Real World Applications

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Real World Applications

So far, we have covered the nuts and bolts required to start analysing. Although examiners are obviously keen that you understand the basics, what they really want to see is whether a candidate has the ability to apply the basics to real world contexts. In this Learn-It, I shall go through a few of the old classics, but examiners are continually coming up with different situations. They want to see if you can apply supply and demand analysis to an unusual, but fair, situation under timed conditions. To this end, you should always be trying to apply supply and demand techniques to any situation that comes your way. Every night on the news there will be a story to which you can apply some supply and demand analysis. Practice makes perfect!

This is an old favourite. Normally you will face a data response question (or 'stimulus' question) of the 'text' type. A good portion of the question will then pick certain quotes from the text and ask you to explain them 'using supply and demand analysis'.

For instance, you may be asked to explain the effect on the market for coffee of "...the severe frost experienced in Brazil just before the harvest..." or "...the strike by the workers was resolved, but only after a significantly higher wage rate was agreed..." or "...a bountiful harvest in many of the tea growing areas of the world had a negative effect on the coffee market...".

All of these situations are best analysed using supply and demand curves. Let's look at the severe frost first. This will ruin at least some of the year's crop in the huge coffee growing country of Brazil. The supply curve will shift to the left, ceteris paribus, and so the price will rise and the quantity demanded/supplied will fall.

The strike by the workers caused the firms' wage bills to rise. This represents an increase in their costs and so, again, the supply curve will shift to the left, ceteris paribus.

If there is an excessive harvest for tea, then the supply curve for tea will shift to the right. This will cause the price for tea to fall. Tea is a very close substitute for coffee, so if the price of tea falls, ceteris paribus, then the demand for coffee will fall. The demand curve for coffee will shift to the left, causing a fall in its price.

The diagram below shows how this analysis can be applied to supply and demand curves:

Real World Applications
  • Initial equilibrium: P1, Q1 (A)
  • The frost causes a shift S1 to S2.
  • New equilibrium: P2, Q2 (B)
  • The strike has the same effect: P2, Q2 (B)
  • The bountiful tea harvest causes the demand for coffee to shift to the left.
  • New equilibrium: P3, Q1 (C)

Notice that the supply curves are vertical. This is true when using supply curves to explain any agricultural product in the short run. Think about it. If you are a farmer one month away from your harvest, it doesn't matter how high or how low the price is, you will be supplying a fixed amount to the market next month. The frost in Brazil reduced supply, but whatever is left to harvest will be the same whatever the market price may be.

This is another popular choice, although the question can have some macro elements to it, such as the effects of a change in interest rates on the housing market.

Here is another situation where the supply curve will be vertical in the short run. Although building companies do respond to increases in demand, this response will not be immediate. This is why one sees the price of housing rise so quickly when there is a significant shift in the demand for housing (the late 80s?).

So what factors will cause a shift in the supply and demand curves in the housing market? On the demand side we have interest rates, tax relief on mortgages (although this has been phased out recently), changes in the population (especially if a certain area has a large influx of people) and, most importantly of all some would say, speculation. The boom of the late 80s was fuelled, to a large extent, by people buying houses as investments rather than as places to live.

On the supply side we have to think what will affect the number of properties available to purchase. In other words, the state of the rental sector will have a large effect on the owner-occupied sector. Are more people becoming landlords, especially with the new 'buy-to-let' mortgages? Obviously the number of new homes being built will affect the supply curve. Are builders given incentives by the government? Perhaps, if they reclaim a 'brownfield' site rather than build on the more convenient 'greenfield' sites. They may even be prevented from building on the latter. What about the cost of building new homes? Changes in the cost of land, materials and workers will affect the supply curve.

This is an interesting one. Although there is a private health care market in this country which follows the rules of supply and demand, the government funded NHS is an odd case.

There are two points to note. First, the price at the point of use is zero. Secondly, the supply is more or less fixed at any one time. Although doctors and nurses are continually being trained, there is a time lag between when governments decide there needs to be an increase in the numbers and when those numbers are fully qualified. The government has been desperately trying to recruit new nurses recently, but the results will not be felt until after the next election.

So in the short run, one has a rather odd diagram for the NHS:

Real World Applications

Again, the supply curve is vertical because, like with coffee, there is only a fixed amount of health care that the government can supply in the short run. The demand curve is a normal downward-sloping one, but because the price is zero, there is a lot of excess demand (A to B). And the result? Queues and waiting lists! Also, because of increases in technology creating new wants in the health service (who had a hip replacement 20 years ago?), the demand curve is continually shifting to the right, and at a faster rate than the government can force the supply curve to the right. The NHS is sometimes perceived as being a bottomless pit for government money!