Introduction to Supply
Introduction to Supply
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.
1. The Law of Supply
LEARNING OUTCOMES
- Explain the law of supply
- Explain a supply curve
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.
You can view the transcript for “Episode 13: Supply” (opens in new window).
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service that 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 are held equal (ceteris paribus).
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 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 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 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.
Figure 1. A Supply Curve for 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.
GLOSSARY
- law of supply:
- the common relationship that a higher price leads to a higher quantity supplied of a certain good or service and a lower price leads to a lower quantity supplied, while all other variables are held constant
- quantity supplied:
- the total number of units of a good or service producers are willing to supply at a given price
- supply:
- the relationship between the price of a certain good or service and the quantity of that good or service producers are willing to offer for sale
- supply curve:
- a graphic representation of the relationship between price and quantity supplied of a certain good or service, with price on the vertical axis and quantity on the horizontal axis
- supply schedule:
- a table that shows the quantity demanded for a certain good or service at a range of prices
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2. Factors Affecting Supply
LEARNING OUTCOMES
- Explain the factors that can change supply
How Production Costs Affect Supply
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, then while the prices for the good or service that 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 1, 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, then 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 1.
Figure 1. Shifts in Supply: A Car Example
Table 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, then 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 S0to 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
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 50 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.
SUMMARY
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 2, 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.
Figure 2. 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.
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? The 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, then you will see the price the firm chooses. An example is shown in Figure 3.
Figure 3 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 4.
Figure 4. 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, then 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 5.
Figure 5. 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, then 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 6.
Figure 6. 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.