The Ministry of Health is still interested in increasing the number of check-ups. As a replacement for the unsuccessful price ceiling policy the Ministry is considering subsidizing dental health checks by £5 per check-up. A subsidy is a payment made by the government to a producer or producers (in this case dentists) where the level of payment depends on the exact level of output. A dentist providing 100 check- ups per month will receive a payment from the Ministry of £500 per month. The Figure 4.14 The market for dental receptionists with a price floor
subsidy has the same effect as a fall in cost because from the perspective of the producer this is exactly what it is. Hence the supply curve shifts downwards (i.e.
to the right) as a result of the subsidy. More precisely, the supply curve shifts downwards by exactly £5 at each output level – see Figure 4.15.
Therefore the effect of the subsidy is to lower price and increase output. Note, though, that the fall in price is not as large as the subsidy. The benefits of the subsidy are distributed between the consumers of dental check-ups and the dentists.
By how much the price falls and by how much output increases depends upon the responsiveness of demand and supply to price. For example, Figure 4.16 shows a Figure 4.15 Effect of a subsidy on the market for dental health checks
Figure 4.16 Effect of a subsidy on the market for dental health checks where demand is very responsive to price
market where demand is very responsive to price (i.e. the demand curve is relatively flat).
In this case, output increases considerably. Most of the subsidy is absorbed by the dentists so that the price does not increase very much. Alternatively if demand is much less responsive to price (i.e. the demand curve is relatively steep) as in Figure 4.17 then the number of dental checks does not increase very much although price drops substantially.
The Ministry might want to collect some data to try to estimate the responsiveness of demand. If demand is very responsive then only a small per unit subsidy is required to substantially increase the number of dental health checks taken every year.
Activity 4.6
The Ministry of Health has conducted a survey which suggested that dental check-ups are highly responsive to price. They decide to go ahead with the subsidy but the minister of finance insists that a new sales tax will have to be levied to pay for the subsidy. A sales tax is a payment extracted from producers by the government that depends on the level of output. The minister of health decides to levy a tax on sweets arguing that this can be justified because sweets are responsible for much tooth decay.
1 Show graphically, in Figure 4.18, the effects of the sales tax in the market for sweets, assuming that this tax will deter the consumption of sweets.
2 Considering your graph, do you think taxing sweets is an effective policy? Make your answer as full as possible, giving reasons for your conclusion.
Figure 4.17 Effect of a subsidy on the market for dental health checks where demand is less responsive to price
Feedback
1 The sales tax has exactly the opposite effect of a subsidy – that is, it shifts the supply curve upwards (to the left), as in Figure 4.19.
2 Quantity traded decreases and price increases. In this example you can see that demand is very responsive to price. This is not really surprising. Sweets have many close substitutes (chocolate, cake, biscuits, fruit etc.) so when the price rises people find a Figure 4.18 The market for sweets
Figure 4.19 The market for sweets – effect of a sales tax
substitute. Because demand is so responsive, price changes little so that producers have to absorb the tax and quantity traded falls dramatically. Such a tax is highly distortion- ary; the tax causes a major change in the allocation of resources. Such a sales tax introduced for the purposes of raising revenue should only be levied on commodities that are less responsive to price. Whether the government decides to go ahead with the tax or not may depend on where the sweets are manufactured. If most sweets are imported then a policy that is hard on the sweet industry will not be too unpopular with the government. There may be health benefits although these would be offset by increased consumption of close substitutes such as cakes.
There is another reason why economists might urge caution in deciding to impose a sales tax. People do get utility from consuming sweets. The act of imposing the tax reduces consumption of sweets and lowers consumer surplus. In general terms, at the aggregate level of the economy, taxes and subsidies may distort the allocation of resources, lower welfare and therefore reduce allocative efficiency. Of course this may be a price worth paying if it means that policy objectives are met. Economists employ a tool called cost–benefit analysis to decide if the costs associated with a policy are fully compensated by the associated benefits. You will learn more about cost–
benefit analysis in Chapter 18.
You have seen that the responsiveness of supply and demand are important determinants of the effectiveness of government regulation of markets. In the next chapter you will look at how economists measure responsiveness and how these measures can be used for policy analysis.
Summary
In this chapter you have learned about the supply function and the effect various factors have on the supply curve. You also learned how prices are determined and about the concept of market equilibrium. Finally you learned about the ways gov- ernments can regulate markets through price regulation and the imposition of taxes and subsidies.
Reference
Green M (1995) The economics of health care. London: Office of Health Economics.