Supply and price determination Overview In the previous chapter you looked at the determinants of demand. In this chapter you will look at the other side of the market, supply. You will identify the ‘determinants of supply and discover how the forces of supply and demand interact to determine the market price. Finally, you will examine the consequences of gov- emment intervention (price regulation and subsidy) for the dental market that was introduced in Chapter 3 Learning objectives After working through this chapter, you will be able to: ‘the factors which influence the supply of a product + show graphically how changes in supply factors influence supply + explain how price is determined by the forces of supply and demand ‘some advantages of markets as a method of resource allocation + give examples of health care markets + describe the consequences of price regulation, subsidies and indirect taxation by the government jm A situation where the price in a given market issuch that the quantity ‘demanded is equal to the quantity supplied. ‘Operational (technical, productive) efficiency Using only the minimum necessary resources +o finance purchase and deliver a particulas activity or sot of activities (ie avoiding waste). Quantity supplied The amount ofa good that producers plan to supply ata given price during an identified period. ‘Subsidy A payment made by the government to a producer or producers where the level of payment depends on the exact level oF output. ‘Supply curve A graph showing the relationship between the quantity supplied of a good andits price when all other variables are unchanged.The supply function In the previous chapter you were told that health service use is determined by supply as well as demand. The following extract by Martin Green (1995) starts by describing the influence of supply, using the example of osteopathy. [LLIJ The free market approach to health care ‘Supply - analysing sellers’ behaviour ‘Weassume that osteopaths want to maximise their profits. Whatare profits and how can they be maximised? Osteopaths ear money (revenue) by selling their services e.g. by ‘massaging away muscular strains. Out of this revenue they need to pay for the factors they use to produce the treatment (costs) e.g. pay their receptionist, pay the rent or pzy for a new ultrasound machine, Profit s the excess of revenue over costs. ‘Seeking to maximise profits leads each osteopath to want to sell more care at higher prices. There Is a relable and predictable positive relationship between price and quanuty ‘supplied. Formally, supply is defined as the quantity of a good or service that sellars are willing and able to sell at every conceivable price. This positive relationship is shown graphically by the supply curve. lf the price changes there Is a movement along the supply ‘curve (Figure 4.1). Price 2 a ao Quantity Figure 4.1, The supply curve for osteopathy treatments ‘SIs the supply curve for treatments. Ac price P’ osteopaths are prepared to sell Q' treatments. ‘When the price ries to P” osteopathe are prepared to sell Q” treatments, Source: Green (1995) If the level of faccor costs change (e.g. nurses wages go up or rent becomes less expensive) ‘then the supply curve wil shift Figures 42 and 4.3)Figure 4.2 Nurses’ wages rise ‘Sis the inal supply curve for treatments. Now nurses! wages rise, pushing up osteopath’ ‘costs. Osteopaths react by being prepared to supply ess treatments at each price. The supply ‘curve shifts inwards to S°S".Ac a price such as P”osteopaths are now only prepared to sell Q” ‘weatmente rather than Q” ‘Source:Greon (1995) Quan Figure 4.3 Rent fill ‘Sie the initial eupply curve for treatments, Now rents flland osteopathe react by being prepared to supply more treatments at each price. The supply curve shifts outwards to SS.Ata price such as PY osteopaths are now prepared to sell Q” ereatments rather than Q. ‘Source:Green (1995) The market ‘We can now put the demand and supply together to gat a picture of the market for ‘osteopathy. This is shown by Figure 44. Notice that there is only one price at which the ‘quanti of creauments people want co buy is the same as the quantiyy tie osteopaths want ‘to sell This is called the equilibrium price (P’ on Figure 4.4). Equilibrium means 2 state of rest where there is no pressure for change.Quantity Figure 44 The market for osteopathy treatments DD shows how many treatments corsumers wish to purchase at each price while SS shows how many osteopaths are prepared to sell.Q’,P’ are the equilibrium quantity and price. Source: Green (1995) D Quantity Figure 45 Excess demand [ACP’ consumers demand Q” but osteopaths are ony prepared to supply Q’ Excess demand leads to the price being bid up to P”. Source: Green (1995) ‘At any other price either buyers or sellers are dissatisfied and act to change the price. Figures 45 and 46 illustrate this. f there is excess demand consumers bid up the price while if there is excess supply sellers aut the price. Both these processes continue until equilibrium is reached. So the free interaction of buyers and sellers in the marker auto- ‘matically leads to a single price at which the quantty traded ‘clears’ the market Le. the ‘quantity supplied equals the quantity demanded.e @ Toe gt ‘Quanticy Figure 4.6 Excess supply AP" osteopath wish to sel Q" but consumers only wish to buy Q’. Excess supply leads to prices being cut to P”. Scurce:Gresn (1995) How the market responds to a shock A shock is anything which moves a market out of equilibrium. Suppose people's incomes rse:how will the osteopatty market react? Figure 47 illustrates this situation. This process will occur whenever there is a shock leading to either 2 shift in demand or supply. D Figure 4.7 Impact of increase in income on market for osteopathy DD and SS are the intial demand and supply curves and P’/Q' is the initial equilibrium. The {increase in income shifts the demand curve oucwards (DD to D’D') reflecting the fact chat ‘osteopathy is a normal good. This shift in demand throws the market out of equilibrium. Now people want to buy Q” treatments at price P’ but the osteopaths are still nly prepared to sell (Q.The resule is excess demand and unsatisfied buyers who react by ‘bidding up’ the price. The ‘market regains equilbrium at price and quantity P'/Q”. Scurce:Green (1995)The market will move out of equilibrium with either excess demand or excess supply appearing Price will adjust until equilibrium is regained. ‘Now, suppose you want to increase the quantity of dental services provided in your country. In the short term this will require dentists and their stalf to work longer hours. Because they value their leisure time they might insist on a higher wage to work these longer, less sociable hours. The wage paid must reflect the opportunity cost of the lost leisure time. In the long term, you might be able to increase the number of dentists. To do this, you would have to raise dentists’ wages to tempt people away from other career paths and into dental school. So in both the short ‘tetm and long term the implication is that to increase output requires making use ‘of more expensive resources. Therefore larger quantities can only be supplied at higher prices. A Pativity A Figure 4.8 shows the supply curve for dental check-ups in a hypothetical city. 5) Price lave! Price (© PP y Quantity (number of checleups) Figure 4.8 The cupply of dental health checks | Suppose that there is an increase in the number of qualified dentists. What do you think would be the effect on quantity supplied, ceteris paribus? Mark and label this ‘effect on Figure 48. 2 Now.suppose that the price charged for a dental check-up falls from p, to p,, ceteris oribus. Mark the effect on Figure 4.8. Feedback | The increase in dentistry graduates is an increase in the number of providers of dental services, including dental check-ups. Other things remaining equal, this means ‘that quantity supplied increases at each price level — that is, the supply curve shifts to the right (a shift from S, to S, on Figure 4.9, resultingin an increase in quantity supplied atthat price from q, to q,).Frice (2) Quantity (number of check-ups) Figure 4.9 Changes in the supply of dental health checks 2 This fallin price can be represented by a downward movement on the supply curve, Dentists are willing to provide fewer check-ups at the lower price. This is shown in Figure 49 by the decrease in quantity supplied from q, to q. 42 ‘Considering the dental practice described in Activity 4.1, what would be the effect on. ‘the supply curve in the following circumstances? | Suppose that there is a movement of dental clinics to an area thatis outside the city. This means that dentists no longer have to pay the high rents of the city centre. Mark this effect on Figure 4.10, ceteris paribus. 5) 4 Quantity (number of cheele-ups) Figure 4.10 The supply of dental health checks2. If receptionists’ salaries Increase, what would be the affect on supply of dental Ccheck-ups.ceters paribus? Again mark the change on Figure 4.10. G Feedback 1 The lower rent charge implies lower costs for all dental activites including check- ups. This means that the dentists will be prepared to supply more dental check-ups fat each price level — that I, the supply curve shifts to the right (from S, to S, on Figure 411), m % 8 Quantity (number of cheele-upe) Figure 4.11 Changes in de supply of dental health checks 2 The higher wage of raceptionists implios higher costs forall dental activity, including check-ups. This means that the dentists will be able to cupply fewer dental check-ups at each price level — that is, the supply curve shifts to the left (from 5, to S, on Figure 4.11). The determination of price You have read about how quantity demanded and quantity supplied respond to price changes. You will now learn how the forces of supply and demand interact to determine marker price and market output. Why do markets automatically move towards equilibrium? Suppose you have @ situation where dentists are selling their services at charges above the masket equi- ibrium charge. Here there will be a situation of excess supply. The quantity of dental services sold is less than the quantity dentists are willing to supply. The dentists still have to spend time in their surgery and pay their staff and rent but they are not selling many services so they find they are making a loss. The only waythe dentist can sell extra services is to lower the charge. Gradually the charge will return to the equilibrium charge because only then are dentists selling the quantity of services that they want and making enough profit. Suppose, alternatively, that dental charges are below the market equilibrium level. Here you have a situation of excess demand. The quantity of dental services sup- plied is less than the quantity demanded at current charge levels. Dentists find that they can sell all the services they want at the current charge level, There will be plenty of consumers who are prepared to pay more than the current charge level but are unable to buy because of the rationing caused by excess demand. Some consumers will offer the dentist a bribein addition to the charge so that they can be seen quickly. Producers will realize that they can raise the charge and still sell all their output. Hence they increase dental charges and increase their profits. It is only when the market is in equilibrium that producers do not have an incentive to change their price. Itis at equilibrium price that producers’ profits (and consumers’ utility) are maximized. A Pativity 43 Suppose the market for dental check-ups is currenty in equlibrium. What would happen to demand i the city’s dental cinics were to relocate outside the city! Markon Figure 4.12 the changes to the market equilibrium price and quantity. Price (©) a Quantity (number of check-ups) Figure 4.12. The market for dental health checks G Feedback Ifthe clinic becomes more distant from the people then this means that travel to the clinic becomes more expensive in terms of time and transport costs. The increasing cost of travel will result na decrease in quantity demanded for the check-up at all prices. The demand curve shifts to the leftIn contrast, the effect of an increase in supply willbe a fallin the equlibrium price (the dental charge) and so will be the effect of fall in demand. Therefore the overall result of the relocation will be 2 fall in price. The overall effect on the quantity traded, however, Is ambiguous because an increase in supply will, ceteris paribus, increase the quantity traded whereas a fall in demand, ceteris paribus, will decrease the quantity traded One effect will partially offset the other. The overall result could be an increase, a decrease or no change in the quantity traded. It depends on the responsiveness of demand to the increase in travel costs and on the responsiveness of supply to the fallin costs. You will learn more about measuring and analysing responsiveness in the next chapter. Markets for health care Now that you have an idea of what determines supply and demand and of the concept of market equilibrium, you are going to consider the relevance of these ‘theories to markets for health cate. The following extract by Martin Green (1995) discusses the key issues. Note that Pareto efficiency Is the same as allocative efficiency. The term ‘productive effi- ciency’ isthe same as operational efficiency and means that, for worthwhile pro- grammes, the best use is made of the available resources to meet the programme's objective. This will be discussed more in Chapter 10. [Ly The free market approach to health care (continued) The market as allocation system ‘We have just demonstrated that our free market will automaticaly produce an equilibrium price and quantity. Itis this which makes ita very powerful allocation system. This is what ‘Adam Smith referred to as ‘The Invisible Hand’. Whe decider how much astoapathy is to be praduced? The answer is consumers. They ge ‘oucand buy osteopathy treauments and the price they are prepared to pay sends signals to the osteopaths. The osteopaths respond by producing ether more or less treatment. The ‘market not only allocates resources automatically, it does so efficiently. Providing certain conditions are met, the free market will achieve a Pareto efficent allocation. How does price mechanism lead to a Pareto efficient allocation? For the consumer, the price meas- ures the benefit or utility that the consumers expect to recelve from consuming the unit. Tobe precise, the demand curve reflects the marginal utlty (extra benefit) that consumers receive from consuming each unit For the producer or seller, the price measures the cost of the resources involved in the production Including the supplier's own time and effort. ‘Again to be precise, the supply curve reflects the seller's margnal costs (tie cost of producing one extra unit). Thus when a market is in equilibrium marginal benefit equals ‘marginal cost. The benefit received from the last unit consuned will exactly equal the resource cost of producing that unit. This fulfls the condition for allocative efficiency. Producers chasing maximum profits will always choose the least cost combination of factors to produce given output Consequently, the free market will also be productively efficient.Regulating markets ‘You have seen that markets can be very dynamic and efficient mechanisms for the allocation of resources. You have also considered the ways in which markets are ‘used to supply health services ia your country. In the next couple of activities you will look at some of the ways in which governments can try to achieve policy ‘objectives by manipulating or regulating markets.Price regulation ‘As you have already seen, in market economies price is the mechanism through which markets achieve equilibrium. Using the example of the market for dental check-ups, suppose the Ministry of Health decides to limit the maximum price that can be charged (a price ceiling) so that poorer people can afford to go for a check-up. Thereare a number of possible consequences. ‘The effect of a price ceiling can be shown graphically as follows: a price ceiling (set below the market equilibrium) in the market for dental check-ups would cause the supply of check-ups (q, on Figure 4.13) to fall as fewer dentists will want to provide ‘them at the lower price. Price calling " o % ‘Quantity (number of check-ups) 13. The market for dental health checks witha price ceiling Figure Quantity demanded, qy, on the other hand, would increase as more people could afford them. This would result in excess demand, q-g...Patients would now have to incur additional search costs, looking for a dentist prepared to provide a check- up, and they would have to wait longer for an available appointment time. They ‘might be faced with additional payments to the dentist, perhaps as under-the-table bribes or possibly as charges for hidden extras (waiting room use for example). ‘These extra costs associated with consumingdental health checks might mean that poorer families are no more able to afford them than they were before the price ceiling was imposed. ‘One likely alternative is that instead of finding themselves faced with additional charges patients might find that the quality of the check-up diminishes. Perhaps ‘the dentist spends less time on each check-up and is less thorough so that they can fitin more check-ups for the same cost. In health services where charges or budgets are held artificially low, quality of service is often found to be reduced. ‘Now assume that the Ministry of Health abandons its policy of dental charge ceil- ings. Suppose instead that the Ministry of Internal Affairs decides to impose a ‘minimum wage for receptionists. Applying the same logic as in the example ofrice ceilings, what would be the consequences for dental receptionists and the ‘market for dental services? Aminimum wageis an example of a price floor. A price floor isa law that restricts the price of a commodity falling below a specific level. A wage level is the price of labour. Its effects are shown in Figure 4.14. Minimum woge Wage rate Ww oo os Quantity (number of dental receptionists) Figure 4.14 The market for dental receptionists with a price floor You can see from the diagram that a price floor above the market equilibrium creates excess supply — far more people are prepared to work as dental reception- ists than dentists are prepared to hire. The effect is to reduce the number of receptionists employed or perhaps to reduce the number of paid hours. It will also impose search costs on individuals secking receptionist work. It may also mean ‘worse working conditions for those who are able to retain their positions. Perhaps they will be expected to work longer hours without additional pay. Some employers may illegally continue to pay wages that are below the minimum wage. If the minimum wage does effectively raise the costs of dental services then you would expect fewer services to be provided and the level of dental charges to tise. ‘The regulation of prices is problematic. Not only might a price ceiling have the ‘opposite effect to the desired objective of raising service use, but it might also encourage corruption. Taxes and subsidies ‘The Ministry of Health isstill interested in increasing the number of check-ups. AS a replacement for the unsuccessful price ceiling policy the Ministry is considering subsidizing dental health checks by £5 per check-up. A subsidy is a payment made by the government toa producer or producers (in this case dentists) where the level cof payment depends on the exact level of output. A dentist providing 100 check- ‘ups per month will receive a payment from the Ministry of £500 per month. Thesubsidy has the same effect as a fall in cost because from the perspective of the producer this is exactly what it is. Hence the supply curve shifts downwards (ie. to the right) as a result of the subsidy. More precisely, the supply curve shifts downwards by exactly £5 at each output level - see Figure 4.15. Ssub Price (2) F sub ‘Quantity (number of check-ups) Figure 4.15. Efect of a subsidy on the market for dental health checks ‘Therefore the effect of the subsidy is to lower price and increase output. Note, ‘though, that the fall in price is not as large as the subsidy. The benofits of the subsidy are distributed between the consumers of dental check-ups and the dentists. By how much the price falls and by how much output increases depends upon the responsiveness of demand and supply to price. For example, Figure 4.16 shows a pe Psub pos Price (€) # Gsub ‘Quanity (number of checkups) Figure 4.16 Efact of subsidy on the market for dental health checke where demand ie very responsive to price‘market where demand is very responsive to price (ie. the demand curve is relatively flat). In this case, output increases considerably. Most of the subsidy is absorbed by the dentists so that the price does not increase very much. Alternatively if demand is ‘much less tesponsive to price (i.e. the demand curve is relatively steep) as in Figure 4.17 then the number of dental checks does not increase very much although price drops substantially. Price (2) au Quantity (number of check-ups) Figure 4.17 Effect of a subsidy on the market for dental health checks where demand is less responsive to price ‘The Ministry might want to collect some data to try to estimate the responsiveness of demand. If demand is very responsive then only a small per unit subsidy is required to substantially increase the number of dental health checks taken every year.