IB-EC-main
TOPIC:
(05) Market supply
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Supply is defined as the quantity of a good or service that producers are willing and able to
supply at different prices in a given time period.
It is not enough for producers to be willing to produce a good or service, they must also be
able to produce it. This is known as effective supply and it is this that is shown on supply
curve.
The law of supply
The law of supply simply states that as the price of a product rises, the quantity supplied of
the product will usually increase, ceteris paribus, the supply curve normally slopes upwards.
The law of supply may be illustrated using either a supply schedule or a supply curve.
The supply curve is a table depicting the relationship between the price of a product and a
corresponding quantity supplied of the product.
The supply curve is a curve that shows the relationship between the price of a product,
which is placed on the vertical axis, and the quantity supplied of the same product over
time, which is placed on the horizontal axis. Supply curves tend to be curved and get steeper
as price rises, however, for ease of analysis, economist often draw them as straight lines.
The supply schedule and supply curve show the sum of all individual producers' supply, and
is known as the market supply.
In the law of supply, a change in the price of a product itself will lead to a change in the
quantity supplied of the product, which means a movement along the existing supply curve.
The phrase "change in the quantity supplied" is important, since it differentiates a change
in price from the effect of a change in any of the other determinants of supply.
In the neoclassical model, the only goal that producers have is to maximize profits. So since
rising prices can translate into higher profits for producers, they will wish to increase supply
to take advantage of the higher potential profits.
The non-price determinants of supply
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There are a number of factors that determine supply and lead to an actual shift of the
supply curve either to the right or to the left. The determinant of supply are outlined below.
1. the cost of factors of production;
2. the price of related goods (competitive and joint supply);
3. the government intervention (indirect taxes and subsidies);
4. expectations about future prices;
5. changes in technology;
6. weather or natural disasters.
If there is an increase in the cost of a factor of production, such as a wage increase in a firm
producing textiles, which is labor-intensive, this will increase the firm's costs. This means
that they can supply less, shifting the supply curve to the left. On the opposite, a fall in the
cost of factors of production will enable firms to increase their supply, shifting the supply
curve to the right.
Competitive supply. Often, producers have a choice as to what they are going to produce,
because the factors of production that they control of capable of producing more than one
product with a minimal change in production facilities. If the price of one of possible
products rise, the producer will be attracted to switch the operations and to aim to supply
more of it.
This would lead to a movement along the existing supply curve of the desired product and a
shift to the left of the entire supply curve of the product which the producer is giving up to.
In this case, the products are competing for the factors of production that the firm has in
their control. Thus, it is said that products are in competitive supply.
Joint supply. Sometimes, when one good is produced, another good is produced at the
same time (by-product), if it happens, the the goods are said to be in joint supply. If the
demand for one good in joint supply increases, then the supply of the other good(s) will also
increase.
This would lead to a movement along the existing supply curve of the desired product and a
shift to the right of the entire supply curve of the product in joint supply. The quantity
supplied of the by-product increases, while the demand remains constant which in al leads
to the fall of its price.
In many countries, government intervene in markets in ways that alter the supply. The two
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most common ways are through indirect taxes and subsidies.
Indirect taxes. Indirect taxes are taxes on goods and services that are added to the price of
a product. The taxes effectively increase the costs of production to the firms, they have the
effect of shifting the supply curve upwards by the amount of the indirect tax. Less of the
product will be supplied at every price.
Government subsidies. Subsidies are payments made by the government to firms that will,
in effect, reduce their costs of production. This then has the effect of shifting the supply
curve downwards by the amount of the subsidy. More of the product will be supplied at
every price.
Producers make decisions about what to supply based on their expectations of future
prices. Producers who expect the demand for their product to rise in the future may assume
that the higher demand will lead to a higher price. The effect on production decision might
vary. The producers might both increase their supply capacities and withhold the product
from the market in order to store it. Similarly, if market research suggests that demand for a
product will fall in the future, then producers will be likely to reduce their supply of the
products.
Improvements in the state of technology in a firm or an industry will lead to an increase in
supply and thus a shift of the supply curve to the right. In the unlikely event of a backward
step in the state of technology, the supply curve will shift to the left.
In markets vulnerable to weather conditions, the weather can have an impact on supply.
Extremely favorable weather could lead to increased supply while poor weather and natural
disasters can lead to significant cuts in supply.
Supply and quantity supplied
The distinction between a movement along the supply curve and a shift of the supply curve.
a. A change in the price of the good itself leads to a movement along the existing
supply curve, since the price of the good is on one of the axes.
b. A change in any of the other determinants of supply will always lead to a shift of the
supply curve to either the left or the right.
The law of diminishing returns
Economists consider two different time periods when looking at production.
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The short run is defined as the period of time in which at least one factor of production is
fixed. All production takes place in the short run.
The long run is defined as the period of time in which all factors of production are variable,
but the stage of technology is fixed. All planning takes place in the long run.
Therefore, if a firm wishes to increase output in the short run, it may only do so by applying
more units of its variable factors to the fixed factors it possesses, while it plans ahead to
change the number of fixed factors that it has.
The length of the short run for a firm will be determined by the time it takes to increase the
quantity of the fixed factor. This will vary from industry to industry.
In the short run, if a firm increases output by adding more and more units of a variable
factor to its fixed factors, it is logical to assume that the output from each unit added will
eventually fall.
Total product (TP) is the total output that a firm produces, using its fixed and variable
factors in a given time period.
Average product (AP) is the output that is produced, on average, by each unit of the
variable factor. It equals the division of the total product by the number of units of the
variable factor employed.
Marginal product (MP) is the extra output that is produced by using an extra unit of the
variable factor. It equals the division of the change in total output by the change in the
number of units of the variable factor employed.
AP = TP / V
MP = dTP / dV
The law of diminishing returns is based on two distinctive hypotheses.
The hypothesis of eventually diminishing marginal returns. As extra units of a variable
factor are added to a given quantity of a fixed factor, the output from each additional unit
of the variable factor will eventually diminish.
The hypothesis of eventually diminishing average returns. As extra units of a variable
factor are added to a given quantity of a fixed factor, the output per unit of the variable
factor will eventually diminish.
Whether we measure it from the amount added by the extra variable factor (marginal
product) or the amount added per unit of the variable factor (average product), logic tells us
that inefficiency must eventually begin to occur.
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Marginal cost (MC) is the increase in total cost of producing an extra unit of output. It
equals to the division of the change in total cost (TC) by the change in the level of output.
The hypothesis of eventually increasing marginal costs. As extra units of a variable factor
are added to a given quantity of a fixed factor, the cost from each additional unit of the
variable factor will eventually increase.
Increasing marginal cost is clearly related to diminishing marginal returns. If the output
produced by each additional unit (MP) begins to fall, yet each unit costs the same, then the
cost of producing each extra unit (MC) begins to increase.
It therefore follows that firms will only be prepared to supply more and increase output, if
the prices that they will receive for their products are also going up as output increases.
The process standing behind the law of supply.
1. To increase output, firms need to add more units of a variable factor to fixed
factors.
2. Eventually, output from each extra unit of the variable factor falls, as inefficiency
sets in (law of diminishing marginal returns).
3. Logically, the cost of producing more output will go up (law of increasing marginal
costs).
4. So, firms will only produce more if prices rise to cover the increased marginal cost.
5. Thus, the supply curve will slope upwards.
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