Welfare Economics

Question: If prices for medical care in private markets are considered to be ‘too high’, the Government might choose either to (a) regulate, by fixing prices below the equilibrium price, or (b) subsidise the consumers’ use of these services. Demonstrate the effect of each approach on price and the quantity demanded and supplied.

Answer :

(a) Because of the high prices for medical care in private sector, the government wants consumers use these services at larger quantities, but consumers are not able or they do not want to pay for larger quantities of health care, at this price level. In an attempt to increase the amount of medical care used by its citizens, the Government is considering imposing an effective price ceiling on medical care suppliers that do business within the country limits. The following diagram, explain the effects of such a policy on the market for medical care, explicitly stating what will happen to demand, supply, equilibrium price and equilibrium quantity exchanged.

As we can observe from the diagram, at the vertical axis are showed the prices for medical care and at the horizontal axis is showed the quantity. Initially, the combination of the price and the quantity that balances the market is (P ,Q ). So we can say that the P clears the market for medical care. P also called equilibrium price, and it is the price at which the quantity demanded equals the quantity supplied. Correspondingly, Q is the equilibrium quantity, and it is the quantity of medical care that consumers want to buy and suppliers wish to supply. We also observe that point E is the market equilibrium. The effect of price ceiling is that the initially price is decreased at a lower price P of medical care.

By fixing the prices below the equilibrium price at P we observe that the quantity that consumers demand has increased at Q (point B), but there is a decrease in the quantity Q that the medical care suppliers wish to supply (point A). When the quantity demanded exceeds the quantity supplied at the fixing price, we call this excess demand.

At a price P , consumers demand Q but sellers supply only Q . In that case the suppliers may be run out of stock (drugs etc.) or they are unable to cover the needs of the consumers if we talk about medical care services. Furthermore, suppliers’ trade on the consumers excess demand for medical care and there is obtained the phenomenon of “Black market”. Finally, the rising of prices continues until the equilibrium price is reached, excess demand is eliminated, and the market clears.

Concisely:

a) Effective price ceiling causes a decrease in the price P of medical care.

b) The lower price of medical care leads to an increase in the quantity demanded Q and a decrease in the quantity supplied Q .

c) The difference between the quantity demanded and the quantity supplied leads to a shortage of medical care services. The equilibrium price is lower, so is the equilibrium quantity exchanged.

(b) The second approach to the problem it has to do with the government’s consideration for subsidizing medical care by providing a subsidy to all consumers in the country. Assuming the subsidy can only be used to pay for medical care expenses, we can explain the effect of price and quantity demanded and supplied by using the following