Understanding Supply
• What is the law of supply?
• What are supply schedules and supply curves?
• What is elasticity of supply?
• What factors affect elasticity of supply?
The Law of Supply
• Supply is the amount of goods available.
• According to the law of supply, suppliers will offer
more of a good at a higher price.
Price
Supply
As price
increases…
Quantity
supplied
increases
Price
Supply
As price
falls…
Quantity
supplied
falls
•The higher the price, the larger the quantity produced
How Does the Law of Supply Work?
• Economists use the term quantity supplied to describe how much
of a good is offered for sale at a specific price.
• The promise of increased revenues when prices are high
encourages firms to produce more.
• Rising prices draw new firms into a market to earn a profit for
themselves and add to the quantity supplied of a good.
• If price of a good falls, some firms will produce less and others
might drop out of the market.
• These two movements combine to create the law of supply:
– individual firms changing level of production
– firms entering or exiting the market
Higher Production
• If firm is already earning profit by selling a good, then
increase in price – ceteris paribus (all other things held
constant)– will increase the firm’s profits.
• Higher profit encourages increased production.
• Search for profit drives supplier’s decision.
• Increase in prices demonstrates chance to make more
money.
• Decrease in price discourages production levels.
Market Entry
• Profits appeal to current producers and people who
may decide to join market.
• Rising prices draw new firms into the market and add
to the quantity supplied of the good.
• Output or quantity supplied of a good increases as the
price of the good increases.
Supply Schedule
• Shows the relationship between the price and quantity
supplied for a specific good.
– Supply schedule is a table that compares two
variables (factors that can change)
– Usually price and quantity
– Lists supplies for a very specific set of conditions
– A change in a good’s price moves the seller from
one row to another in the same supply schedule but
does not change the supply schedule itself.
– All of the supply schedules of individual firms in a
market can be added up to create a market supply
schedule.
Supply Schedules
• A market supply schedule shows the relationship between prices and
the total quantity supplied by all firms in a particular market.
• It is a chart that lists how much of a good all suppliers will offer at
different prices. More pizza at higher prices!
Market Supply Schedule
Price per slice of pizza
Slices supplied per day
$.50
1,000
$1.00
$1.50
1,500
2,000
$2.00
2,500
$2.50
3,000
$3.00
3,500
Supply Curves
Data points in a supply
schedule are graphed to
create a supply curve.
•
A market supply curve is a
graph of the quantity
supplied of a good by all
suppliers at different
prices.
•
•
Key feature in supply
curve – always rises from
right to left, moving
towards higher and higher
output (or supply) levels
Illustrates law of supply
that states that higher
price leads to higher
output
Market Supply Curve
3.00
Supply
2.50
Price (in dollars)
•
2.00
1.50
1.00
.50
0
0
500
1000 1500 2000 2500 3000 3500
Output (slices per day)
Elasticity of Supply
•Elasticity of supply is a measure of the way suppliers react to a
change in price.
•Tells how firms will respond to changes in the price of a good
• If supply is not very
responsive to changes in
price, it is considered
inelastic.
• An elastic supply is very
sensitive to changes in price.
What Affects Elasticity of Supply?
Time
• In the short run, a firm
cannot easily change
its output level, so
supply is inelastic.
• In the long run, firms
are more flexible, so
supply can become
more elastic.
Section 1 Assessment
1. What is the law of supply?
(a) the lower the price, the larger the quantity supplied
(b) the higher the price, the larger the quantity supplied
(c) the higher the price, the smaller the quantity supplied
(d) the lower the price, the more manufacturers will produce the good
2. What happens when the price of a good with an elastic supply goes down?
(a) existing producers will expand and some new producers will enter the market
(b) some producers will produce less and others will drop out of the market
(c) existing firms will continue their usual output but will earn less
(d) new firms will enter the market as older ones drop out
Section 1 Assessment
1. What is the law of supply?
(a) the lower the price, the larger the quantity supplied
(b) the higher the price, the larger the quantity supplied
(c) the higher the price, the smaller the quantity supplied
(d) the lower the price, the more manufacturers will produce the good
2. What happens when the price of a good with an elastic supply goes down?
(a) existing producers will expand and some new producers will enter the market
(b) some producers will produce less and others will drop out of the market
(c) existing firms will continue their usual output but will earn less
(d) new firms will enter the market as older ones drop out
Costs of Production
• How do firms decide how much labor to hire?
• What are production costs?
• How do firms decide how much to produce?
A Firm’s Labor Decisions
• Basic question of any
Business owner: how many
workers to hire?
• Answer: MUST consider
how the number of workers
they hire will affect their
total production.
• The marginal product of
labor is the change in
output from hiring one
additional unit of labor, or
worker. It is called the
marginal product because it
measures the change in
output at the margin, where
the last worker has been
hired or fired.
Marginal Product of Labor
Labor
(number of
workers)
Output
(beanbags
per hour)
Marginal
product
of labor
0
0
—
1
4
4
2
10
6
3
17
7
4
23
6
5
28
5
6
31
3
7
32
1
8
31
–1
This table shows the relationship between the # of
workers in the factory and the # of beanbags
produced.
Marginal Returns
Increasing marginal returns occur when
marginal production levels increase with
new investment. As workers are added,
specialization increases output per worker.
Increasing, Diminishing, and
Negative Marginal Returns
8
7
Negative marginal returns occur when the
marginal product of labor becomes
negative. Adding too many workers
actually decreases output. At this stage
workers get in each other’s way and
disrupt production.
Diminishing
marginal
returns
6
Marginal Product of labor
(beanbags per hour)
Diminishing marginal returns occur when
marginal production levels decrease with
new investment. As the firm hires
additional workers, benefits of
specialization end. At that point, adding
more workers increases total output, but
at a decreasing rate.
Increasing
marginal
returns
5
4
2
Negative
marginal
returns
1
8
3
0
–1
1
2
3
4
5
6
7
–2
–3
Labor
(number of workers)
9
Production Costs
• A fixed cost is a cost that does not change, regardless
of how much of a good is produced. Most fixed costs
involve the facility. Examples: rent, property taxes,
repairs, salaries of non-production employees
• Variable costs are costs that rise or fall depending on
how much is produced. Examples: costs of raw
materials, production related labor costs, heat,
electricity
• The total cost equals fixed costs plus variable costs.
• The marginal cost is the additional cost of producing
one more unit of a good.
Setting Output
• Marginal revenue is the additional income from selling one more
unit of a good. It is usually equal to price.
• To determine the best level of output, firms determine the output
level at which marginal revenue is equal to marginal cost.
Production Costs
Beanbags
(per hour)
Fixed
cost
Variable
cost
0
$36
$0
1
36
8
2
36
3
36
4
5
Total cost
(fixed cost +
variable cost)
Marginal
cost
Marginal
revenue
(market price)
Total
revenue
Profit
(total revenue –
total cost)
$36
—
$24
$0
$ –36
44
$8
24
24
–20
12
48
4
24
48
0
15
51
3
24
72
21
36
36
20
27
56
63
5
7
24
24
96
120
40
57
6
36
36
72
9
24
144
72
7
36
48
84
12
24
168
84
8
36
63
99
15
24
192
93
9
36
82
118
19
24
216
98
10
36
106
142
24
24
240
98
11
36
136
172
30
24
264
92
12
36
173
209
37
24
288
79
•The ideal level of output is where marginal revenue (price) is equal to
marginal cost. Any other quantity of output would generate less profit.
Responding to Price Changes
• What happens if price rises?
• Thinking at the margin, we predict the firm would
increase production to the price at which the marginal
cost if equal to the new, higher price.
• Marginal revenue would soar above marginal cost at
that level of output and allow the firm to capture profits
previously unrealized.
• This is the law of supply in action.
The Shutdown Decision
• Consider the problems faced by a factory that is losing money.
• Factory is producing at a level of output at which marginal revenue
is equal to marginal costs.
• However, market price is so low that factory’s total revenue is still
less than total cost, and therefore, losing money.
• Should the factory continue to produce goods and lose money or
should the owners shut down?
• The firm should keep the factory open if the total revenue from
goods and services the factory produces is greater than the cost
of keeping it open (operating costs). Keep in mind the owners
must pay FIXED costs even if the factory is closed.
• Operating costs – include variable costs but not fixed costs which
are only paid when the factory is running.
The Shutdown Decision
• Consider the other choice. If the firm were to shut down the
factory, it would still have to pay ALL of the fixed costs.
• Total revenue would be ZERO because it is producing NADA and
it would lose an amount of $$ equal to its fixed costs.
• The factory would lose money either way but it would lose less
money by continuing to produce goods as long as total revenue
exceeded variable costs. That would leave some revenue to
cover part of the fixed costs.
• The factory is losing money either way but it is losing LESS
money by continuing production.
• How long will a firm continue to operate a factory at a loss? It
will stay in the market only if the market price of the good is
high enough to cover all production costs.
Section 2 Assessment
1. What are diminishing marginal returns of labor?
(a) some workers increase output but others have the opposite effect
(b) additional workers increase total output but at a decreasing rate
(c) only a few workers will have to wait their turn to be productive
(d) additional workers will be more productive
2. How does a firm set its total output to maximize profit?
(a) set production so that total revenue plus costs is greatest
(b) set production at the point where marginal revenue is smallest
(c) determine the largest gap between total revenue and total cost
(d) determine where marginal revenue and profit are the same
Section 2 Assessment
1. What are diminishing marginal returns of labor?
(a) some workers increase output but others have the opposite effect
(b) additional workers increase total output but at a decreasing rate
(c) only a few workers will have to wait their turn to be productive
(d) additional workers will be more productive
2. How does a firm set its total output to maximize profit?
(a) set production so that total revenue plus costs is greatest
(b) set production at the point where marginal revenue is smallest
(c) determine the largest gap between total revenue and total cost
(d) determine where marginal revenue and profit are the same
Changes in Supply
• How do input costs affect supply?
• How can the government affect the supply of a good?
• What other factors can influence supply?
Input Costs and Supply
• Any change in the cost of an input such as the raw
materials, machinery, or labor used to produce a good,
will affect supply.
• A rise in the cost of an input will cause a fall in supply
at all price levels because the good has become more
expensive to produce.
• The reverse is also true: a fall in the cost of an input
will cause an increase in supply at all price levels.
Effect of Rising Costs
• As input costs increase, the firm’s marginal costs also
increase, decreasing profitability and supply.
• Explanation??
• Supplier sets output at the most profitable level, where
price is equal to marginal cost. Marginal cost includes
the cost of the inputs that go into production, so a rise
in the cost of labor or raw material will translate directly
into a higher marginal cost. If cost of inputs increase
enough, marginal cost may become higher than the
price, and the firm may not be as profitable as it could
be.
• If firm has no control over price, only solution is to cut
production and lower marginal cost until it equals the
lower price. Supply falls at each price.
Technology
• Input costs can also decrease. Advances in technology can lower
production costs and increase supply at all price levels in many
industries.
• Ex: sophisticated robotics, computers, e-mail
Government Influences on Supply
• By raising or lowering the cost of producing goods, the
government can encourage or discourage an entrepreneur or
industry within the country or abroad.
Subsidies
A subsidy is a government payment that supports a business or
market. Subsidies cause the supply of a good to increase.
EX: paying farmers to take land out of cultivation
Taxes
The government can reduce the supply of some goods by placing
an excise tax on them. An excise tax is a tax on the production or
sale of a good which increases production costs by adding an
extra cost for each unit sold. EX: tax on harmful products like
cigarettes, alcohol, high-pollutant gas
Regulation
Regulation occurs when the government steps into a market to
affect the price, quantity, or quality of a good. Regulation usually
raises costs. EX: lead-free gas, emissions technology on car
exhaust
Other Factors Influencing Supply
• The Global Economy
– The supply of imported goods and services has an impact on
the supply of the same goods and services here.
– Government import restrictions will cause a decrease in the
supply of restricted goods.
• Future Expectations of Prices
– Expectations of higher prices will reduce supply now and
increase supply later. Expectations of lower prices will have
the opposite effect.
• Number of Suppliers
– If more firms enter a market, the market supply of the good will
rise. If firms leave the market, supply will decrease.
Section 3 Assessment
1. What affect does a rise in the cost of raw materials have on the cost of a good?
(a) A rise in the cost of raw materials lowers the overall cost of production.
(b) The good becomes cheaper to produce.
(c) The good becomes more expensive to produce.
(d) This does not have any affect on the eventual price of a good.
2. When government actions cause the supply of a good to increase, what happens to
the supply curve for that good?
(a) It shifts to the left.
(b) It shifts to the right.
(c) It reverses direction.
(d) The supply curve is unaffected.
Section 3 Assessment
1. What affect does a rise in the cost of raw materials have on the cost of a good?
(a) A rise in the cost of raw materials lowers the overall cost of production.
(b) The good becomes cheaper to produce.
(c) The good becomes more expensive to produce.
(d) This does not have any affect on the eventual price of a good.
2. When government actions cause the supply of a good to increase, what happens to
the supply curve for that good?
(a) It shifts to the left.
(b) It shifts to the right.
(c) It reverses direction.
(d) The supply curve is unaffected.