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2.5: Supply

  • Page ID
    3599
  • What you’ll learn to do: explain the law of supply

    So far you’ve learned about the role of demand in economics—which is the consumer side of the story. In this section, you’ll learn about the producer side of economics to see what factors impact the amount of goods supplied in a market. For example, suppose the global price of petroleum falls significantly. What do you think will happen to the supply of gasoline? How are supply and price connected? In the following readings you’ll examine the law of supply and see why this counterpart to “demand” is also essential to understanding economics.

    learning objectives

    • Explain the law of supply
    • Explain a supply curve
    • Explain the factors that can change supply

    The Law of Supply

    The law of supply states that more of a good will be provided the higher its price; less will be provided the lower its price, ceteris paribus. There is a direct relationship between price and quantity supplied. Watch this video to learn more.

    Supply of Goods and Services

    Five stacked rows of green-colored oil barrels.When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply, like the law of demand, assumes that all other variables that affect supply (to be explained in the next reading) are held equal.

    supply vs. quantity supplied

    In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that can be illustrated with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve, and quantity supplied refers to the (specific) point on the curve.

    Figure \(\PageIndex{1}\), below, illustrates the law of supply, again using the market for gasoline as an example. Like demand, supply can be illustrated using a table or a graph. A supply schedule is a table—like Table \(\PageIndex{1}\), below—that shows the quantity supplied at a range of different prices. Again, price is measured in dollars per gallon of gasoline, and quantity demanded is measured in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. You can see from this curve (Figure \(\PageIndex{1}\)) that as the price rises, quantity supplied also increases and vice versa. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.

    The graph shows an upward-sloping supply curve that represents the law of supply.

    Figure \(\PageIndex{1}\). A Supply Curve for Gasoline

    Table \(\PageIndex{1}\). Price and Supply of Gasoline
    Price (per gallon) Quantity Supplied (millions of gallons)
    $1.00 500
    $1.20 550
    $1.40 600
    $1.60 640
    $1.80 680
    $2.00 700
    $2.20 720

    The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: They slope up from left to right and illustrate the law of supply. As the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.

    practice question \(\PageIndex{1}\)

    Michael is the owner of a steel refinery in Pittsburgh, PA. In October the price for a ton of steel was $400, which increased to $600 by November. According to the law of supply, what would be a rational response by Michael to this change in market price for steel?

    1. Shut down 2 out of the 4 smelters at his steel plant.
    2. Hire additional workers.
    3. Layoff workers and reduce output.
    Answer

    b. The law of supply postulates a positive relationship between quantity supplied and price. If price increases, so must steel output.

    practice question \(\PageIndex{2}\)

    Joshua operates a small information technology business which supplies advanced microchips to local businesses. His supply schedule for microchips is displayed below. Which supply curve shown more accurately reflects his supply schedule?

    Price and Supply of Computer Chips
    Price Quantity Supplied
    $100.00 120
    $120.00 150
    $140.00 180
    $160.00 210
    $180.00 240
    $200.00 270
    $220.00 300
    1. Graph showing the market for computer chips. The x axis is quantity supplied and the y axis is price. There is an upward sloping line with plot points at 150,120 and 180,140 and 210,160 and 240,180 and 270,200 and 300,220
    2. Graph showing the market for computer chips. The x axis is price and the y axis is quantity supplied. There is an upward sloping line with plot points at 100,120 and 120,150 and 140,180 and 160,210 and 180,240 and 200,270 and 220,300
    3. Graph showing the market for computer chips. The x axis is quantity supplied and the y axis is price. There is an upward sloping line with plot points at 110,100 and 170,120 and 210,140 and 270,160 and 350,180 and 590,220
    Answer

    a.

    Factors Affecting Supply

    How Production Costs Affect Supply

    Large truck loaded with new cars.A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus, so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as a shift in demand is represented by a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.

    In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. Goods and services are produced using combinations of labor, materials, and machinery, or what we call inputs (also called factors of production). If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it’s more motivated to produce output (goods or services), since the more it produces the more profit it will earn. So, when costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. This can be shown by the supply curve shifting to the right.

    Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver packages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.

    Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.

    Consider the supply for cars, shown by curve S0 in Figure \(\PageIndex{2}\), below. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. The same information can be shown in table form, as in Table \(\PageIndex{1}\).

    The graph shows supply curve S sub 0 as the original supply curve. Supply curve S sub 1 represents a shift based on decreased supply. Supply curve S sub 2 represents a shift based on increased supply.

    Figure \(\PageIndex{2}\). Shifts in Supply: A Car Example

    Table \(\PageIndex{1}\). Price and Shifts in Supply:  A Car Example
    Price Decrease to S1 Original Quantity Supplied S0 Increase to S2
     $16,000 10.5 million 12.0 million 13.2 million
    $18,000 13.5 million 15.0 million 16.5 million
     $20,000 16.5 million 18.0 million 19.8 million
    $22,000 18.5 million 20.0 million 22.0 million
    $24,000 19.5 million 21.0 million 23.1 million

    Now imagine that the price of steel—an important component in vehicle manufacturing—rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. This can be shown graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.

    Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.

    Other Factors That Affect Supply 

    Photo of wheat with bright blue sky and white clouds in the background.In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.

    The cost of production for many agricultural products will be affected by changes in natural conditions. For example, the area of northern China that typically grows about 60 percent of the country’s wheat output experienced its worst drought in at least fifty years in the second half of 2009. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied; conversely, especially good weather would shift the supply curve to the right.

    When a firm discovers a new technology that allows it to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world was grown with these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.

    Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Taxes are treated as costs by businesses. Higher costs decrease supply for the reasons discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace; complying with regulations increases costs.

    A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right.

    practice question \(\PageIndex{3}\)

    As an economist at the USDA you observe there has been a change in the market for processed corn this past year (displayed below). Which option below can best explain this recent market shift?
    Graph showing the market for corn. The x axis is quantity in millions of tons and the y axis is price in thousands. There are two upward sloping lines. One line starts at 120,10 and ends at 220,70. Another line starts at 160,10 and ends at 260,70. There are two arrows pointing to the right in between the two lines

    1. There has been an exceptionally short growing season this past year.
    2. The cost of farm labor has decreased
    3. The price of wheat, a substitute, has increased
    Answer

    b is correct - Lower input costs are one factor that can shift the supply curve rightwards. 

    a is incorrect - Unfavorable natural conditions are likely to shift the demand curve leftwards, not rightwards.

    c is incorrect - Higher substitute cost will shift the demand curve rightwards, not the supply curve.

    Exercise \(\PageIndex{4}\)

    Several unfavorable changes have occurred this past year for almond suppliers in California. A drought continues to ravage crops, and a recent strike by migrant farm laborers has sent production costs soaring. In response to these recent events the almond growers lobby has successfully petitioned the California state legislator for a significant subsidy to almond farmers.

    Given these events, how would we expect the supply curve for almonds to react?

    1. The supply curve would shift inwards
    2. The supply curve would shift outwards
    3. It is impossible to tell with the given information
    Answer

    C - A subsidy should shift supply rightwards, while the drought and labor strike has the opposite effect. We have no way of knowing which is stronger.

    Summary

    3538883411_8215f13960_b (1)

    Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.

    Figure \(|PageIndex{3}\), below, summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.

    The graph on the left lists events that could lead to increased supply. The graph on the right lists events that could lead to decreased supply.

    Figure \(\PageIndex{3}\). Factors That Shift Supply Curves. (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.

    Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. Factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.

    Exercise \(\PageIndex{5}\)

    List and explain three out of the four factors responsible for shifts in the supply curve.

    Answer

    The four factors that can shift the supply curve include natural conditions, input prices, technology, and government. Natural conditions include any natural event that may favorably or unfavorably impact production. Lower input costs will increase the profit margin of the supplier, encouraging them to provide more output at any given price. Improved technology can increase what a supplier can produce with a given set of inputs. Government intervention can either encourage or discourage production depending on the type of intervention (subsidy vs. tax, regulation vs. deregulation, etc).

    worked example: Shift in supply due to production-cost increase

    We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to an increase in production cost.

    Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. An example is shown in Figure \(\PageIndex{4}\).

    The graph represents the directions for step 1. A supply curve shows the minimum price a firm will accept (P sub 0) to supply a given quantity of output (Q sub 0).

    Figure \(\PageIndex{4}\). Supply Curve. The supply curve can be used to show the minimum price a firm will accept to produce a given quantity of output.

    Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the average cost of production: in this case, the cost of the pizza ingredients (dough, sauce, cheese, pepperoni, and so on), the cost of the pizza oven, the rent on the shop, and the wages of the workers. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as shown in Figure \(\PageIndex{5}\).

    The graph represents the directions for step 2. For a given quantity of output (Q sub 0), the firm wishes to charge a price (P sub 0) equal to the cost of production plus the desired profit margin.

    Figure \(\PageIndex{5}\). Setting Prices. The cost of production and the desired profit equal the price a firm will set for a product.

    Step 3. Now, suppose that the cost of production goes up. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as shown in Figure \(\PageIndex{6}\).

    The graph represents the directions for step 3. An increase in production cost will raise the price a firm wishes to charge (to P sub 1) for a given quantity of output (Q sub 0).

    Figure \(\PageIndex{6}\). Increasing Costs Lead to Increasing Price. Because the cost of production plus the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.

    Step 4. Shift the supply curve through this point. You will see that an increase in cost causes a leftward shift of the supply curve so that at any price, the quantities supplied will be smaller, as shown in Figure \(\PageIndex{7}\).

    The graph represents the directions for step 4. An increase in the cost of production will shift the supply curve vertically by the amount of the cost increase.

    Figure \(\PageIndex{7}\). Supply Curve Shifted Left. When the cost of production increases, the supply curve shifts leftward to a new price level.

    Simulation: Supply of Food Trucks

    Play the simulation below multiple times to see how different choices lead to different outcomes. All simulations allow unlimited attempts so that you can gain experience applying the concepts.