Supply

Summary and Introduction to Supply

At the other side of every transaction is a seller. Economists refer to the behavior of sellers as that market force of supply. It is the combined forces of supply and demand that make up a market economy. In microeconomics, the smallest unit of supply is the firm, which is analogous to the demand unit of the household. Firms operate independently of each other, making decisions about what to sell, and how much to sell, depending on the price. How do firms make their selling decisions? Once they have decided what to sell, a decision they make based on what they believe buyers will want to buy, their decision is then influenced by the market price of the goods. If a firm in Boston decides to sell warm hats, they will want to sell more hats if the going price is high than if the going price is low. Just like households, firms try to maximize their utility when making selling decisions. Whereas a buyer's utility is a complex combination of preferences, needs, and happiness, economists usually assume that sellers derive utility from profit, that is, the more money a seller makes from a sale, the happier it will be. Firms will maximize their utility by selling whatever will make them the most money. In this way, sellers' utility is somewhat easier to study and understand, since we don't have to take personal preferences into account (in theory). Instead, we look purely at price and profit. In this unit on supply, we will look at graphical and mathematical ways to represent supply, and we will see what factors can affect supply.

Terms
Aggregate Demand - The combined demand of all buyers in a market. Aggregate Supply - The combined supply of all sellers in a market. Buyer - Someone who purchases goods and services from a seller for money. Competition - In a market economy, competition occurs between large numbers of buyers and sellers who vie for the opportunity to buy or sell goods and services. The competition among buyers means that prices will never fall very low, and the competition among sellers means that prices will never rise very high. This is only true if there are so many buyers and sellers that none of them has a significant impact on the market equilibrium. Demand - Demand refers to the amount of goods and services that buyers are willing to purchase. Typically, demand decreases with increases in price, this trend can be graphically represented with a demand curve. Demand can be affected by changes in income, changes in price, and changes in relative price. Equilibrium Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the market-clearing price. Equilibrium Quantity - Amount of goods or services sold at the equilibrium price. Because supply is equal to demand at this point, there is no surplus or shortage. Firm - Unit of sellers in microeconomics. Because it is seen as one selling unit in microeconomics, a firm will make coordinated efforts to maximize its profit through

sales of its goods and services. The combined actions and preferences of all firms in a market will determine the appearance and behavior of the supply curve. Goods and Services - Products or work that are bought and sold. In a market economy, competition among buyers and sellers sets the market equilibrium, determining the price and the quantity sold. Horizontal addition - The process of adding together all quantities demanded at each price level to find aggregate demand Household - Unit of buyers in microeconomics. Because it is seen as one buying unit in microeconomics, a household will make coordinated efforts to maximize its utility through its choices of goods and services. The combined actions and preferences of all households in a market will determine the appearance and behavior of the demand curve. Market - A large group of buyers and sellers who are buying and selling the same good or service. Market Economy - An economy in which the prices and distribution of goods and services are determined by the interaction of large numbers of buyers and sellers, none of whom have a significant individual impact on prices or quantities. Market Equilibrium - Point at which quantity supplied and quantity demanded are equal, and prices are market-clearing prices, leaving no surplus or shortage. Market-Clearing Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the equilibrium price. Profit - Actual amount that a firm makes from selling a good. Is equal to Total Revenue (TR) - Total Cost (TC). Seller - Someone who sells goods and services to a buyer for money. Supply - Supply refers to the amount of goods and services that sellers are willing to sell. Typically, supply increases with increases in price, this trend can be graphically represented with a supply curve. Supply Curve - A supply curve is the graphical representation of the relationship between quantities of goods and services that sellers are willing to sell and the price of those goods and services. Total Cost - All of the money a firm has to pay in order to be able to sell its products. Includes total variable costs and total fixed costs. Total Revenue - All of the income a firm makes from selling its products. Is equal to price per unit times quantity sold, (P)x(Q). Utility - An approximate measure for levels of "happiness." Wage - Price per unit of time when the good being sold is some form of labor or work (instead of a physical product).

Supply

The Graphical Approach

Economists graphically represent the relationship between product price and quantity supplied with a supply curve. Typically, supply curves are upwards sloping, because as price increases, sellers are more likely to be willing to sell something. For instance, if someone offered you $10 for one of your favorite shirts, you might not want to part with

it, since it wouldn't be worth it. However, if someone offered you $500 for that same shirt, you would probably consider it. Each individual seller can have their own supply curve, showing how many products they are willing to sell at any given price, as shown below. This graph shows what James's supply curve for hours of tutoring in economics might be:

Figure %: James's Supply Curve To find out how many hours of tutoring James will give for a given wage (when we put a price on hours of work, we call it a wage), extend a perpendicular line from the price on the y-axis to his supply curve. At the point of intersection, extend a line from the supply curve to the x-axis (perpendicular to the x-axis). Where it intersects the x-axis (quantity) is how many hours of tutoring James will teach. For instance, in the graph above, James will teach for 3 hours when the hourly wage is $30 an hour. Typically, however, economists don't look at individual supply curves. Instead, they look at aggregate supply, the combined quantities supplied by all potential sellers. To do this, you add the quantities that sellers are willing to sell at different prices, just like we do to find aggregate demand. For instance, if James and Ina are the only two tutors in the market for economics tutoring, we would add how many hours they are willing to tutor at wage w=20 and record that as aggregate demand for w=20. Then we would add how many they are willing to tutor at wage w=30 and record that as aggregate demand for w=30, and so on. Combining the two supply curves in the first graph results in the aggregate supply curve in the second graph:

Figure %: Two Supply Curves

Figure %: Aggregate Supply Curve Since at w=20 James is unwilling to work and Ina is willing to work 2 hours, at w=20 the aggregate supply curve equals 2 hours. At w=30, James is willing to work 5 hours and Ina 6, so at w=20 the aggregate supply curve equals 11 hours. This method is called horizontal addition, since we add across each price level to find the total quantity supplied. There are two ways that supply quantity can change: one is through movements along the same supply curve, the other is through shifts in the supply curve. Let's look at the first one: movements along one supply curve. Movements along one supply curve follow the same idea as movements along a single demand curve: nothing is changing except for the price of the good, so the only thing influencing supply is a change in price. With all else being equal, we can see how James might change how much he is willing to tutor when his wage rises or falls in the following graph:

Figure %: James's Supply Curve Note that when the wage is higher, the quantity supplied is higher, and vice versa. The reservation price (or in this case, the reservation wage) is the lowest price that a seller is willing to accept for its products. Most firms will sell products up to the point where their profits are 0, or where the amount they spend to make and sell the product is equal to the amount they receive for the product on the market. To find the reservation wage on James's supply curve, find the point where his quantity supplied will be 0. The reservation price will be marginally higher than the price at Q = 0. If we assume that James can only tutor in hourly increments (that is, he can't tutor for less than an hour), then his reservation wage will be the wage at which he will only tutor for one hour. On the graph, it looks like James's reservation wage will be about $10/hour. The other way in which supply quantity can change is through actual shifts in the supply curve. If you recall when we studied shifts in demand curves, you will remember that such shifts are caused by outside factors. While demand curves are shifted by changes in income or changes in preferences, supply curves can be affected by changes in profit. Profit is how much a firm actually gains when they make a sale. For instance, if a bookstore buys a used book for $1 and sells it for $5, their profit is $4. Changes in the selling price of the book can change how many books they are willing to sell, and such changes would be represented by sliding up and down the same supply curve, as in the previous example. If the price the bookstore has to pay for the book changes, however, that would cause their supply curve to shift, even if the selling price doesn't change. If they have to pay more for the book, their profits drop, and make them less willing to sell books at prices they were willing to sell at before the change. We can see this below:

Figure %: A Shift in the Supply Curve

Notice that for any given price, the store will sell fewer books than before, reflecting the higher costs and lower profits they get for each book. Without changing the price at which they sell the book, we have shifted their supply curve and changed their willingness to sell. Thus, changes in profits can shift a firm's supply curve, even if the market price stays constant. We will later learn how to graphically visualize a firm's profits in a given market by using their different costs, sources of income, and the market price and demand.

The Algebraic Approach

As with demand, it is also possible to model supply using equations. These supply equations, or supply functions, are used to numerically represent firm behavior and the variation of firm behavior with price. For simplicity's sake, we will again use simple algebraic equations. If Amy's bookstore sells textbooks with a supply curve that looks like this:

Figure %: Amy's Bookstore's Supply Curve The corresponding equation that describes the bookstore's supply of textbooks will be the equation for the line, or: Q = -10 + P If we want to see how many books the store is willing to sell if the price is $50, we plug 50 in for P and solve for Q. In this case, Q = [-10 + 50] = 40 textbooks If we want to solve for aggregate supply using the algebraic approach instead of the graphical approach, we just add the supply equations together. So, if we're adding Amy's bookstore's supply to Tony's bookstore's supply, it will look like this:

Figure %: Aggregate Supply If price is still equal to 50, we find out that together, Amy and Tony will sell

Q = [-15 + 2.5(50)] = 110 textbooks One caveat: It is possible that some supply functions will sometimes give a negative quantity for some prices. For instance, the supply equation for Amy's bookstore will give a negative quantity supplied if the price is under $10 per textbook. Since it is impossible to supply a negative quantity of textbooks, for values under $10 the store will not sell any textbooks. Before adding together two or more supply equations, always check to make sure that none of them will give you negative results for the price for which you are solving. To find the reservation price when working with supply functions, set Q equal to 0 and solve for P. The reservation price will be marginally higher than P when Q is equal to 0. For instance, if we want to find Amy's reservation price: Q = -10 + P 0 = -10 + P P = 10 Amy's reservation price will be marginally higher than $10. Assuming that she can only sell whole books (that is, she can't sell 1/2 of a book), then her reservation price will be the price when her supply quantity will be 1: 1 = -10 + P P = $11 per textbook If we want to see how supply can change even without a change in the market price, we need to look at utility. While buyers get their utility from their preferences and needs, firms get their utility from profit. Basically, profit is how much a seller actually gains by making a sale (and what we use to measure how happy the seller will be), and is derived by subtracting the costs from income. The simplest form of the profit equation is as follows: Profit = Total Revenue (TR) - Total Cost (TC) For instance, if an ice cream store pays $500 in rent, $500 in wages, and $200 for ice cream each month, and they sell 500 ice cream cones at $3 each, then their profit each month is: [(500)(3) - (500 + 500 + 200)] = $300. One thing that can change their profit margin is the price. We know from before that changes in price are reflected in movements along one supply curve. However, changes in their costs, such as rent, wages, or gallons of ice cream can cause their supply curve to shift, since any of these changes would affect their willingness to sell ice cream at a given price. We can see how this works when we change how much rent the ice cream store has to pay each month without changing the price they charge for an ice cream cone. If the monthly rent increases to $600, and nothing else changes, then their monthly profits will fall to $200. If you were the ice cream store owner, and you had this happened to you, how willing would you be to sell ice cream cones? Last month, you sold 500 cones and

made $300. This month, you would have to work just as hard to make less money. It is easy to see why firms can be affected by more than just the price of a good when deciding how much to sell, and it is these considerations that can cause shifts in their supply curves.