.

Demand - analysing the buyers behaviour

Osteopaths manipulate and massage bones,
muscles and ligaments that have been
twisted or strained.

What will inIluence how much osteopathy people are prepared to buy at any
particular time?

Substitution and income effects
Perhaps the most important Iactor will be the price oI the treatment. The more
expensive it is to buy osteopathy, all other Iactors remaining constant, the less we
will buy. Why?

When osteopathy becomes more expensive two things happen:
1. 7elative p7ices change; and
2. our 7eal income changes.
When we react to the price rise, we are taking both oI these changes into account.
The change in relative price means that osteopathy is now more expensive
compared to other goods and services. How do we respond to this? Economists
assume that people are satisIaction maximisers. This means that we all try to gain
as much satisIaction as possible Irom our consumption oI goods and services. So
we react to the Iact that osteopathy is now relatively more expensive by choosing
to buy less oI it and more oI something else instead (substitution eIIect).



The increase in the price oI osteopathy has also reduced our 7eal income - we can
now buy less than beIore with our money income. The way which we react to this
change in real income depends on the kind oI good or service. Osteopathy, like
most goods, is a no7mal good - an increase in income leads to an increase in
demand and vice versa. So a Iall in real income will Iurther reduce the amount oI
treatment bought (income eIIect).

%e demand curve
This predictable relationship between price and quantity demanded allows us to
deIine demand Iormally as the quantity oI a good or service that buyers are willing
and able to buy at every conceivable price. The demand curve (see Figure 6 on the
leIt) shows this relationship graphically.


DD shows the quantity oI osteopathy treatments that consume7s are prepared to
buy at every conceivable price. A change in price leads to a movement along the
demand curve.When the price is P consumers will -uy Q. II the price Ialls to P'
then the quantity demanded will 7ise to Q'. A change in price has led to a
movement along the demand curve.
What else will inIluence how much osteopathy we buy? The answer is our income,
our preIerences and the prices oI other goods.
Osteopathy is a no7mal good so iI our income rises we will buy more treatment at
each price, and iI it Ialls we will buy less.
II our preIerences change, we will buy more or less osteopathy at each price. II we
decide we are keen on osteopathy, then we will buy more oI it. II we go oII the
idea oI osteopathy, then the amount we buy will drop.
Our demand Ior osteopathy will also be aIIected by the prices oI related services.
An obvious example is the price oI physiotherapy, which is an alternative (or
substitute) treatment Ior many oI the conditions treated by osteopaths. II the price
oI physiotherapy Ialls then some people are likely to switch Irom osteopathy to
physiotherapy, so the demand Ior osteopathy would Iall.

Our demand Ior goods and services is also aIIected by changes in prices oI
complementa7y goods. These are goods and services which tend to be bought
together. For instance, iI the price oI eye tests rose signiIicantly, then many people
would not bother to get their eyes checked regularly. This would lead to a Iall in
the demand Ior spectacles.
Whenever income, preIerences or the price oI a related good or service changes,
the demand curve shiIts. You can try out the eIIects oI changes in the graph on the
leIt.




ow Iook at tese (ceck te status bar for information)



b. Supply - analysing the sellers'
behaviour


Further questions





"uestion nswer
Is this statement true or false?
"If the price of osteopathy falls, the demand curve will shift."





Reset



igure 6 The demand for osteopathy treatments
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Unit 2. The free market approach

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b. Supply - analysing the sellers behaviour





igure 7. The supply curve for osteopathy
treatments

The sellers in this market are the osteopaths we described earlier. We assume that these osteopaths want to maximise their proIits.
What are proIits and how can they be maximised? Osteopaths earn money (7evenue) by selling their services e.g. by massaging
away muscular strains. Out oI this revenue they need to pay Ior the Iactors they use to produce the treatment (costs) e.g. pay their
receptionist, pay the rent or pay Ior a new ultrasound machine. ProIit is the excess oI revenue over costs.

aximising profits
Seeking to maximise proIits leads each osteopath to want to sell more care at higher prices. There is a reliable and predictable
positive relationship between price and quantity supplied. Formally, supply is deIined as the quantity oI a good or service that a
population oI sellers is willing and able to sell at every conceivable price. This positive relationship is shown graphically by the
supply curve on the leIt - SS. II the price changes there is a movement along the supply curve (see Figure 7). At price P the
osteopath population is prepared to sell Q t7eatments. When the price rises to P' the osteopath population is prepared to sell Q'
t7eatments - this might be because more people become osteopaths when it becomes a more lucrative job.


ange in costs
II the level oI Iactor costs changes then the supply curve will shift. For example nurses' wages could go up or the rent could Iall.
Let's look at the eIIects oI these.
In Figure 8, SS is the initial supply curve Ior treatments. Imagine that nurses' wages rise, pushing up osteopaths' costs. The
osteopaths react by being prepared to supply Iewer treatments at each price (this may be because there are Iewer osteopaths). At a
price such as P' osteopaths are now only prepared to sell Q" treatments rather than Q'. The supply curve shiIts inwards to S'S'.

Now imagine that rents Iall. The proIit oI osteopaths will increase Ior each treatment. The osteopath population will react by being
prepared to supply more treatments at each price. At the price P' osteopaths are now prepared to sell Q"' treatments rather than Q'.
The supply curve shiIts outwards.
ow Iook at tese check the status bar for information)

c. The market

Further questions





"uestion nswer
urses' wages rise. Which one of these describes the behaviour of osteopaths?
A. They will be prepared to sell more treatments
B. They will be prepared to sell the same number of treatments
C. They will be prepared to sell fewer treatments








Fall Nurses' pay Rise
Fall Rent Rise

igure 8.
Reset
Co
Lo

1he Lconomlcs of
PealLh Care


unlL 2 1he free markeL
approach

age 16




l


c 1he markeL





llgure 9

We can now puL Lhe demand and supply curves
LogeLher 1hls wlll glve us a plcLure of Lhe markeL for
osLeopaLhy 1hls ls shown by llgure 9 noLlce LhaL Lhere
ls only one prlce aL whlch Lhe quanLlLy of LreaLmenLs
people wanL Lo buy ls Lhe same as Lhe quanLlLy Lhe
osLeopaLhs wanL Lo sell 1hls ls called Lhe equlllbrlum
prlce
e
1he correspondlng quanLlLy ls Lhe equlllbrlum
quanLlLy C
e
1he equlllbrlum ls a sLaLe of resL where
Lhere ls no pressure for change

AL any oLher prlce elLher buyers or sellers are
dlssaLlsfled and acL Lo change Lhe quanLlLy demanded or
supplled
Excess demand
II there is excess demand, consumers bid up the
price. At price P' consumers demand Q'. The price is
low so a lot oI people are willing and able to buy
treatments. However, the low price means that there
aren't enough osteopaths prepared to provide this
amount oI treatment. They are only prepared to
provide Q". The excess demand (Q' - Q") causes the
consumers to bid the price up to the equilibrium
price P
e
.
Excess supply
At P" the price is too high. Consumers only demand
Q"' treatments. However,the osteopaths want to sell
more treatment: Q"". So there is an excess oI supply
(Q"" - Q"'). This will lead to osteopaths having to
cut their prices (to encourage more consumers to
buy treatment). As sellers, they will have to reduce
their prices until they reach the equilibrium price P
e
.




So Lhe free lnLeracLlon of buyers and sellers ln Lhe
markeL auLomaLlcally leads Lo a slngle prlce aL whlch Lhe
quanLlLy Lraded clears Lhe markeL le Lhe quanLlLy
supplled equals Lhe quanLlLy demanded


now look aL Lhese (check Lhe sLaLus bar for lnformaLlon)



d Pow a markeL allocaLes
resources



lurLher quesLlons






CuesLlon Answer
lmaglne LhaL Lhe prlce ln a markeL ls seL below Lhe equlllbrlum ls Lhere
A. excess supply?
. excess demand?
C. neither?



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Unit 2. The free market approach

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d. How a market allocates resources






We have shown how supply and demand combine to give a single
stable price and output - the equili-7ium. ut what happens when
something comes along and upsets this equilibrium?

Economists call anything which moves a market out oI equilibrium
a shock. Shocks could come Irom shifts in demand caused by such
things as changes in income or Irom shiIts in supply caused by
such things as a change in costs. In each case the shock upsets the
market equilibrium. How will the ma7et respond?

ow te market responds to a sock

Let's analyse the reaction by looking at a demand shock caused by
a rise in people's incomes. How will the osteopathy market react?
The graph on the leIt, Iigure 10, shows the initial supply and
demand curves - SS and DD. The initial market equili-7ium is at a
price P' and quantity Q'.


igure 10.


Now imagine that there is an increase in people's income. The
demand curve will shiIt outwa7ds to D'D' because people are
willing to buy more osteopathy treatments at the same price
(osteopathy is a no7mal good). This shiIt in demand throws the
market out oI equilibrium. Now people want to buy Q"' treatments
at price P' but the osteopaths are still only prepared to sell Q' at that
price. The result is excess demand and unsatisIied buyers who
react by '-idding up' the price. The rise in price simultaneously
7educes the demand and increases the supply until the market
regains equili-7ium at a new price and quantity.
The rise in people's incomes has led to a new equilibrium at a
highe7 p7ice P" and a higher quantity Q" than beIore.


This process will occur whenever there is shock leading to either a
shiIt in demand or supply. The market will move out oI equilibrium
with either excess demand or excess supply appearing. The price
will then adjust until equilibrium is regained.

%e 'invisibIe and'

We have just demonstrated that our Iree market will automatically
produce an equilibrium price and quantity. It is this which makes it
a very powerIul allocation system. (See page 6 in Unit 1). This is
what Adam Smith (the Iounding Iather oI economics) reIerred to as
the "invisible hand".

Who decides how much osteopathy is to be produced? The answer
in a Iree market is consumers. They go out and buy osteopathy
treatments and the price they are prepared to pay sends signals to
the osteopaths. The osteopaths respond by producing either more or
less treatment. The market not only allocates resources
automatically, it does so eIIiciently. Providing certain conditions
are met, the Iree market will achieve a Pa7eto efficient allocation.
(See page 5 in Unit 1).

rom price mecanism to a Pareto efficient
aIIocation

For the consumer, the price they are willing to pay measures the
beneIit or utility that the consumers expect to receive Irom
consuming the last unit. To be precise, the demand curve reIlects
the marginal utility (extra beneIit) that consumers receive Irom
consuming the last unit. Consumers only buy something iI it is
worth as much as or more than the other things that the same
money could buy. So iI the price oI something is greater than the
beneIit they get Irom consuming it, they will not buy it.

For the p7oduce7 or seller, the price they are willing to accept
measures the cost oI the resources involved in the production
including the supplier's own time and eIIort. Again to be precise,
the supply curve reIlects the seller's marginal costs (the cost oI
producing an extra unit). Thus when a market is in equilibrium,
marginal beneIit equals marginal cost equals price. The beneIit
received Irom the last unit consumed will exactly equal the
resource cost oI producing that unit. This IulIils the condition Ior
allocative efficiency. Competing producers chasing maximum
proIits will always choose the least cost combination oI Iactors to
produce a given output. Consequently, the Iree market will also be
productively eIIicient.

ow Iook at tese (ceck te status bar for information)



e. Case study - cosmetic surgery


Further questions





"uestion nswer
Who decides how much osteopathy is to be produced?
A. The osteopaths
B. The government
C. Consumers



o
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Unit 2. The free market approach

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e. Case study - cosmetic surgery





How well does our theoretical model oI a market explain what has been
going on with cosmetic surgery? Look at this newspaper report on the
growth oI cosmetic dentistry.


More durable and lifelike dental porcelains
and resins, developed recently, have given
rise to specialists in cosmetic dentistry selling
off-the-peg designer smiles. The Guardian.

Putting your money were your mout is
Maggie Smith is a publisher in her late 40s who has just splashed out on a
1,400 "tooth liIt". "I saw the treatment as an investment. Compared with
the cost oI a couple oI outIits, it's not that expensive and it lasts much
longer".
Smith purchased her cosmetic dentistry Irom Dentics on London's Kings
Road. Dentics opened its Iirst "tooth boutique" Iour years ago and now has
three London branches. Customers can walk into the shop-Ironted
surgeries without an appointment and browse through albums oI photos
showing wayward canines tamed into piano keyboards by bleaching, Iiling
down, building with resins or covering with porcelain veneers. Each
treatment costs around 200.
Primary school teacher Elizabeth Eccose-Westley regarded the treatment
as an aIIordable luxury. "I'm not rich and I'm not vain, but at 42 I started
to Ieel I was getting long in the tooth. I spent 1,000 on porcelain veneers,
instead oI a summer holiday, and it's really boosted my conIidence. Give it
another couple oI years and people won't think twice about it. Everybody
will be having it done "

Emma rooker Guardian 16.9.93

Clearly there is a demand Ior cosmetic dentistry - people are willing and
able to pay Ior it. oth the women in the article viewed the cosmetic
treatment as something which gave them 'utility' , i.e. satisIaction, and
they consciously compared the satisIaction gained with that Irom other
purchases.

The article also provides evidence that the market is growing. Why is this
happening?


igure 11.

conomic anaIysis
The initial supply and demand curves are shown in Figure 11 - the system
is in equili-7ium.
The Iirst change is that technology has reduced the costs oI such treatment
- shiIting the supply cu7ve outwa7ds. Demand also seems to be growing;
why is this? According to a recent national survey, one in Iour people
dislikes their appearance suggesting that they would consider buying this
kind oI treatment iI they could aIIord it. So consume7s are likely to
respond to the lower prices brought about by the shift in supply - a
movement down the market demand curve. This sets up a new
equili-7ium at P" and Q".
The next change is an increase in consumers' 7eal income leading to an
outwa7d shift in the demand curve Irom DD to D'D'. So there's a new
equilibrium at P'" and Q'".

Suppliers have reacted to the growth oI consumer demand in exactly the
way our theory predicts. Dentics has expanded its operations by opening
more shops and providing more t7eatments. There is a new equili-7ium.
Reduced costs and ext7a consume7 demand have both led to the
allocation oI mo7e 7esou7ces to cosmetic dental treatment.
So our model has perIormed Iairly well. ut we can develop it Iurther by
introducing the concept oI elasticity.

ow Iook at tese (ceck te status bar for information)


f. Elasticity

Further questions




"uestion nswer
Why have more dentists opened offering cosmetic surgery?



lasticity




Elasticity provides a way oI measuring how sensitive
demand or supply is to Iactors such as a change in price.
Take the relationship between price and quantity
demanded. We know that iI price rises then people will buy
less but we do not know how much less. Price elasticity oI
demand allows us to calculate this.


Price eIasticity of demand (P)
The Iormula Ior price elasticity oI demand (PED) is
change in quantity demanded

change in price oI the good

So iI the price oI osteopathy rose by 10 and the quantity
bought Iell by 5 then the PED would be 5/10 -
0.5. This tells us that demand Ior osteopathy is not
particularly sensitive to changes in price. It is what
economists call p7ice inelastic. Take another example, iI
the price oI eye tests Iell by 20 and the quantity oI eye
tests bought rose by 30 then the value oI PED would be
30/-20 -1.5. In this case the demand Ior eye tests is
p7ice elastic, i.e. sensitive to changes in price.

Notice several things about PED. First, the value oI PED is
always negative reIlecting the inverse relationship between
price and quantity demanded. Second, PED is just a
number, it is not expressed in terms oI any particular units.

How do we know whether demand is elastic or inelastic?
The rule is:

Demand is price inelastic whenever the change in price
leads to a smaller change in quantity demanded. This
gives PED values between 0 and 1.

Demand is price elastic whenever the change in price
leads to a larger change in quantity demanded. This gives
PED values between 1 and inIinity.

Price elasticity oI demand allows us to predict what will
happen to spending when price changes. Take the example
oI the increase in the price oI osteopathy used above. As the
price oI osteopathy rises, people will buy Iewer treatments
but will they spend less? Suppose the price oI a treatment
rose Irom 20 an hour to 22 (a price increase oI 10). At
20 an hour, consumers were buying 1,000 treatments per
week and spending 20,000. AIter the price rise, they
bought 950 a week (a Iall oI 5) but their spending had
risen to 20,900 ( 950 x 22). So the answer in this case is
no. People spend more on osteopathy aIter the price rise
because the percentage increase in price is greater than the
percentage Iall in sales volume. So although osteopaths sell
Iewer treatments, the higher price oI each treatment more
than oIIsets the lost quantity oI treatments sold. This gives
us a general rule:
II PED is inelastic, a rise in price will lead to people
spending more while a Iall in price will lead to people
spending less;
II PED is elastic, a rise in price will lead to people spending
less while a Iall in price will lead to people spending more.

Price elasticity oI demand allows economists to analyse and
predict the eIIect oI changes in prices on diIIerent markets.
We can see an example oI this by looking at the debate over
cost sharing in health care.


ost saring in eaIt care
Cost sharing is the term used to describe diIIerent Iorms oI
direct charging Ior health care services. Increasingly, direct
charging is seen as a way oI reducing demand but also as a
way oI raising revenue. How eIIective is this policy? For
instance, in the UK, many people have to pay prescription
charges, that is they have to pay a certain amount every
time they want to have a prescription dispensed. What has
been the eIIect oI this charging? Estimates made by Hughes
and McGuire have indicated that demand Ior prescriptions
is rather price inelastic with a mean value oI -0.32. This
would suggest that prescription charges would be an
eIIective way oI raising revenue but not have a great eIIect
on the level oI demand. Hughes and McGuire calculated,
Ior instance, that the rise in prescription charges Irom 3.75
in 1992 to 4.25 in 1993 would have resulted in the
generation oI an estimated 17.3 million in extra revenue
but led to a Iall oI 2.3 million in the number oI prescriptions
dispensed. However, their research also suggests that
demand Ior prescriptions is becoming more price elastic as
time passes. They Iound that PED was 0.125 in 1969, -
0.22 in 1980, -0.68 in 1985 and 0.94 in 1991. This
suggests that raising prescription charges is now likely to
raise less revenue but lead to greater reductions in use oI
prescribed medicines than it did in the past.


ter forms of eIasticity
The concept oI elasticity can be applied to the impact oI
both income and changes in the prices oI other goods on
quantity demanded. ncome elasticity of demand (YED)
measures how demand reacts to changes in income.
The Iormula Ior income elasticity of demand is:
change in quantity demanded

change in income

II the result is positive then the goods are normal, iI it is
negative then they are inIerior. All the evidence suggest
that health care is not only a normal good but that it is
income elastic, i.e. rising income leads to a greater rise in
demand Ior health care.

C7oss p7ice elasticity of demand (XED) measures how
demand reacts to changes in the price oI other goods.
The Iormula Ior c7oss p7ice elasticity of demand is:
change in quantity demanded oI main good

change in price oI other good

II cross price elasticity oI demand is positive then this
indicates that the goods are substitutes. II it is negative then
the goods are complements.

Finally, the concept oI elasticity can be applied to supply.
P7ice elasticity of supply (PES) measures how sensitive
quantity supplied is to a change in the price oI the good.
The Iormula Ior p7ice elasticity of supply is:
change in quantity supplied

change in price oI the good

Price elasticity oI supply is always positive, reIlecting the
positive relationship between price and quantity supplied.
PES becomes more elastic over time. This reIlects the time
it takes to switch resources into a market. For instance, in
health care the PES is likely to be Iairly inelastic in the
short run but much more elastic in the long run. Even iI
price rises signiIicantly it will take time Ior Iirms to react
and to produce more health care. For instance, to deliver
more health care new hospitals will need to be built or
existing hospitals extended and extra doctors and nurses
will need to be trained. All oI this takes time.

The concept oI elasticity has helped to make our market
theory more sophisticated. However, the model still suIIers
Irom being rather static.

ow Iook at tese (ceck te status bar for
information)


g. Markets as dynamic systems

Further questions




"uestion nswer
The $ only pays a part of the cost of adult dental
treatment; the remainder has to be paid by the
patient. What would be the effects of raising dental
charges by 10% if the PED for dental treatment was
estimated to be -0.6?



In an earlier book "Challenge to the NHS", IEA 1986, Green looked at the
perIormance oI the health care ma7et in the US and came to the conclusion
that the introduction oI a more eIIective Iree market in the early 1980s
resulted in the emergence oI a Ilexible, cost eIIective system. He claimed that
problems oIten associated with the American health care system, such as
rapidly rising costs and doctors providing patients with unnecessary surgery,
were the result oI a Iailure oI the Iree market to operate.

octors' monopoIy
Green argued that the problems oI US health care in the 1960s and 1970s
were the result oI the doctors' monopoly power over supply. The doctors
achieved this partly by restricting entry to the medical proIession through
limits on entry to medical schools and partly by keeping consume7s in
ignorance. The doctors' association, the American Medical Association
(AMA), "was able to keep a tight grip on the number oI doctors trained and
hence to limit the supply oI doctors in active practice." They also maintained
the monopoly by preventing doctors Irom advertising which prevented
consumers Irom gaining the inIormation they needed to make a rational
market choice.

This monopoly power was Iatally undermined in 1982 when the US Supreme
Court outlawed the AMA's ban on advertising. The Federal Trade
Commission had already enIorced a number oI other pro-competition policies
on the doctors such as making price Iixing by the Michigan State Medical
Society illegal. Combined with a signiIicant expansion in the number oI
doctors, this led to the eIIective emergence oI competition between them.
Green argues that the emergence oI this eIIective competition in the health
care market has led to exactly the results predicted by the Iree market model.

Since Green wrote this paper, new types oI health care purchaser have grown
up in the US, called Health Maintenance Organisations (HMOs). These have
more bargaining power over doctors on behalI oI the patients who are insured
with them. This is seen by many commentators as a Iurther example oI the
Iree market working, although others have argued that HMOs restrict patients'
access to doctors in order to hold down costs.


The growth of new 574;/078 of health care
such as day surgery centres offering one-day
surgery, home health agencies and walk-in
at are te resuIts?
As we saw earlier in this Unit a Iree market will provide an
allocation which is allocatively efficient. This means diIIerent
types oI health care in a mixture which accurately reIlects
consumer demand. It will also be productively eIIicient and so
deliver the health care Ior the lowest possible cost.

Green believes that American consumers now have a much
greater choice oI where to get their medical treatment and that
increased competition has led to the producers oI health care
becoming more responsive to consumer demand.

emergency clinics has given consumers
more choice.

Another result oI the increase in competition, Green argues, has
been a signiIicant Iall in costs. In other words he claims that
American health care has become more productively eIIicient.
He cites as evidence the Iall in hospital use and the Iall in visits
to doctors' surgeries between 1981 and 1985 - "the producers are
on the deIensive as competition cuts costs and promotes high
quality".


itting te free market modeI
Green believes that the extension oI the Iree market in health
care in the US in the early 1980s brought substantial beneIits,
and in particular delivered exactly the kind oI result that the Iree
market model predicts. He does not claim that the American
health care system is without problems but he does believe that
those problems stem Irom the eIIects oI state interIerence rather
than the Iailure oI the market.

Many economists would totally disagree with Green. They
argue that a Iree market cannot operate eIIectively in health
care. To see why go to the next Unit in this esource - 'The case
against a Iree market'.
ow Iook at tese check the status bar for information)


3. The case against a free market


Further questions





"uestion nswer
What does Green think has happened as a result of
more competition in the U$ health care market?