyone (and possibly no industry!)•Nanny state verses freedom of choice•Impact of policies on different groups: producers/ consumers, exporters/ importers, manufacturers/ service providers, taxpayers/ government, etc etc•Are minimum prices considered (by politicians) easier to get away with than taxes?

Further reading:Smith, Smith & Etherington

Revision Express: Economics

Longman – Pearson

END