Unit 3: Supply - Business Economics

2.74 BUSINESS ECONOMICS UNIT -3: SUPPLY LEARNING OUTCOMES After studying this unit, you would be able to:  Explain the meaning of supply.  List and provide specific examples of determinants of...

2.74 BUSINESS ECONOMICS UNIT -3: SUPPLY LEARNING OUTCOMES After studying this unit, you would be able to:  Explain the meaning of supply.  List and provide specific examples of determinants of supply and elasticity of supply.  Describe the law of supply.  Describe the difference between movements on the supply curve and shift of the supply curve.  Explain the concept of elasticity of supply with examples.  Illustrate how the concepts of demand and supply can be used to determine price. 3.0 INTRODUCTION In a market economy, sellers of products and services constitute the supply side. The sellers may include individuals, firms and governments. As the term ‘demand’ refers to the quantity of a good or service that the consumers are willing and able to purchase at various prices during a given period of time, the term ‘supply’ refers to the amount of a good or service that the producers are willing and able to offer to the market at various prices during a given period of time. Three important points apply to supply: (i) Supply refers to what a firm offer for sale in the market, not necessarily to what they succeed in selling. What is offered may not get sold. © The Institute of Chartered Accountants of India  1.75 THEORY OF DEMAND AND SUPPLY 2.75 (ii) Supply requires both willingness and ability to supply. Production cost is often the primary influence on ability. (iii) Supply is a flow. Supply is identified for a specified time period. The quantity supplied is ‘so much’ per unit of time, per day, per week, or per year. 3.1 DETERMINANTS OF SUPPLY Although price is an important consideration in determining the willingness and desire to part with commodities, there are many other factors which determine the supply of a product or a service. These are discussed below: (i) Price of the good: Other things being equal, the higher the relative price of a good the greater the quantity of it that will be supplied. This is because goods and services are produced by the firm in order to earn profits and, ceteris paribus, profits rise if the price of its product rises. (ii) Prices of related goods: If the prices of other goods rise, they become relatively more profitable to the firm to produce and sell than the good in question. When a seller can get a higher price for a good, producing and selling it becomes more profitable. Producers will allocate more resources towards its production even by drawing resources from other goods they produce. For example, a rise in the price of comic books will encourage publishers to shift resources out of the production of other books (such as novels) and use them in the production of comic books. As another example, if price of wheat rises, the farmers may shift their land to wheat production away from corn and soya beans. It implies that, if the price of Y rises, the quantity supplied of X will fall. (iii) Prices of factors of production: Cost of production is a significant factor that affects supply. If the firm’s cost exceeds what it can earn from selling the good, the firm sells nothing. A rise in the price of an input causes a decrease in supply. When the cost of resources such as wages, raw material prices and interest rates increase, producers decrease the amount they are willing to supply. Lower input costs indeed, make production more profitable, encourage existing firms to expand production and new firms to enter the market. A rise in the price of a particular factor of production will cause an increase in the cost of making those goods that use a great deal of that factor than in the costs of producing those that use relatively small amount of the factor. For example, a rise in the cost of land will have a large effect on the cost of producing wheat and a very small effect on the cost of producing automobiles. Thus, a change in the price of one '+ )$%)$,( - 340056 7 ! "#$% &'() *./ 0,'+1) ) 2 "#$% "') $++$&)( ), 8 0,'+1) - 2 (40056 9 © The Institute of Chartered Accountants of India  2.76 BUSINESS ECONOMICS factor of production will cause changes in the relative profitability of different lines of production and will cause producers to shift from one line to another and thus supplies of different commodities will change. (iv) State of technology: The supply of a particular product depends upon the state of technology also. The use of new technology in an industry (such as automation) increases production efficiency and reduces production costs. Inventions and innovations tend to make it possible to produce more or better goods with the same resources, and thus they tend to increase the quantity supplied of some products and to reduce the quantity supplied of products that are displaced. Availability of spare production capacity and the ease with which factor substitution can be made and the cost of such substitution also determine supply. (v) Government Policy: Government rules and regulations affect how much firms want to sell or are allowed to sell. The production of a good may be subject to the imposition of commodity taxes such as excise duty, sales tax and import duties. These taxes raise the cost of production and so the quantity supplied of a good would increase only when its price in the market rises. Subsidies and other funding programmes to producers, on the other hand, reduce the cost of production and thus provide an incentive to the firm to increase supply. When government imposes restrictions such as import quota on consumer products and inputs, rationing of input supply etc, production tends to fall. (vi) Nature of competition and size of industry: Under competitive conditions, supply will be more than that under monopolized conditions. (vii) Expectations: Choices of firms in respect of selling the product now or later depends on expectations of future prices. Sellers compare current prices with future prices. An increase in the anticipated future price of a good or service reduces its supply today; and if sellers expect a fall in prices in future, more will be supplied now. (viii) Number of sellers: If there are large number of firms in the market, supply will be more. Besides, entry of new firms, either domestic or foreign, causes the industry supply curve to shift rightwards. Other Factors: The quantity supplied of a good also depends upon government’s industrial and foreign policies, goals of the firm, infrastructural facilities, natural factors such as weather, floods, earthquake and man- made factors such as war, labour strikes, communal riots etc. © The Institute of Chartered Accountants of India  1.77 THEORY OF DEMAND AND SUPPLY 2.77 :- ;<.= > - )#$% ?@(% 3.2 THE LAW OF SUPPLY > ) )#$% A1( ), In general, producers are prepared to sell their product for a price if that price is at least as 1$ B high as the cost to produce an additional unit of the product. Therefore, the willingness to supply depends on the price at which the good can be sold as well as the cost of production >C)'1( for an additional unit of the good. The greater the difference between those two values, the greater is the willingness of producers to supply the good. Supply refers to the relationship of quantity supplied of a good with one or more related variables which have an influence on the supply of the good. Normally, supply is related with price, but it can also be related with other factors such as the type of technology used, scale of operations etc. The law of supply can be stated as: Other things remaining constant, the quantity of a good produced and offered for sale will increase as the price of the good rises and decrease as @ the price falls. @ This law is based upon common sense, because the higher the price of the good, the greater the profits that can be earned and thus greater the incentive to produce the good and offer it for sale. The law is known to be correct in a large number of cases. There is an exception however. If we take the supply of labour at very high wages, we may find that the supply of labour has decreased instead of increasing. Thus, the behaviour of supply depends upon the phenomenon considered and the degree of possible adjustment in supply. The behaviour of supply is also affected by the time period under consideration. In the short run, it may not be easy to increase supply, but in the long run supply can be easily adjusted in response to changes in price. The law of supply can be explained through a supply schedule and a supply curve. A supply schedule is the tabular presentation of the law of supply. It shows the different prices of a commodity and the corresponding quantities that suppliers are willing to offer for sale, with all other variables held constant. Consider the following hypothetical supply schedule of good X. Table 10: Supply Schedule of Good ‘X’ Price (`) (per kg) Quantity supplied (kg) 1 5 2 35 3 45 4 55 5 65 © The Institute of Chartered Accountants of India  2.78 BUSINESS ECONOMICS The table shows the quantities of good X that would be produced and offered for sale at a number of alternative prices. At Re 1, for example, 5 kilograms of good X are offered for sale and at ` 3 per kg. 45 kg. would be forthcoming for sale. We can now plot the data in table 10 on a graph. In Figure 25, price is plotted on the vertical axis and quantity on the horizontal axis, and various price-quantity combinations of the schedule 10 are plotted. Fig. 25: Supply Curve When we draw a smooth curve through the plotted points, what we get is the supply curve of good X. The supply curve is a graphical presentation of the supply schedule. The supply curve shows the quantity of a good that producers are willing to sell at a given price, holding constant any other factor that might affect the quantity supplied. The supply curve is thus a relationship between the quantity supplied and the price. To be more precise, the supply curve shows simultaneously: (a) the highest quantity willingly supplied by the suppliers at each price and (b) the minimum price which will induce suppliers to offer the various quantities for sale The supply curve slopes upwards towards right (positive slope) showing that as price increases, the quantity supplied of X increases and vice-versa. This direct relationship between price and quantity is reflected in the positive slope of the supply curve. The market supply, like market demand, is the sum of supplies of a commodity made by all individual firms or their supply agencies. The market supply of a commodity gives the amounts of the commodity supplied per time period at various alternative prices by all the producers of this commodity in the market. It is derived by adding the quantity supplied by each seller at different prices. The market supply curve for ‘X’ can be obtained by adding horizontally the supply curves of various firms. The market supply is governed by the law of supply and depends on all the factors that determine the individual producer’s supply and, in addition, on the number of producers of the commodity in the market. © The Institute of Chartered Accountants of India  1.79 THEORY OF DEMAND AND SUPPLY 2.79 3.3 MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR DECREASE IN THE QUANTITY SUPPLIED When the supply of a good increase as a result of an increase in its price, we say that there is an increase in the quantity supplied and there is an upward movement on the supply curve. A rise in market price causes an expansion of supply; there is a upwa rd movement on the supply curve and producers offer more for sale. When market price falls, there is contraction of supply as producers have less incentive to offer products for sale in the market. (See Figure 26) D4$ )' >,1%$ &#C0 Fig. 26: Figure Showing Change in Quantity Supplied as a Result of Price Change 3.4 SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY While a change in quantity supplied is a movement along a given supply curve, a change in supply is a shift of the supply curve. When the supply curve bodily shifts towards the right as a result of a change in one of the factors that influence the quantity supplied other than the commodity’s own price, we say there is an increase in supply. When the supply curve shifts to the right, more is offered for sale at each price. In figure 27(i), we find that at price P, the quantity supplied rises from Q to Q1. When the factors other than price change and cause the supply curve to shift to the left, we call it decrease in supply. When the supply curve shifts to the left, less quantity is offered for sale at each price. In figure 27(ii), we find that at price P the quantity supplied falls from Q to Q1. © The Institute of Chartered Accountants of India  )' 2.80 BUSINESS ECONOMICS 0,$ 1% '4, '), EC$)# Fig. 27: Shifts in Supply Curves Just as in the case of demand curves, a change in the price of a good itself will result in a movement along the supply curve and a change in quantity supplied, a change in any variable other than own-price will cause a shift in the supply curve, called a change in supply. 3.5 ELASTICITY OF SUPPLY The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a change in its price. Elasticity of supply is measured by dividing the percentage change in quantity supplied of a good by the percentage change in its price i.e., Percentage change in quantity supplied Es = Percentage change in Price Change in quantity supplied quantity supplied Or Change in price Price or  q q q p = × p p q ::G  ? '0 p Where @q denotes original quantity supplied. q denotes change in quantity supplied. p denotes original price. © The Institute of Chartered Accountants of India  1.81 THEORY OF DEMAND AND SUPPLY 2.81 p denotes change in price. Example a. Suppose the price of commodity X increases from ` 2,000 per unit to ` 2,100 per unit and consequently the quantity supplied rises from 2,500 units to 3,000 units. Calculate the elasticity of supply. Here ∆q = 500 units ∆p = `100 p = ` 2000 q = 2500 units 500 2000 Es = × =4 100 2500 Elasticity of Supply = 4. 3.5.0 Types of Supply Elasticity The elasticity of supply can be classified as under: (i) Perfectly inelastic supply: If as a result of a change in price, the quantity supplied of a good remains unchanged, we say that the elasticity of supply is zero or the good has perfectly inelastic supply (Es = 0.). The vertical supply curve in Figure 28 shows that irrespective of price change, the quantity supplied remains unchanged. In other words, the quantity supplied is unaffected by any change in price. As the elasticity rises, the supply curve gets flatter, which shows that the quantity supplied responds more to changes in price. Fig. 28: Supply Curve of Zero Elasticity © The Institute of Chartered Accountants of India  2.82 BUSINESS ECONOMICS (ii) Relatively less-elastic supply: If as a result of a change in the price of a good its supply changes less than proportionately, we say that the supply of the good is relatively less elastic or elasticity of supply is less than one. In this case, the coefficient of elasticity falls in the range 0 < Es < 1. The percentage change in quantity is less than the percentage change in price. In other words, the quantity is not very responsive to price. Figure 29 shows that the relative change in the quantity supplied (∆Q) is less than the relative change in the price (∆P). 7) $H)1%&) B I C) C CH1( Fig. 29: Showing Relatively Less Elastic Supply (iii) Relatively greater-elastic supply :If elasticity of supply is greater than one i.e., when the quantity supplied of a good changes substantially in response to a small change in the price of the good we say that supply is relatively elastic. The percentage change in quantity is greater than the percentage change in price. The coefficient of elasticity falls in the range 1 < E < ∞.Figure 30, shows that the relative change in the quantity supplied (∆Q) is greater than the relative change in the price. 7) $C)$,6 &4) = J1( Fig. 30: Showing Relatively Greater Elastic Supply © The Institute of Chartered Accountants of India  1.83 THEORY OF DEMAND AND SUPPLY 2.83 (iv) Unit-elastic: In this case, the coefficient of elasticity is one.(Es = 1). If the relative change in the quantity supplied is exactly equal to the relative change in the price, the supply is said to be unitary elastic. The percentage change in quantity is equal to the percentage change in price. Unit elasticity is essentially a dividing line or boundary between the elastic and inelastic ranges. In Figure31, the relative change in the quantity supplied (∆Q) is equal to the relative change in the price (∆P). 7) $H)$%A >C(( )#1K# ',1K1% Fig. 31: Showing Unitary Elasticity (v) Perfectly elastic supply: At the opposite extreme of zero elasticity supply is perfectly elastic. This occurs as the price elasticity of supply approaches infinity and the supply curve becomes horizontal. Elasticity of supply is said to be infinite (E = ∞)or perfectly elastic when nothing is supplied at a lower price and an infinitesimally small change in price results in an infinitely large change in quantity supplied indicating that producers will supply any quantity demanded at that price. Figure 32 shows infinitely elastic supply. Fig. 32: Supply Curve of Infinite Elasticity © The Institute of Chartered Accountants of India  2.84 BUSINESS ECONOMICS In some cases, the elasticity of supply is not constant but varies over the supply curve. Figure33 shows the case of an industry with limited capacity for production. For low levels of quantity supplied, firms respond substantially to changes in price. When there is a small rise in price from P1 to P2, the quantity supplied increases more than proportionately (Q1 to Q2). In this region, firms have idle capacity and therefore when price rises, they respond by increase in quantity supplied using the idle capacity available. Once firms reach their full capacity, further increase in production is possible only by building new plants and incurring expenses towards this. To induce firms to increase output, price must rise substantially (P3 to P4) and supply becomes less elastic. 40 )' )$55 @