Economic Reasoning & Public Policy

Selected Applications of .
DEMAND & SUPPLY

by
Mukul Asher* & Vinay Kumar Singh**

Contents
 Price ceiling and floor: Minimum Wage and Rent Controls
 Consumer and Producer Surplus
 Incidence of Taxes
 Tariffs and Quotas
 Meaning of ‘Free’ and its Applications

* Professor of Economics, Lee Kuan Yew School of Public Policy, National University of Singapore
** Additional Director, National Academy of Direct Taxes, Nagpur

1
Selected Applications of Demand and Supply
Price Ceiling and Floor: Minimum
Wage and Rent Controls
Figure 1 depicts a Price Ceiling—an artificial
ceiling above which a product cannot be sold. It
is imposed by the authority of the government,
often for keeping prices affordable. As we can
see it will result in a demand—supply mismatch
manifested as shortages. A large proportion of
those willing to pay for the product will still not
be able to get it, often requiring some kind of
rationing in the end.
How do you ration available supply?
One way could be the first-come-first-served
queue.
Another could be the basis of income or other
indications of need. How does one get an ob-
jective criteria? How do you prevent reselling?
Done to match incomes and prices. But must
work on both otherwise the system becomes
inefficient and corrupt.
Such a system can easily deteriorate to a state
of favoritism or it will result in underground
economies. Hence the policies should be based
as far as possible on objective criteria. Note
that with price ceiling less supply available and
tends to go to those with money connections
and those with low social conscience.
2
Price Ceilings can also be imposed to Rent con-
trol. Majority would agree with the statement
that a well-designed rent control program can
be beneficial, but there is a change in the ap-
proach of younger economists.
Here one needs to differentiate between
“hard” and “soft” rent controls. The two are
vastly different.
“Soft” controls commonly permit an automatic
percentage of rent increases related to the rate
of inflation. They often contain provisions for
other rent increases too, like cost pass-through
provisions, hardship (cash-flow problems) pro-
visions & rate of return provisions. “Soft” con-
trols commonly exempt rental housing con-
structed after the application of controls –
there are also provisions for vacancy decontrol,
inter-tenancy decontrol, etc.
All these features may not be seen in “hard”
price floors which can be comparatively rigid
and inflexible.
This leads to the argument that soft controls
are very different and should be evaluated
differently. One should also note that housing
is increasingly being recognized as not homoge-
neous but heterogeneous. However, most text-
books on rent control ceiling on pricing services
assume homogeneous housing (D quality sub-
sumed as quantity). They also assume perfect
competition, but market is imperfectly com-
petitive, and there is asymmetric information.
There is also a differential between optimal
rent control & rent control evolving from the
political process. Note that in perfect competi-
tion, rent controls will create excess demand
and distortions.
Rent Control in Monopoly Markets
When monopoly power exists, then, the rent
controls could reduce price while increasing
quantity. This is because with monopoly power
the supplier maximizes profit where the extra
(or marginal) revenue from renting one more
housing unit just equals the cost of supplying it.
So “appropriate” (big caveat) rent controls just
prevent the supplier from using the monopoly
power. This result is opposite of the one in
perfect competition.
 Economic Reasoning & Public Policy

Price Floor
All rich countries subsidize their farmers. In
U.S., European countries, Korea, Japan, Taiwan.
This is for distributional and other reasons.
Figure 2 depicts such a situation, where higher
artificial prices lead to excessive supply.
What is to be done with excess supply?
It may need programs to restrict supply – to
affect the size of the surplus. Another way out
could be to purchase, store and then sell in a
segmented market. e.g. food aid, but it de-
presses price of agricultural goods in general.
There can be many unintended effects of price
controls. As an example, price ceiling on good
whisky may encourage consumption of bootleg
whisky. Controls create even greater difficulties
if they are applied over a longer term.

Consumer & Producer Surplus

Consumer Surplus: It is the difference between
the maximum amount that a consumer is will-
ing to pay for a good and the amount consumer
actually pays.
Producer Surplus: The amount that a producer
is willing to pay for a factor of production and
the amount that it needs to pay in the market.
These concepts are widely used in analyzing
and valuing the change in welfare as a result of
a particular policy, project, or a program.
Whom the burden of taxation falls on depends
on the elasticity of Demand and Supply.
Partial equilibrium analysis: Given the supply
curve, the more elastic the demand curve, the
lower the burden borne by the consumer.
Given the demand curve, the more elastic the
supply curve, the lower will be the burden
borne by producer.

Incidence of Taxes
Taxes impact prices as well as production, and
can be considered an interference in the mar-
ket process. Different taxes can lead to some-
what different impacts.

Impact of Sales Tax on Producers and

Consumers
Figure 3 depicts the incidence of taxation. One
should note that we can shift Demand Curve
instead of Supply Curve. Method of collecting
tax makes no difference.
Pb Ps = amount of the tax
Pb Po = borne by the consumer
Po Ps = borne by the producer.

3
Selected Applications of Demand and Supply

Tariffs and Quotas

plus for domestic and foreign producers
Tariffs refer to import duties (or taxes), while
and businesses. This has political and eco-
quotas refer to quantitative restrictions on the
nomic implications.
import (or export) of commodities. Some coun-
tries levy taxes (or duties) on selected exports. Quotas normally provide greater certainty of
the quantity of imports and therefore pro-
Analytically, tariffs and quotas can be regarded
vide more control to policymakers. Tariffs
as equivalent. However, there are two major
require estimating demand curve and for-
differences between the two.
eign producer responses which are not as
Tariffs generate tax revenue for the govern- amenable to control.
ment; while quotas generate producer sur-

4

Meaning of ‘Free’ and its
Applications
Chris Anderson, in his work, titled, Free: The
Future of Radical Price (2009) raises an argu-
ment against the traditional view of free distri-
bution.
In traditional economic activities, where mar-
ginal costs are high, attempts (particularly by
governments) to provide a good or a service at
zero price (free) could turn out to be very ex-
pensive for individuals, firms and for the soci-
ety a s a whole.
Economic Reasoning & Public Policy
Anderson does not deny the above line of argu-
ment. He, however, argues that when marginal
costs of provision is near zero, for example in
digital age, then ‘free’ or zero price for some
goods or services may be profitable. He states
that “free that has emerged over the past dec-
ade is different from free that came before”.
While marginal costs are near zero, fixed costs
are high and they must be covered. This book
provides examples of how this is being done by
different companies.
Key is to understand when the above argument
applies in a particular context and for a particu-
lar good or a service, and when it does not.
5
Selected Applications of Demand and Supply
Anderson argues that giving away something
for free to create demand for another is a pow-
erful marketing tool. He gives example of
Monty Python team which provided good qual-
ity videos of their work on YouTube for free,
and created demands for their DVDs etc. You
Tube incidentally is yet to make money for the
Google.
Key Substance of “Free”:
It involves shifting money around from product
to product, person to person, between now
and later, or into non monetary markets and
back again.
Gillette giving razors away at very low price,
but making high level of per unit profits on
blades is a classic business example.
He uses the word “cross subsidies” to describe
the above concept. He has an interesting exam-
ple of how Rayanair can sell London-Barcelona
tickets for $20, when its costs is $70. Three
strategies: cut costs, charge fees for ancillary
services( including check-in bags, seat in first
two rows, etc.), and offset losses with higher
fare when demand is high, and less elastic , i.e.
sensitive to price.
The implications of ‘zero’ price strategy for
competition also needs to be examined. This is
because only a dominant market player is likely
to make money from this strategy.
The ‘zero’ price strategy is not a new economic
model as the author claims. So, some insights,
but its arguments should be kept in perspec-
tive.