Lesson-7

Supply and Demand-- Supply Analysis

Why is it that farmers are more willing to grow certain crops one year and different crops
the next? The price they receive for the crop they grow determines what seeds the
farmers will sow. The information below will help you to understand the supply side of
the equation.

Supply

What determines the amount of a good or service that people are willing and ready to sell
during some period of time? People sell things because it is a way, indirect but effective,
of obtaining other things that they prefer. Sellers intend to make a profit from their sales,
and economists assume that they want their profits to be as large as possible. Because
profit is the difference between benefits in the form of revenues and costs, anything that
influences revenues or costs can influence the amounts sellers want to sell.

Supply focuses on the producer of goods and services. It refers to the quantities of a
product that producers are willing and able to offer at a given price during some period of
time. Like demand, there are price and non-price determinants for supply. Producers
make decisions on how much to supply based on profitability.

Revenue is calculated by multiplying the price of the product by the amount sold. A
change in price changes revenues, and hence profits. So, it is a major determinant of the
amount sellers will want to sell. Because a higher price leads to higher profit, and a
higher profit leads to a larger amount that sellers will want to sell, one expects that a
greater quantity should be supplied when the price is higher. Thus, the relationship
between quantity that sellers will sell and price should be direct or positive.

Though the positive relationship is almost always the case, there are a few exceptions. An
example is labor. As wages go up, people may decide to enjoy their higher wages and
work less. As a result, there is no law of supply that matches the law of demand.

The cost of something is what must be given up in order to get it. When costs are only
monetary, they are easy to see. If the price of an input increases, the cost of the output
will increase, and, other things held constant, profits will decrease. The seller will then
have to decide if shifting part of his resources and effort to other products will improve
his well-being.

Production costs are determined not only by the prices of inputs, but also by technology.
Technology represents the knowledge of how inputs (such as labor, raw materials, energy
and machinery) can be combined to produce the product. If this knowledge increases so
that people find cheaper ways to make the same output, then, other things held constant,
profit increases and we expect sellers to respond by producing more.
Costs may be non-monetary as well as monetary. For example, a farmer takes the
expected price of soybeans into account in deciding how much corn to plant. If soybeans
are expected to sell for a high price, then the farmer may find that shifting some of his
land from corn production to soybean production will increase profit. The decision to
plant corn means that the farmer gives up the opportunity to plant soybeans (as well as
giving up the money for seed, fuel, equipment and labor). Because we have defined cost
as what must be given up to get something, the prices of other goods that sellers could
otherwise produce and sell must be part of the calculation of the cost of production.

There are other factors that can influence the amount of a product that sellers will sell.
These include the number of sellers, expectations about the future, and whether or not
there are by-products in production that are valuable. An example of a valuable by-
product is cottonseed in the production of cotton. A farmer who produces cotton also gets
cottonseed, which yields cottonseed oil, a widely used vegetable oil. But, the emphasis of
supply is on the relationship between quantity and price. To focus on this relationship, all
other factors must be assumed to be constant.

The supply side of the equation also has a law. The law of supply states that sellers will
offer more of a good at a higher price and less at a lower price.

The Supply Schedule and Supply Curve

The relationship between the quantity sellers want to sell during some time period
(quantity supplied) and price is what economists call the supply curve. Though usually
the relationship is positive, so that when price increases so does quantity supplied, there
are exceptions. Hence, there is no law of supply that parallels the law of demand.

The supply curve can be expressed mathematically in functional form as below:

Qs = f (price, with other factors held constant)

It can also be illustrated in the form of a table or a graph. The tabular representation is
known as “supply schedule,” whereas graphical representation is called “supply curve.”

A Supply Schedule
Price of Number of Widgets
Widgets Sellers want to sell
$1.00 10
$2.00 40
$3.00 70
$4.00 140
Table A
The graph shown below in Figure A has a positive slope, which is the slope one normally
expects from a supply curve.

Figure A

For all practical purposes, we assume this curve to be a straight line. Examine the
following curve:

Figure B

A change in quantity supplied occurs when there is a movement between points along a
stationary supply curve. Once again, this movement is influenced by price. This change
can be seen in the graph above with the movement from point A to point B.

There can also be a shift in supply. A shift in supply refers to an increase (rightward
change) or a decrease (leftward change) in the quantity supplied at each possible price.
These shifts are influenced by non-price determinants.

Shift in Supply
If one of the factors that is held constant changes, the relationship between price and
quantity (supply) will change. If the price of an input falls, for example, the supply
relationship may change, as in the following table:

A Supply Curve Can Shift

Price of Number of Widgets
Widgets Sellers want to sell
$1.00 [10] becomes 20
$2.00 [40] becomes 60
$3.00 [70] becomes 100
$4.00 [140] becomes 180
Table B

The same changes can be shown with the help of a graph in the following figure:

Figure C

The theoretical purpose will assume the supply curve to be a straight line. This shift in
demand can either be increase or decrease, as shown in the graph in the figure below.

Increase in Demand-- It results from the increase in the price of substitute, increase in
income, or change in taste and preferences etc.

Decrease in Demand-- It results from the decrease in the price of substitute, decrease in
income, or change in taste and preferences etc.
 Figure D

The most important distinction to keep in mind is that a change in quantity supplied is a
movement along a single curve, while a shift in supply involves the creation of a second
curve.

Non-Price Determinants of Supply

There are other factors besides price that influence producers to sell products. A brief
description of each is provided below.

1. Change in Technology

New, efficient technology makes it possible to offer more products at any possible selling
price. Technological devices such as computers and robots have made it possible to
reduce production costs and increase the supply of goods and services.

2. Change in Production Costs

A change in the cost of labor, taxes or a resource needed to produce a good impacts the
decisions of sellers on how much to produce.
3. Change in the Number of Sellers

An increase or decrease in the number of sellers can influence the production of goods
and services. If the United States removes a restriction on foreign imports, then there are
more sellers in the market.

4. Change in Supplier Expectations

Expectations of the future can influence the production of goods and services. If prices of
a good or service is expected to rise in the future, sellers may hold back production in the
present in the hope of making more profit by selling more in the future. For example, if
farmers think the future price of the corn will decline, they will increase the present
supply of corn in the hope of making more money now.

Supply Terminology

As with demand, economists separate changes in the amount that sellers will sell into two
categories. A change in supply refers to a change in behavior of sellers, caused because a
factor held constant has changed. As a result of a change in supply, there is a new
relationship between price and quantity. At each price, there will be a new quantity, and
at each quantity, there will be a new price. A change in quantity supplied refers to a
change in behavior of sellers, caused because price has changed. In this case, the
relationship between price and quantity remains unchanged, but a new pair in the list of
all possible pairs of price and quantity is realized.

Supply curves as well as demand curves appear much more concrete on an economist's
graph than they appear in the real markets. A supply curve is mostly potential-- what will
happen if certain prices are charged, most of which will never be charged. From the
buyer's perspective, the supply curve has more meaning as a boundary than as a
relationship. The supply curve says that only certain price-quantity pairs will be available
to buyers which are lying to the left of the supply curve.

The Long and Short Run

The supply relationship will depend on how long the suppliers have to adjust to a change
in the price.

With respect to supply, time plays a role which it does not (in most cases) play in the case
of demand. If there is plenty of time for the suppliers to adjust to a change in the price,
we have a “long run” analysis. This means that the sellers can invest and expand
productive capacity in response to a high price, or can gradually reduce the productive
capacity by under-replacing worn-out equipment in the case of a low price. However, if
the sellers are not sure that the high or low price will continue for a long time, a “short
run” analysis may be more appropriate. In a short run analysis, we treat the plant and
equipment of the industry as inflexibly given. In that case, output can be increased only
by using that fixed plant and equipment more intensively. Thus, we would expect the
adjustment of supply to a change in price to be more complete in the long run than in the
short run.

We do not ordinarily apply the long run versus short run distinction to demand, but there
are some special cases where it might be important. For example, for durable goods such
as cars, buyers might adjust less completely in the short run than in the long, since they
can postpone replacement of their durable goods until the price comes down. In the long
run, the goods wear out and so the consumers cannot postpone replacement for long
enough.

Summary

In the short run, the plant and equipment (productive capacity) of the industry are fixed.
While in the long run, sellers can change the productive capacity in response to the price.