CHAPTER 4 THEORY OF SUPPLY
We now turn to the Theory of Supply, as part of Theme 2: Markets, to see how producers behave. Afterwards, we will be able to understand and analyse how market forces of DD and supply (SS) interact to bring about market equilibrium (aka Market Mechanism).
There is no government involvement in a free market. It is the interaction of Supply (SS) and supply (SS) forces that determine the prices of the goods and services. The consumers Supply finished goods for consumption whereas the producers/firms supply the goods for profits. Changes in DD and SS will cause changes in the market price and in turn, influences the way in which the economy allocates its resources. This is still part of the price mechanism, assuming that individual buyers and suppliers are motivated by self-interest and that the “invisible hand” of the market guides this self-interest into promoting economic well being. Previously we have seen how consumers behave. Now, let’s examine clearly how suppliers conduct themselves in a market.
(Unless you are a seller right now, you will find that it is slightly harder to understand Producer Theory. It’s alright, just be patient. Or join our live online Econs tuition.)
4.1 Definition of Supply
Supply refers to the various quantities of a good a producer is willing and able to offer for sale at a given set of prices over a period of time in a given market.
4.2 The Law of DD
The law of supply (SS) states that a direct relationship exists between the price of a good and the quantity supplied of the good, ceteris paribus. Thus, as price rises (falls), the quantity supplied will rise (falls). (ie, a upward sloping SS curve)
4.3 Individual Supply vs Market Supply
The individual supply refers to the supply of an individual producer.
On the other hand, the market supply refers to the total quantity supplied of all producers who are willing and able to sell the good at each price level. It is derived by the horizontal summation of all the individual supply curves.
4.4 Changes in Quantity Demanded vs Changes in DD
Quantity supplied refers to a particular point on a given supply curve. A change in quantity supplied is illustrated by a movement along the supply curve, which is a response to a change in the price of the good itself. This is termed: change in quantity supplied.
On the hand, supply is the relation between price and quantity supplied, as expressed by the entire supply curve. A change in supply is illustrated by a shift of the entire supply curve in response to a change in the conditions of supply, other than price of the good itself. This is termed: change in supply.
4.5 Determinants of Supply
While a change in a good’s price (price factor) is said to lead to a change in quantity supplied (movement along the Supply curve), other factors that influence the Supply curve, other than the price of the good itself (non-price factors) will change the Supply (shift of the Supply curve).
The factors determining the producers’ willingness and ability to sell the goods and services are: (ceteris paribus condition: the price of the good remains unchanged)
4.5.1 Cost of Production
Changes in factor prices like wages, prices of raw materials, fuel will affect the cost of production (COP). E.g.: A rise in the price of electricity will raise the cost of operating machines. Producers would supply less of the good, due to the higher production cost, causing its supply to fall.
Government policies will also affect cost of production where a subsidy is given or where indirect taxes are imposed. The former lowers while the latter raises the COP.
4.5.2 State of Technology
The state of technology represents the economy’s stock of knowledge about how resources can be combined most efficiently. Technology is assumed to be constant for a given supply curve.
Technological changes take place over time as a result of discoveries and innovation, influencing the level of productivity of productive factors. If some new method is devised to produce the good more efficiently, production costs will fall, so supply will increase.
4.5.3 Prices of Related Goods
If two goods use the same types of resources in production, a change in the price of one good can cause the supply of the other to change.
1. Substitutes (in Supply) aka Competitive Supply
Goods, which are competitive in supply, use the same factors of production such that when the factors are being used to produce one good, they cannot be used to produce another. For example, if farmers plant land with corn, they can no longer use that land to produce wheat.
Hence, the production of corn and wheat means that a change in the price of one can shift the supply curve of the other. E.g.: A rise in the price of wheat will shift the supply for corn to the left, resulting in a decrease in supply for corn.
2. Complements (in Supply) aka Joint Supply
Goods, which are complements in production, are goods that are produced jointly with the same resources. E.g.: gasoline and petrochemicals, beef and leather, lumber and paper.
An increase in the price of a good, which is produced jointly with another good, causes the supply curve for the other good to shift rightward. For example, if the price of beef increases, the quantities of beef supplied increase, as well as raise the supply of leather.
4.5.4 Number of Producers
Since the market supply is the total amount supplied by all producers, market supply depends on the number of producers in the market. If the number of producers increases, supply will rise and vice versa. In S’pore, we are open to foreigner coming in to compete, so we usually have a large number of sellers.
4.5.5 Natural & Climate (aka Weather)
This condition is especially so in the agricultural and fishing industries. When there is storm, flood or rain, the supply of goods, usually primary products, will be affected adversely.
4.5.6 Government Action – Taxes and Subsidies
The imposition of indirect taxes and granting of subsidies will bring about changes in supply. A tax imposed on a good increase the cost of production of supplying that good, and the supply curve will move to the left. Subsidies have the opposite effect, i.e. costs are lowered and supply rises.
If you are able to, recognise whether the tax is a lump sum tax, or specific tax, or ad-valorem tax. Why? Because each type of tax shifts the SS curve differently. (More in our Econs accelerated tuition lessons.)
In the next chapter, we look at the way consumers and producers interact in a market.
3.6 Sample Short Answer Questions
- Explain the main factors of biofuels in the global market.
- Explain why the price of laptops have been increasing.
- Discuss whether the fall of costs of production or the improvement in technology is more important in explain the decrease in the price of solar photovoltaic systems in Singapore.
The above questions require not only your knowledge of the content of basic Supply Theory, it also requires some type of exam skills, aka higher order thinking skills (HOT) of Application, Analysis and Evaluation. More of such HOT exam techniques in our Econs tuition lessons.