Demand and Supply Analysis: Top 7 Applications

The following points highlight the top seven applications of demand and supply analysis
under perfect competition. The applications are: 1. Application on Farm Products 2.
Price Control 3. Black Market 4. Consumer’s Surplus and Producers’ Surplus 5.
Minimum Wage Legislation 6. Subsidy 7. Taxation.
Application # 1. Application on Farm Products:
There is perfect competition in the market for farm products. Farm products like wheat or rice
are usually homogeneous. They are produced by many farmers and each farmer is producing
a very small portion of the total supply of a particular farm product, say wheat.
Since total farm product is the sum of the production of many farmers, no individual producer
or farmer can affect its market supply. Each producer is a price-taker in the product market.
He cannot affect its price and has to accept the prevailing market price. Thus, the market in
which the farm products are sold and bought is perfectly competitive.
If the demand and supply forces bring a fall in the price of a farm product, the producer of
that particular product shall have to produce more to maintain his income. In fact, there is
instability and uncertainty in agriculture. As pointed out by Samuelson, “Farming is an up
and down industry.”
This is because it depends upon the vagaries of nature. A drought or heavy rains may damage
the crop and bring misery to the farmer. On the other hand, timely rains and good weather
conditions may lead to a bumper crop and bring prosperity to them.
Moreover, agriculture is subject to the law of diminishing returns earlier than in
industry because:
(i) Land is limited in supply,
(ii) Agricultural operations are largely dependent on nature, and
(iii) Economies of large scale production are not available, except on very large farms in
countries like America and Australia.
Given these peculiar conditions of farm operations, the prices of farm products are
determined by demand and supply.
Demand for Farm Products:
Farm products generally fall under the category of necessary goods. So their demand is less
elastic. This means that when the price of a farm product falls, its demand will not rise much
and when its price rises, its demand will not fall much. Changes in farm prices do not
influence the demand for them because a consumer has to consume these products under all
circumstances.
The consumer spends only a small portion of his income on them. There are no substitutes for
these products. The less elastic nature of farm products also implies that when there is a
bumper crop, their supply in the market increases. Demand being less elastic, the price of the
farm products will fall.
Supply of Farm Products:
The supply of farm products is also less elastic. The less elastic supply is due to the
inelasticity of the factors of production at the disposal of the farmers. The cultivable land of
producers is fixed and unchangeable. Similarly, farm labour lacks in free mobility.
Moreover, all costs of farm production are fixed and the proportion of variable costs is very
insignificant. So whatever quantity a farmer produces, his costs do not change. He will not,
therefore, curtail the supply. Rather, he will produce more, in the hope of compensating
himself when the price of his product falls. Thus supply increases.
Price Determination:
The price of a farm product is determined at a point where its demand and supply curves
intersect each other. This is shown in Fig. 1 where D and S are demand and supply curves
respectively which are less elastic. Both intersect at point E and determine OP equilibrium
price and OQ quantity demanded and supplied.

Suppose the supply of farm product, say rice, increases and the supply curve shifts to the
right from S to and the new equilibrium is established at E1 But the demand remains
unchanged which brings down the price to OP1 With the fall in price, the supply increases to
OQ1because the producers want to maintain their former levels of income. But the total
revenue of the producers falls from OPEQ to OPE1Q1 as measured by shaded rectangles.
Agricultural Price Support:
The government in developing countries like India generally provides the facility of price
support to the farm producers and at the same time, it provides farm products at reasonable
prices to consumers. It provides price support so that the prices of farm products do not fall
below specified levels.
The government fixes minimum prices:
(i) To protect farmers’ incomes from price fluctuations of farm products, and
(ii) To create buffer stocks to prevent possible future shortages of farm products.
The specified level of minimum prices is called price floors. It is illegal to undertake any
transaction below the price floor.

Agricultural price support by the government is illustrated in Fig. 2, where D and S are
demand and supply curves respectively. OP is the equilibrium price and OQ the equilibrium
quantity. Suppose the government imposes a price floor at OP1 price level above the
equilibrium price OP.
At this price floor, the producers are willing to sell OQ1 quantity, while the demand falls to
OQ2, resulting in a surplus of Q2Q1 which the government buys as buffer stock. The
consumers have to pay higher price OP1 than the equilibrium price OP.
The surplus is eliminated by the government generally in three ways:
(i) Supply i.e., limiting the acreage of land for the farmers to grow certain agricultural
commodities;
(ii) Stimulating demand i.e., new uses for farm products are sought; and
(iii)Purchasing surpluses i.e., certain farm products are bought and stored by the government
for future use as “buffer stocks”.
Application # 2. Price Control:
Sometimes the government may think it necessary to interfere in the market process and set
maximum (low) price limits for some basic goods. These are known as price ceilings.
Producers of such goods cannot charge prices higher than the ceiling prices i.e., the
maximum prices fixed by the government.
Price ceilings are generally imposed on many essential consumer goods during war or other
critical inflationary periods to prevent them from rising above a certain level.
In the case of such commodities, the maximum prices fixed by the government are below the
equilibrium price. At a price lower than the equilibrium price, the quantity demanded is more
than the quantity supplied which leads to the shortage of the commodity. This necessitates the
introduction of rationing by the government whereby restriction is imposed on the quantity of
a good that a consumer can buy.
A price ceiling can be illustrated by the normal demand and supply curves. In Fig. 3, D and S
are demand and supply curves respectively. They intersect at point E where OP is the equilib-
rium price and OQ equilibrium quantity.
If the government regards the equilibrium price as too high, it may fix a ceiling price at
OP1 .This will result in a shortage of the good equal to Q2 Q1 because OP, price indicates
excess demand (O Q1) over OQ2supply. In this situation, the government may find it
necessary to introduce rationing so that the limited goods may be allocated among all the
buyers who want them.

Application # 3. Black Market:

Black market of a commodity is the market in which a commodity is sold illegally by the
sellers at a price higher than the controlled legal maximum price or ceiling price. It develops
on account of excess demand in the market. Some buyers are prepared to pay a higher price
for procuring more quantity of the commodity. Sellers are also interested in the black market
to sell the products at higher prices and earn more profits.
The working of black market is shown in Fig. 4 where D and S are demand and supply
curves. They intersect at point E and determine OP market price and OQ market quantity. But
the available quantity of the product is OQ1 due to OP2 price ceiling. But the demand is
OQ2 and Q2Q1 is the shortage of the commodity.
Therefore, the buyers are ready to offer OP1 price for procuring more units of the commodity.
If the total quantity OQ1 is sold in the black market, the total amount paid by the consumers
will be OP1 BQ1 But the receipts of the producers will only be OP2 AQ1 because of the price
ceiling.
Thus, the amount OP1 BO1 – OP2 AO1 = P BAP2 will be the extra gain of black marketers
shown by the shaded area. However, the entire supply is generally not sold in the black
market, because of price laws.
Application # 4. Consumer’s Surplus and Producers’ Surplus:
Demand and supply analysis is very helpful in knowing consumer’s surplus and producer’s
surplus. Consumer’s surplus is the difference between the a total value that consumer is
willing to pay and the payment that they actually makes for the purchase of that product. The
total value that a consumer is willing to pay is the area under the demand curve.
On the other hand, what he actually pays is the market price line. Producer’s surplus is the
area above the supply curve and below the market price line. It is the difference between the
actual amount that a producer receives by selling a given quantity of a commodity and the
minimum amount that he expects to receive for its same quantity.
In Fig. 5, DD1 is the demand curve and SS1 is the supply curve. Both intersect at E and
determine OP price and PE is the market price line. OQ is the equilibrium quantity. The
consumer’s surplus on OQ units of the product is the area EPD and the producer’s surplus on
the same units of the product is ESP. The sum of consumer’s and producer’s surplus will be
the maximum, when the market structure is perfectly competitive.
Application # 5. Minimum Wage Legislation:
Fixation of minimum wages by the government can also be shown by demand-supply
analysis. Fixing minimum wages by the state for sweated trades tends to remove exploitation
of labour.
Minimum wages will so increase the incomes of workers that their consumption expenditures
will increase which will, in turn, lead to expansion of the consumer’s goods industries and to
the capital goods industries. This will increase employment, output and national income.
Figure 6 illustrates the effects of fixing the minimum wage above the competitive level. It
shows the determination of the equilibrium wage rate OW1 when the demand and supply
curves for labour DL and SLrespectively intersect at point E.
At this wage rate, ON of labour is employed. Suppose the government fixes a minimum wage
of OW2 which is higher than the competitive wage OW1. The increase in the price of labour to
OW2 reduces the demand for labour to ON2 But the supply of labour increases to ON1with the
fixation of the higher minimum wage. This excess supply over the demand for labour leads to
N2 – N1 unemployment.
Application # 6. Subsidy:
When the government feels that the market price for the farm product is too low for the
farmers, it decides to pay them a subsidy. They will receive it in addition to the market price.
A subsidy is a government grant given to producers to reduce the price per unit of a product.
This is to encourage the farmers to produce more which will, in-turn reduce the market
prices. The benefits shift from the producers to the buyers which depend on the elasticity of
demand and supply.

Subsidy shifts the supply curve downward to the right. This is illustrated in Figure 7 where
demand and supply curves are D and S respectively. They intersect at point E. OP is the
equilibrium price and OQ equilibrium quantity.
The government decides that the farmers should get a price of OP2 for their product.
Accordingly if a subsidy equal to BC is granted, the supply curve shifts downward to the
right to S1 .The new equilibrium is at C. OP1 is the new equilibrium price and OQ1 the new
equilibrium quantity.
Thus, as a result of the subsidy, the price falls to OP1 and the quantity rises to OQ1 .The
benefit to consumers is equal to PP1 .They can buy more quantity OQ1 at a lower price
OP1 The benefit to producers is equal to P1P2 .The subsidy paid by the government is equal to
the sum of the benefits of consumers and producers the shaded area P1P2BC.
Application # 7. Taxation:
The demand and supply analysis is applicable to the problem of incidence of indirect
taxation. The incidence of a tax involves the process of transfer from the person on whom the
tax is imposed initially to the ultimate taxpayer who bears the money burden of the tax.
The incidence of commodity taxation is shared between the buyers and sellers in the ratio of
the elasticity of supply of the taxed commodity to the elasticity of demand for it.  
Es/Ed = Incidence on Buyers/Incidence on Sellers
This is explained diagrammatically in Figure 8. Let D be the demand curve and S be the
supply curve of the commodity before the tax is levied. OQ quantity of the commodity is sold
and bought at QA (=OP) price.
Suppose an excise duty equivalent to ET is imposed on per unit of the commodity, which is
collected from the sellers. As a result, the supply curve shifts upward as S1 and the price of
the commodity rises to Q1 T (=OP1). But the per-unit increase in price is RT. the difference
between the new price (Q1T) and the pre-tax price (QA).

Thus the RT portion of the tax is borne by the buyers and ER portion by the sellers, ET = ER
+ RT. Given the elasticity of supply, the greater the elasticity of demand for a commodity, the
greater will be the incidence of the tax upon the producers and vice versa. Likewise, given the
elasticity of demand, the greater the elasticity of supply, the higher will be the incidence of
tax upon the buyers, and vice versa.