Theory of Supply

Dr. Muhammad Shahadat Hossain Siddiquee

Professor, Department of Economics
University of Dhaka
Email: [email protected]
Contact: +8801719397749
Supply

• Individuals control the factors of production –

inputs, or resources, necessary to produce goods.
• Individuals supply factors of production to
intermediaries or firms.
Supply (Contd..)

• The analysis of the supply of produced goods has two

parts:

– An analysis of the supply of the factors of

production to firms.
– An analysis of why firms transform those factors
of production into usable goods and services.
The Law of Supply
• There is a direct relationship between price and
quantity supplied.
– Quantity supplied rises as price rises, other
things constant.
– Quantity supplied falls as price falls, other things
constant.
The Law of Supply (Contd..)
• Law of Supply:
– As the price of a product rises, producers will be
willing to supply more.
– The height of the supply curve at any quantity
shows the minimum price necessary to induce
producers to supply that next unit to market.
– The height of the supply curve at any quantity also
shows the opportunity cost of producing the
next unit of the good.
The Law of Supply (Contd…)
• The law of supply is accounted for by two factors:

– When prices rise, firms substitute production of

one good for another.
– Assuming firms’ costs are constant, a higher
price means higher profits.
The Supply Curve

• The supply curve is the graphic representation of the

law of supply.
• The supply curve slopes upward to the right.
• The slope tells us that the quantity supplied varies
directly – in the same direction – with the price.
A Sample Supply Curve

S
Price (per unit)

A
PA

0 QA
Quantity supplied (per unit of time)
Shifts in Supply Versus Movements
Along a Supply Curve

• Changes in price causes changes in quantity

supplied represented by a movement along a
supply curve.
Shifts in Supply Versus Movements
Along a Supply Curve

• A movement along a supply curve – the graphic

representation of the effect of a change in price on
the quantity supplied.
Shifts in Supply Versus Movements
Along a Supply Curve

• If the amount supplied is affected by anything other

than a change in price, there will be a shift in supply.
Shifts in Supply Versus Movements
Along a Supply Curve

• Shift in supply – the graphic representation of the

effect of a change in a factor other than price on
supply.
Change in Quantity Supplied

S0

B
Price (per unit)

Change in quantity
A supplied (a movement
$15
along the curve)

1,250 1,500
Quantity supplied (per unit of time)
Shift in Supply

S0
S1
Price (per unit)

A B
$15
Shift in Supply
(a shift of the curve)

1,250 1,500
Quantity supplied (per unit of time)
Shift Factors of Supply

• Other factors besides price affect how much will be

supplied:
– Prices of inputs used in the production of a good.
– Technology.
– Suppliers’ expectations.
– Taxes and subsidies.
Factors that Shift Supply

Resource
Prices

Prices of
Technology
Related
And
Goods and
Productivity
Services
Supply

Number Expectations
Of Of
Producers Producers
 Price of Inputs (Resource Prices)
• When costs go up, profits go down, so that the
incentive to supply also goes down.
 Technology
• Advances in technology reduce the number of inputs
needed to produce a given supply of goods.
• Costs go down, profits go up, leading to increased
supply.
 Expectations

• If suppliers expect prices to rise in the future, they may

store today's supply to reap higher profits later.
 Number of Suppliers
• As more people decide to supply a good the market
supply increases (Rightward Shift).
Individual and Market Supply Curves
• The market supply curve is derived by horizontally
adding the individual supply curves of each supplier.
From Individual Supplies to a Market
Supply

(1) (2) (3) (4) (5)

Quantities Price Ann's Barry's Charlie's Market
Supplied (per DVD) Supply Supply Supply Supply
A $0.00 0 0 0 0
B 0.50 1 0 0 1
C 1.00 2 1 0 3
D 1.50 3 2 0 5
E 2.00 4 3 0 7
F 2.50 5 4 0 9
G 3.00 6 5 0 11
H 3.50 7 5 2 14
I 4.00 8 5 2 15
From Individual Supplies to a Market Supply

Charlie Barry Ann Market Supply

$4.00 I
3.50 H
3.00
Price per DVD

G
2.50 F
2.00 E
1.50 D
1.00 C
0.50 B CA
0 A
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quantity of DVDs supplied (per week)
 Price of Related Goods or Services
• The opportunity cost of producing and selling any good
is the value of the other good a firm could produce.
• If the price of alternate good changes then the
opportunity cost of production changes too!
 Taxes and Subsidies
• When taxes go up, costs go up, and profits go down,
leading suppliers to reduce output.
• When government subsidies go up, costs go down, and
profits go up, leading suppliers to increase output.
Decrease in Supply
Increase in Supply
 Price Elasticity of Supply
• Elasticity of Supply (Es)
• Determinants of Price Elasticity of Supply
• When Government Taxes Products
 Price Elasticity of Supply
• A measure of the extent to which the quantity supplied
of a good changes when the price of the good changes,
and all other influences on seller’s plans remain the
same (ceteris paribus)

• Price Elasticity of Supply (Es)

=
% Change in Qs
% Change in Price
Computing Price Elasticity of Supply
• Percentage change in quantity supplied
Percentage change in price

• If Price Elasticity of Supply > 1, Supply is elastic

• If Price Elasticity of Supply = 1, Supply is unit elastic
• If price elasticity of supply< 1, Supply is inelastic
 Price Elasticity of Supply
• Perfectly Elastic Supply – When the quantity supplied
changes by a very large percentage in response to an
almost zero increase in price
• Elastic Supply – When the % change in the quantity
supplied > the % change in the price
• Unit Elastic Supply – When the % change in the
quantity supplied = the % change in price
• Inelastic Supply – When the % change in the quantity
supplied is < the % change in price
• Perfectly Inelastic Supply – When the quantity supplied
remains the same as the price changes
Perfectly Elastic Supply Curve

Quantity
Perfectly Inelastic Supply Curve
S

Quantity
Relative Elasticities of Supply
S1

S2

Quantity
 Influences of Price Elasticity of
Supply
• Storage Possibilities

The better the storability, the more elastic is the supply

curve is.
 Influences on Price Elasticity of
Supply
• Production Possibilities

-- Opportunity Costs
constant or gently rising opportunity costs
> the elasticity of price
-- Fixed Production < the elasticity of price
-- Time Elapse – longer time, > the elasticity of price
 Substitution and Production Costs
• The ease of substitution can vary in production as well
as in consumption. If capital, labour, equipment and/or
land can be easily shifted from one product to another,
than the supply of Product A would be elastic.
 Spare Capacity
• If the firm has lots of space to expand production
quickly, then the supply will be more elastic
 Inventory

• If the firm has a lot of raw materials and components

on hand, they can easily respond to a change in price,
causing the supply curve to be more elastic.
 Elasticity over Time
• Remember, supply elasticity increases over time,
especially when enough time has passed for new firms
to enter the industry and for existing firms to increase
their output

• Economists have identified two distinct time periods

– The short run
– The long run
 The Short Run
• In the short run a firm has an essentially fixed productive
capacity but labor flexibility
– A firm has some ability to increase output
• A firm could go from two 8-hour shifts to three
8-hour shifts
• Store hours could probably be extended
• And so, an increase in demand will result in more
output
 The Long Run
• In the long run there is sufficient time for a firm to alter
its productive capacity
– The firm can leave the industry
– New firms can enter the industry
– When a rise in demand is considered to be long
lasting, some existing firms will add to their plant
and equipment
– If demand falls, some or all firms will cut back on
their plant and equipment, while others may leave
the industry
 When Government Taxes Products
• A tax on a product is called an excise tax and will
change (reduce) the supply curve as an additional cost.
• Question! Who pays the excise tax?
• Possibilities:
• The Consumer who buys the product?
• Or, someone in the supply chain who participates in
the supply of the product (manufacturer, distributor,
retailer)
 Cross Elasticity of Supply
• Cross elasticity of supply is defined as the
responsiveness of the supply of good A to a change in
the price of good B. Using an example of a farmer who
grows both potatoes and carrots the cross elasticity of
supply of carrots against potatoes is how much supply
of carrots will change if the price of potatoes changes.
 Cross Elasticity of Supply
• Many may see carrots and potatoes as being substitutes
for each other and therefore it would be a safe
assumption that as the price of potatoes increases, the
supply of carrots falls. This is because the farmer now
uses more land to produce potatoes and less to produce
carrots.