Unit 2.1 Demand, Supply and Market Equilibrium
Supply and Supply Function
Supply
Supply is the quantity of goods and services produced by a producer, which are ready for trade in the market at a fixed price and on time.
While demand in the market is affecting production and supply, supply also affects demand. As the demand for the product increases, so does the price increase, which has a positive effect on the producer's profit and motivates for more production and supply. Therefore, price increase means increase in supply. The change in price and the change in supply are directly proportional to each other. Which is explained by the law of supply. i.e Qsx = f(Px) = α+βPx
Supply Function
The quantitative supply of a certain commodity in the market is affected by various factors. Technically, these factors are known as determinants of supply, while the mathematical relationship between the same determinants of supply and supply is called the supply function. For instance,
Qsx = f(Px, Py, Fp, Tech., Cl., Gp, Ns., Expect., ...)
Types of Supply Function
1. Short Run Supply Function: Qsx = f(Px) -----Ceteris Paribus
2. Long Run Supply Function: Qsx = f(Px, Py, Fp, Tech., Cl., Gp, Ns., Expect., ...)
3. Linear Supply Function: The slope of the supply curve remains constant throughout its length is known as linear supply function. In other words, if both independent and dependent variable changes at a constant rate, the supply function will be linear. Numerical illustration with table and graph for linear supply function is as follows:
It is a straight-line curve with constant ΔP/ΔQ i.e. change in supply with respect to change in price is same on the whole curve. It creates the straight supply line.
4. Non-Linear Supply Function: A supply function is said to be non-linear when the slope of a supply curve changes all along the supply curve. In other words, if both dependent and independent variable changes at different rate and generally expressed in power function, the supply function will be linear. Numerical illustration with table and graph for non-linear supply function is as follows:
Video Link: Concept of Supply and Supply Function
Determinants of Supply
We know that, in short-run the basic dependency of supply is the price of the same product. But in the long run, there are some other non-price factors as well. Which also affect supply. This dependency of supply on various price and non-price factors is described as supply function. The determinants of supply also expressed in supply function as:
Qsx = f(Px, Py, Fp, Tech., Cl., Gp, Ns., Expect., ...)
1. Price of the Same Product (Px)
Px↑⟶Qsx↑ and Px↓⟶ Qsx↓
Price is perhaps the most obvious determinant of supply, since as the price of the product increases, it becomes more attractive to produce more and supply more.
2. Factor Price (Fp)
Input Prices↑⟶ Qsx↓ and Input Prices↓⟶ Qsx↑
Producers make production decisions based on wages as the value of labor, interest as the value of capital, and other production costs.
When the available capital for production cost is limited, the increase in the price of inputs makes less production than before. Conversely, if the price of inputs decreases, production becomes more attractive and supply increases.
3. State of Technology (Tech.)
Tech. Adv.↑⟶Qsx↑ and Primitive Tech.⟶ Qsx↓
In economics, the process of converting input into output is known as technology. With the improvement in technology, more output from the same inputs or the same output from the lesser inputs is possible. On the other hand, the use of primitive technology reduces the supply in the market by producing less than the production potential.
4. Climate Condition (Cl.)
Fav. Cl.⟶Prod.↑⟶Qsx↑ and Unfav. Cl.⟶Prod↓⟶Qsx↓
Good weather increases the production of agriculture and other sectors, which results in more supply and vice versa.
5. Government policy (Gp.)
Tax↑⟶Prod.↓⟶Qsx↓ and vice versa
Subs.↑⟶Prod.↑⟶Qsx↑ and vice versa
Among the various government policies, the main ones affecting production are taxation policy and subsidy policy.
When the government raises the tax rate to control the consumption of harmful substances or to control pollution, it ultimately reduces production and supply. On the other hand, if the government adopts a policy of providing tax exemptions, grants and subsidies to build a self-reliant economy or to produce more essential commodities, then production will increase and supply will also increase.
6. Number of Sellers (Ns)
Ns↑⟶Qsx↑ and vice versa
Although no one seller is able to determine the market supply, changes in the number of sellers will definitely affect the market supply. That is, if the number of sellers increases, the supply increases and if the number of sellers decreases, the supply also decreases.
7. Expected Future Price (Exp.)
EFP↑⟶Qsx↑ and vice versa
If the producer expects the price to increase in the near future, the current supply decreases, while if the price is expected to decrease, the current supply increases.
8. Goal of the Firm (Goal)
ㄫMax.⟶Qsx↑ with high price and Sales Max⟶Qsx↑ with constant price
Market supply is also affected by the firm's objectives. If goal of the firm is to maximize profits, more quantity of the commodity will be offered at a higher price. On the other hand, if the goal of the firm is to maximize sales more will be supplied even at the same price.
9. Price of other commodity (Py)
Px↑⟶Qsy↓ and vice versa
There is an inverse relationship between the price of one commodity and the supply of another. For example, if the price of vegetables increases in the market, the farmer increases the production of vegetables. As a result, the supply of food grans is reduced.
10. Development of Infrastructure (Devt. of Infra.)
Infra. Devt.⟶Qsx↑ and vice versa
The supply of the commodity depends on available facilities of infrastructure such as transport and communication, electricity etc. Producer can supply more quantity of the product with the proper development of such infrastructure and vice-versa. For e.g. production of apple in 'Jumla' and their supply in the market may depend on infrastructure development.
Video Link: Determinants of Supply
Law of Supply
Introduction
Law of supply is a fundamental principle of economic theory which states that other factors remaining constant, price and quantity supplied of a good are directly or positively related to each other.
In other words, if the price paid by the buyer increases, the supply of that commodity increases in the market. Because rising prices are driving up profits and profits are the main objective of most producers. Conversely, if the price of a product falls, production becomes less profitable and supply also reduced.
The functional relationship between quantity supply and the price of a commodity can be expressed as Qsx = f(Px) = α+βPx
Symbolically,
Px↑⟶Qsx↑ and Px↓⟶Qsx↓
As price and quantity supply are positively related in mathematical notation this expressed as ΔP/ΔQ>0.
Assumptions
- Input cost remains unchanged
- Technology remains constant
- Price of related (substitute) goods is constant
- No change in climate
- No change in transport cost
- Government policies are unchanged
- No anticipation of prices by the sellers
- No change in number of firms in the market
- No change in objective of the firm
- The level of foreign trade remains unchanged
- No change in availability of natural resources
- No change in political situation
Explanation with Table and Diagram
The above table shows that when the price of say, orange, is Re. 1 per Kg., 100 Kg. are supplied. If the price increases to Rs. 2, the supply also increases to 200 Kg. Similarly, when the price of orange increases to Rs. 5, then supply increases to 500 Kg. On the contrary, as the price declines from Rs. 5 supply continuously decline from 500 Kg.
In the above figure, point 'a' of the supply curve shows supply of 100 Kg. at the Re. 1. As the price increases to Rs. 2, Rs. 3, Rs. 4 and Rs. 5, the supply rises to 200, 300, 400 and 500 Kg. respectively. This is clearly shown at the point 'b', 'c', 'd' and 'e'. Thus, the supply curve shows increase in supply of orange when its price rise. This indicates the positive relation between price and supply.
Exceptions of Law of Supply
The situations, in which the law of supply does not hold true considered as limitations of law of supply. Under certain circumstances, the supply curve slopes downward from left to right i.e. it has a negative slope. Many causes are attributed to downward sloping supply curve. Some are as follows:
1. Expectation regarding Future Prices
Even if prices rise, sellers can reduce supply by adopting a wait-and-see policy if they expect prices to rise further in the future. In addition, sellers can increase supply even when prices are falling to avoid further losses that may fall in the future. In this case, the opposite relationship between price and supply is established and the supply curve slopes downward.
2. Agricultural Products
Agricultural production and supply of agricultural products depend more on climate conditions than its market price. In other words, even at rising prices, supply may decline due to adverse weather situations. Which is contrary to the rules of supply.
3. Perishable Products
Sometimes, even if the price of perishable goods that cannot be stored for a long time does not increase, there may be a need to supply more to avoid possible losses. For example, fruits, vegetables, flowers, meat are also sold at a reduced price rather than being wasted. That is, even in such a case, the law of supply does not apply.
4. Fear of being out of Fashion or stock clearance
Even if it is possible to sell the item at a higher price during the fashion, it may be necessary to clear the stock at a lower price as there is a risk that the item will go out of circulation.
5. Economic Slowdown
Entrepreneurs try to adapt their business to different economic conditions. However, in the event of a recession, they will not be able to take advantage of rising prices by not taking the risk of increasing production. So, the law of supply is not applicable in this case.
6. Change in Business
In case of closing down the existing business and running a brand-new business, the trader can supply more at a lower price to clear the stock. So, even here, the law of supply has not been followed.
7. Immediate Requirement of Funds
If the seller is in dire need of money, he may have to supply more of the commodity at a lower price. In this case, the law of supply does not hold true.
Video Link: Law of Supply
Reason for Upward Sloping Supply Curve
The direct relationship between quantity supply and price is reflected in the upward sloping curve and that relationship can exists because of some reasons summarized as follows:
1. Profit
As the price increases, the profit as per the target will also be maximized, so the producers are encouraged to increase the production and consequently the supply also increases. Conversely, when prices fall, profit shrink, so there is no incentive to increase production, that is, production begins to decline. In this way a positive relationship between price and supply is established and the supply curve rises.
2. Cost of Production
When the price of labor, capital, land and other means of production increases, that is, wages, interest, rent, etc., the cost of production increases. producers have to increase prices to maintain profitability due to rising production costs. Thus, in case of increase in production cost, the producer can increase the supply only by increasing the price. In this way a positive relationship between price and supply is established and the supply curve slopes upward.
3. Future Expectations
Producers take advantage of the current favorable situation to increase supply if there is a rising trend of prices at the present time and prices are expected to fall in the future. Which establishes a positive relationship between price and supply.
4. To Equate Marginal Cost with Marginal Revenue
According to the rules of economics, the marginal revenue and marginal cost of a firm must be equal to maximize profits or minimize losses. Which is a state of firm's equilibrium. Similarly, according to the law of diminishing marginal returns, marginal costs also increases as producer increase production.
That is, as production increases, marginal costs also increase and the firm becomes unbalanced. In such a case, the firm has to increase the marginal income by increasing the price to maintain the balance. Increasing production in this way increases marginal cost and in order to equalize marginal income, the price of production has to be increased. This leads to a positive relationship between supply and price.
Video Link: Reason For Upward Sloping Supply Curve
Individual and Market Supply Schedule and Curve
Supply Schedule
Supply schedule is a tabular presentation showing different quantities of a commodity that would be supplied at different prices.
The individual supply schedule lists the supply by individual producers at different prices while the market supply schedule lists the total market supply by the overall producer at different prices. Which can be shown in the below tables with imaginary figures as follows.
Supply Curve
The graphical representation of supply schedule is called a supply curve.
The individual supply shows the supply by individual producers at different prices while the market supply curve shows the total market supply by the overall producer at different prices. Which can be illustrate in the below figures with imaginary data as follows.
Quantity supply of goods and services my influence by various determinants like price factor and non-price factors and it results in change in supply curve. It can be further simplified by supply function.
Qsx = f(Px, Py, Fp, Tech., Cl., Gp, Ns., Expect., Goal, Devt. of Infra., ...)
1. Movement along a Supply Curve (Extension and Contraction of Supply)
If there is a change in price, there is a movement along the same supply curve. 'Extension' and 'contraction' of supply refer to movements on the same supply curve. If with a rise in price, the supply rises, it is called an extension of supply; if, with a fall in price, the supply declines it is called a contraction of supply. This movement along a supply curve can be illustrate in the following figure.
2. Shift in Supply Curve (Increase and Decrease in Supply)
A shift in the supply curve occurs when the whole supply curve moves to the right or left. 'Increase' and 'decrease' in supply causes shifts in the supply curve. A shift in the supply curve due to a change in some factor other than price of the commodity is refereed to as a change in supply.
Supply is said to increase when more is offered in the market without a change in price. Supply is said to decrease when less is offered in the market without a change in the price of the commodity. This shift in supply curve can be illustrate in the following figure.
Video Link: Change in Supply
Market Equilibrium
At a fixed price, the condition in which the quantity that the buyer wants to buy and the quantity that the seller wants to sell is equal is called market equilibrium. That is, when supply and demand are equal at a fixed price, market equilibrium is maintained. Equilibrium price and equilibrium quantities are determined by the state of market equilibrium.
Under the price mechanism, when demand increases, price increases, when price increases, supply increases and when supply increases, price decreases. Thus the market equilibrium is maintained through the interactive relationship between price, demand and supply. It can be explained with the help of following table and diagram.
In the above table, at price 10 both demand and supply are equal with 100 units. Thus, Price 10 is market clearing price and there is no tendency for prices to change.
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