Managerial Economics ECO404 SUPPLY ANALYSIS

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1 SUPPLY ANALYSIS Lesson 5 BASIS FOR SUPPLY The term Supply refers to the quantity of a good or service that producers are willing and able to sell during a certain period under a given set of conditions. Factors that must be specified include the price of the good in question, prices of related goods, the current state of technology, levels of input prices, weather, and so on. The amount of product that producers bring to the market, the supply of the product depends on all these influences. LAW OF SUPPLY A decrease in the price of a good, all other things held constant, will cause a decrease in the quantity supplied of the good. An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good. Changes in price result in changes in the quantity supplied shown as movement along the supply curve, while Changes in non-price determinants result in changes in supply shown as a shift in the supply curve. Among the factors influencing the supply of a product, the price of the product itself is often the most important. Higher prices increase the quantity of output producers want to bring to market. When marginal revenue exceeds marginal cost, firms increase supply to earn the greater profits associated with expanded output. Higher prices allow firms to pay the higher production costs that are sometimes associated with expansions in output. On the other hand, lower prices typically cause producers to supply a lower quantity of output. Just as there are non-price determinants of demand, there are non-price determinants of supply. A change in any one or a combination of these factors will cause the supply curve shift to the right or to the left. NON-PRICE DETERMINANTS OF SUPPLY costs and technology prices of other goods or services offered by the seller future expectations number of sellers input prices weather conditions INDUSTRY SUPPLY VERSUS FIRM SUPPLY Just as in the case of demand, supply functions can be specified for an entire industry or an individual firm. Even though factors affecting supply are highly similar in industry versus firm supply functions, the relative importance of such influences can differ markedly. Managerial decision making requires understanding both individual firm supply and market supply conditions. Market supply is the aggregate of individual firm supply, so it is ultimately determined by factors affecting firm supply. SUPPLY CURVE AND SUPPLY FUNCTION Supply curve shows price and quantity relation holding everything else constant. Along a supply curve, all non-price variables are held constant. A rise in price will increase the quantity supplied, while a fall in price will decrease the quantity supplied. The supply function specifies the relation between the quantity supplied and all variables that determine supply. The supply curve expresses the relation between the price charged and the quantity supplied, holding constant the effects of all other variables. Copyright Virtual University of Pakistan 1

2 SUPPLY CURVE SHIFTS Supply increases if a non-price change allows more to profitably produced and sold. S-curve shits downwards (right). On the other hand, supply decreases if a non-price change causes less to be profitably produced and sold. S-curve shifts upwards (left). The market supply function for a product is a statement of the relation between the quantity supplied and all factors affecting that quantity. The generalized supply function expressed in a supply Equation must lists variables that influence supply. As is true with the demand function, the supply function must be made explicit to be useful for managerial decision making. Consider the supply function for automobile industry and assume that the supply function has been specified as follows: Q = b 1 P + b 2 P + b 3 W + b 4 S + b 5 E + b 6 i The above equation states that the number of new domestic cars supplied during a given period, Q, is a linear function of the average price of new domestic cars, P; average price of new sport car, P ; average hourly price of labor, W; average cost of steel, S; average cost of energy, E; and average interest rate (cost of capital in percent), i. The terms b1, b2,..., b6 are the parameters of the supply function. MOVEMENT ALONG THE SUPPLY CURVE Copyright Virtual University of Pakistan 2

3 CHANGE IN SUPPLY MARKET EQUILIBRIUM Market equilibrium is determined at the intersection of the market demand curve and the market supply curve. Equilibrium price is the price that equates the quantity demanded with the quantity supplied. This price is referred to as the market equilibrium price, or the market clearing price, because it just clears the market of all supplied product. Equilibrium quantity is the amount that people are willing to buy and sellers are willing to offer at the equilibrium price level. Market equilibrium describes a condition of perfect balance in the quantity demanded and the quantity supplied at a given price. In equilibrium, there is no tendency for change in either price or quantity. Copyright Virtual University of Pakistan 3

4 MARKET DISEQUILIBRIUM A surplus is created when producers supply more of a product at a given price than buyers demand. Surplus describes a condition of excess supply. Conversely, a shortage is created when buyers demand more of a product at a given price than producers are willing to supply. Shortage describes a condition of excess demand. Neither surplus nor shortage will occur when a market is in equilibrium, because equilibrium is defined as a condition in which the quantities demanded and supplied are exactly in balance at the current market price. Surplus and shortage describe situations of market disequilibrium because either will result in powerful market forces being exerted to change the prices and quantities offered in the market. COMPARATIVE STATICS Equilibrium exists when there is no economic incentive for change in demand or supply. Changing demand or supply affects equilibrium. Comparative Statics is the study of how equilibrium changes with changing demand or supply. This change continues until a new equilibrium is established. A surplus describes an excess in the quantity supplied over the quantity demanded at a given market price. A surplus results in downward pressure on both market prices and industry output. Shortage describes an excess in the quantity demanded over the quantity supplied at a given market price. A shortage results in upward pressure on both market prices and industry output. COMPARATIVE STATICS ANALYSIS The short run is the period of time in which: sellers already in the market respond to a change in equilibrium price by adjusting variable inputs buyers already in the market respond to changes in equilibrium price by adjusting the quantity demanded for the good or service SHORT-RUN ANALYSIS Comparative statics of Changing Demand: Holding supply conditions constant, demand will vary with changing interest rates. Demand falls with a rise in interest rates; demand increases as interest rates falls. Copyright Virtual University of Pakistan 4

5 COMPARATIVE STATICS: CHANGING SUPPLY An increase in supply causes equilibrium price to fall and equilibrium quantity to rise while a decrease in supply causes equilibrium price to rise and equilibrium quantity to fall. LONG RUN ANALYSIS The long run is the period of time in which: new sellers may enter a market existing sellers may exit from a market existing sellers may adjust fixed factors of production buyers may react to a change in equilibrium price by changing their tastes and preferences Copyright Virtual University of Pakistan 5

6 Initial change in the left panel: decrease in demand from D 1 to D 2, as a result there is a reduction in equilibrium price and quantity (to P 2, Q 2 ) Follow-on adjustment: movement of resources out of the market leftward shift in the supply curve to S 2 Equilibrium price and quantity (to P 3, Q 3 ) Initial change in the right panel: increase in demand from D 1 to D 2 that results in an increase in equilibrium price and quantity (to P 2, Q 2 ) Follow-on adjustment: movement of resources into the market rightward shift in the supply curve to S 2 Equilibrium price and quantity (to P 3, Q 3 ) Copyright Virtual University of Pakistan 6