Theory of Supply

Meanings of Supply and Stock:

Supply is of the scarce goods. It is the amount of a commodity that sellers are able and willing to offer fore sale at different price per unit of time.

In the words of Meyer: “Supply is a schedule of the amount of a good that would be offered fore sale at all possible price at any period of time; e.g., a day, a week, and so on”.

Definition of Stock:

"Stock is meant the total quantity of a commodity this exists in a market and can be offered for sale at a short notice".

Difference/Distinction Between Supply and Stock:

Here it seems necessary that the meaning of the term ‘supply’ and ‘stock’ may be made clear as they are often confused by the readers. Supply refers to that quantity of the commodity which is actually brought into the market fore sale at a given price per unit of time. While Stock is meant the total quantity of a commodity this exists in a market and can be offered for sale at a short notice.

The supply and stock of a commodity in the market may or may not be equal if the commodity is perishable, like vegetables, fruits, fish, etc; then the supply and stock is generally the same. But in case of a product find that the price of his product is low as compared to its cost of production, he tries to withhold the entire or a part of a stock. In case of a favorable price, the producer may dispose of large quantities or the entire stock of his commodity; it will all depend upon his own valuation of the commodity at that particular time.

Law of Supply:

There is direct relationship between the price of a commodity and its quantity offered fore sale over a specified period of time. When the price of a goods rises, other things remaining the same, its quantity which is offered for sale increases as and price falls, the amount available for sale decreases. This relationship between price and the quantities which suppliers are prepared to offer for sale is called the law of supply.

Explanation of Law of Supply:

The law of supply, in short, states that ceteris paribus sellers supply more goods at a higher price than they are willing at a lower price.

Supply Function:

The supply function is now explained with the help of a schedule and a curve.

Market Supply Schedule:

Market Supply Schedule of a Commodity:

In the table above, the produce are able and willing to offer for sale 100 units of a commodity at price of $4. As the price falls, the quantity offered for sale decreases. At price of $1, the quantity offered for sale is only 40 units.

Law of Supply Curve/Diagram:

The market supply data of the commodity x as shown in the supply schedule is now presented graphically.

In the figure (5.1) price is plotted on the vertical axis OY and the quantity supplied on the horizontal axis OX. The four points d, c, b, and a show each price quantity combination. The supply curve SS^/ slopes upward from left to right indicating  that  less quantity is offered  for sale at lower price and more at higher prices by the sellers not supply curve is usually positively sloped.

Formula for Law of Supply/Supply Function:

The supply function can also be expressed in symbols.

Q_x^S = f (Px, Tech, S_i, F_n, X,........)

Here:

Q_x^s = Quantity supplied of commodity x by the producers.

F =  Function of.

P_x =  Price of commodity x.

T = Technology.

S  =  Supplies of inputs.

F  =  Features of nature.

X  =  Taxes/Subsidies.

Example of Law of Supply:

The law of supply is based on a moving quantity of materials available to meet a particular need. Supply is the source of economic activity. Supply, or the lack of it, also dictates prices. Cost of scarce supply goods increase in relation to the shortages. Supply can be used to measure demand. Over supply results in lack of customers. An over supply is often a loss, for that reason. Under supply generates a demand in the form of orders, or secondary sales at higher prices.

If ten people want to buy a pen, and there's only one pen, the sale will be based on the level of demand for the pen. The supply function requires more pens, which generates more production to meet demand.

Assumptions of Law of Supply:

(i) Nature of Goods. If the goods are perishable in nature and the seller cannot wait for the rise in price. Seller may have to offer all of his goods at current market price because he may not take risk of getting his commodity perished.

(ii) Government Policies. Government may enforce the firms and producers to offer production at prevailing market price. In such a situation producer may not be able to wait for the rise in price.

(iii) Alternative Products. If a number of alternative products are available in the market and customers tend to buy those products to fulfill their needs, the producer will have to shift to transform his resources to the production of those products.

(iv) Squeeze in Profit. Production costs like raw materials, labor costs, overhead costs and selling and administration may increase along with the increase in price. Such situations may not allow producer to offer his products at a particular increased price.

Limitations/Exceptions of Law of Supply:

Exceptions that affect law of supply may include:

(i) Ability to move stock.

(ii) Legislation restricting quantity.

(iii) External factors that influence your industry.

Importance of Law of Supply:

(i) Supply responds to changes in prices differently for different goods, depending on their elasticity or inelasticity. Goods are elastic when a modest change in price leads to a large change in the quantity supplied. In contrast, goods are inelastic when a change in price leads to relatively no response to the quantity supplied. An example of an elastic good would be soft drinks, whereas an example of an inelastic service would be physicians' services. Producers will be more likely to want to supply more inelastic goods such as gas because they will most likely profit more off of them.

(ii) Law of supply is an economic principle that states that there is a direct relationship between the price of a good and how much producers are willing to supply.

(iii) As the price of a good increases, suppliers will want to supply more of it. However, as the price of a good decreases, suppliers will not want to supply as much of it. For producers to want to produce a good, the incentive of profit must be greater than the opportunity cost of production, the total cost of producing the good, which includes the resources and value of the other goods that could have been produced instead.

(iv) Entrepreneurs enter business ventures with the intention of making a profit. A profit occurs when the revenues from the goods a producer supplies exceeds the opportunity cost of their production. However, consumers must value the goods at the price offered in order for them to buy them. Therefore, in order for a consumer to be willing to pay a price for a good higher than its cost of production, he or she must value that good more than the other goods that could have been produced instead. So supplier's profits are dependent on consumer demands and values. However, when suppliers do not earn enough revenue to cover the cost of production of the good, they incur a loss. Losses occur whenever consumers value a good less than the other goods that could have been produced with the same resources.

Determinants of Supply:

There are four important Determinants of Supply as under:

Thus:

Q_x^s = f (P_x) Ceteris Paribus

Ceteris Paribus. In economics, the term is used as a shorthand for indicating the effect of one economic variable on another, holding constant all other variables that may affect the second variable.

Shift in supply curve

When resource prices increase, supply decreases (shifts left); and when resource prices decrease, supply increases (shifts right). If a more cost effective technology is discovered then supply increases, increases in taxes cause the supply curve to shift left (decrease). An increase in a subsidy effects the supply curve in the same way as a cut in taxes, an increase in supply. If the price of other goods a producer can supply increases, the producer will reallocate resources away from current production (decrease in supply) and to the goods with a higher market price. For example, if the price of corn drops, a farmer will supply more beans. If producers expect future prices to increase, current supply will decline in favor of selling inventories at higher prices later. In other words, supply will decrease (a shift to the left, and exactly the opposite response will occur if producer expect future prices to be lower. If the number of suppliers increases, so too will supply, but if the number of producers declines, so too will supply. 

A decrease in supply is shown in the first panel, notice that there is a lower quantity supplied at each price with S2 (dotted line) than with S1 (solid line). The second panel shows an increase in supply, notice that there is a larger quantity supplied at each price with S2 (dotted line) than with S1 (solid line).  

Changes in price cause changes in quantity supplied, an increase in price from P2 to P1 causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1 to P2 causes a decrease in the quantity supplied from Q1 to Q2. 

Movement of the Supply Curve

Considering the following graph, movement of the supply curve from S1 (solid line) to S2 (dashed line) is an increase in supply. Such increases are caused by a change in a nonprice determinant (for example, the number of suppliers in the market increased or the cost of capital decreased). With an increase in supply there is a shift of the supply curve to the right along the demand curve, therefore equilibrium price and quantity move in opposite directions (price decreases, quantity increases). If we move from S2 to S1 that is called an decrease in supply, possibly due to an increase in the price of a productive resource (capital) or the number of suppliers decreased. When supply decreases, equilibrium price increases and the quantity decreases as a result. That is the result of the supply curve moving up along the negatively sloped demand curve (which remains unchanged).

Shortages and Surpluses

There is some rationale for limited government intervention in a free market economy. Perhaps the most powerful rationale for limited government arises from the effects of price controls in competitive markets. Shortages and surpluses can only result because by having some sort of price controls in the market.

For example, the Former Soviet Union had a centrally planned economy and the government decided what would be produced and for what price that production would be sold. The government also was the sole employer and paid very low wages, therefore prices were also controlled at below market equilibrium levels. The result was that whenever any commodity was available in the market, there were long lines observed at any store with anything to sell, prices were low but there was nothing to buy (shortages). The popular Russian immigrant comedian, Yakov Simirnov, summed-up the plight of the working class consumer in Russia prior to break-up of the Soviet Union. He said, "In Russia we used to pretend to work, but that was alright, the government only used to pretend to pay us!" 

Shortage is caused by an effective price ceiling (the maximum price you can charge for the product). Effective, in this sense, means that the government can and does actively enforce the price ceiling. With the exception of the Second World War, there is little evidence that the government can effectively enforce price ceilings. Consider the following diagram that demonstrates the effect of a price ceiling in an otherwise purely competitive industry. 

For a price ceiling to be effective it must be imposed below the competitive equilibrium price. Note that the Qs is below the Qd, which means that there is an excess demand for this commodity that is not being satisfied by suppliers at this artificially low price. The distance between Qs and Qd is called a shortage.

It is interesting to consider the last time that wage and price controls were attempted during the Carter administration. These short-lived price ceilings resulted in producers technically complying with the price restrictions, but they frequently changed the product. For example, warranties were no longer included in the sales price, service was extra, delivery was extra, and where possible, the product was reduced in size. For example, in the previous administration’s failed wage and price controls (Nixon) candy bars were made smaller and they put fewer M & Ms in the package and the price for these treats was not changed – effectively cutting costs, but not price, hence increasing the profit margin without raising the price of the candy. The lesson is simple, if government is going to control prices, they must be prepared to control virtually all other aspects of doing business.

Surplus is caused by an effective price floor (minimum you can charge): 

For a price floor to be effective it must be above the competitive equilibrium price. Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs is the amount of the surplus. Implicit in these analyses is the fact that without government we could have neither shortage or surplus. In large measure, the suspicion of government is because it has the power to create these sorts of peculiar market situations. Even with the power of government to enforce law, the only way that a shortage or surplus could occur is if the price ceiling or the price floor were effective.