Unit 5 - Law of Supply

Business Economics Unit 5 – The Theory of Production B.
Com 1st Sem

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Meaning of Production:
The term production means transformation of physical inputs into physical

outputs. The term ‘inputs’ refers to all those things or times which
are required by the firm to produce a particular product like raw
materials, power, fuel and services like transport and
communications, warehousing, banking, shipping and insurance.
‘Output’ refers to finished products.
Production always results in either creation of new utilities or addition of

values. It is an activity that increases consumer satisfaction of goods
and services. Production is undertaken by producers and mainly it
depends on cost of production. Production is always done in physical
terms and it shows the relationship between physical inputs and
physical outputs.
Inputs Transformati Output

on
Process
Entry into Transformati Exit out of

firm on firm
Process
Importance:
It helps an individual to fulfill his requirements or wants by consuming

different kinds of goods and services.
Higher levels of production is an indication of a progressive society
Higher levels of production leads to higher income, employment and
economic prosperity. It is an index of the rate of economic growth in
an economy.
Production of different type of goods and services in different nations
indicate the nature of economic inter dependence between different
nations.
Production Function:
A production function expresses the technological or engineering

relationship between quantity of physical inputs and physical outputs
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"Every truth has four corners: as a teacher I give you one corner,
and it is for you to find the other three." –Confucius. “The best
use of knowledge is human welfare”
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M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 1 of

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Business Economics Unit 5 – The Theory of Production B.Com 1st Sem
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of a firm. It is table or graph or an equation specifying maximum
output rate from a given amount of inputs used. Since it relates
inputs to outputs, it is also called as “Input-Output relation”. The
production is purely physical in nature and is determined by the
technology, availability of equipment, labour, materials, efficiency
and productivity and managerial and so on.
Mathematically production function is:

Q = f(L, N, K etc)
Q is the quantity of output per unit of time
L, N, K etc., are the various inputs like land, capital, labour etc
Thus rate of output Q is thus, a function of the factor inputs L, N, K etc.,

employed by the firm per unit of time.
Inputs factors are of 2 types:
Fixed Factors: They remain constant irrespective of the level of output.

For e.g. Land, buildings, machines, tools, equipments, superior types
of labour etc.
Variable Factors: Its quantity varies with variations in the level of output
of production. For e.g. Raw materials, power, fuel, transport and
communication etc.
The distinction between the two will hold good only in the short run, in
the long run, all factor inputs will become variable in nature.
Production Function is of 2 types:
Short Run Production Function: In this case, the producer will keep all
fixed factors as constant and change only a few variable factor
inputs. In the short run, we come across two kinds of production
functions:
Quantities of all inputs both fixed and variable will be kept constant and
only one variable input will be varied. For e.g., the law of variable
proportions.
Quantities of all factor inputs are kept constant and only two variable factor
inputs are varied. For e.g., ISO-Quants and ISO-Cost Curves.
Long Run Production Function: In this case, the producer will vary the
quantities of all factor inputs in the same proportion. For e.g., the
laws of returns to scale.
Improvements in production function can be brought about as

below:
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The quantities of input may be reduced while the quantity of output may
remain same.
The quantity of output may increase while the quantities of input may
remain same.
The quantities of output may increase and quantities of inputs may
decrease.
Uses of Production Function:

It can be used to calculate the least cost input combination for a given
output or the maximum output-input combination for a given cost.
It is useful in working out an optimum and economic combination of inputs
for getting a certain level of output. Additional employment of the
variable factor input is desirable only when the marginal revenue
productivity of a variable factor input is equal to its cost of employing
or it should be greater than its employment cost.
It helps in making long run decisions. If returns to scale (large scale
production) are increasing, it is wise to employ more factor inputs
and increase production. If returns to scale are diminishing, it would
be unwise to increase factors inputs. Incase of constant returns on
scale, the manager will be indifferent to the increase or decrease in
production.
Thus production functions of immense utility to the mangers and

executives in decision making process in the short and long run.
Production Function: One variable input case

The law of variable proportions:
The law of variable proportions or the law of non-proportional output will

explain how variation in one factor input give place for variations in
outputs. In order to expand the output, scarce factors must be kept
constant and variable factors are to be increased in greater
quantities. Additional units of a variable factor on the fixed factors
will certainly mean a variation in output. The law states that “as the
quantity of different units of only one factor is increased to a
given quantity of fixed factors, the total average and
marginal output decreases in different proportions”.
The law of variable proportions is the new name for the famous “Law of
diminishing returns” of classical economists. According to Prof.
Benham, “As the proportion of one factor in a combination of
factors is increased, after a point, first the marginal and then
the average product of that factor will diminish.
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Assumptions:
Only one factor unit is to be varied while all other factors should be kept
constant.
Different units of a variable factors are homogenous
Plant size, its capacity, efficiency and scale of production remains constant
Techniques of production remain constant
The law will hold good only for a short or given period
There is possibilities of a varying the proportion of factor inputs.
Illustration:
A hypothetical production schedule is worked out to explain the operation
of the law. Fixed factors = 1 acre of land + Rs.5,000 capital.
Variable factor = Labour
Units of TP AP MP
variabl (Total (Average (Marginal
e Produc Produc Produc
Stages
inputs t or t or t or
(labou Outpu Outpu Outpu
r) t) t) t)
0 0 0 0
1 10 10 10
2 24 12 14 1st Stage
3 39 13 15
4 52 13 13
5 60 12 8
6 66 11 6
7 70 10 4 2nd Stage
8 72 9 2
9 72 8 0
10 70 7 -2 3rd Stage
Total Product or Output (TP): It is the output derived from all factor
inputs, both fixed and variable employed by the producer per unit of
time. It is also a sum of marginal output.
Average Product or Output (AP): It is obtained by dividing total output

by the number of variable factors employed. AP = TP/Qty of variable
factors.
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Marginal Product or Output (MP): It is the output derived from the
employment of an additional unit of variable factor MP = ∆TP/∆Qty of
variable factors.
Trends in Output:
From the table, one can observe the following tendencies in the TP, AP and
MP.
Total output goes on increasing as long as MP is positive. It is the highest
when MP is zero and TP declines when MP becomes negative.
MP increases in beginning, reaches the highest point and diminishes at the
end.
AP will also have the same tendencies as the MP. In the beginning MP will
be higher than AP but at the end AP will be higher than MP.
Stage 1: The law of increasing returns: In this case, as the quantity

of variable inputs are increased to given quantity of fixed
factors, output increases more than proportionately. The total
output increases upto the point P because corresponding to this point
P, the MP is rising and reaches its highest point. AP of the variable
factors increases through out this stage. After the point P, MP
declines due to abundant quantity of fixed inputs and as such TP
increases gradually.
The first stage comes to an end at the point where MP curve cuts the AP
curve at N when the AP is maximum and AP = MP (at the 4th input in
the illustration, AP = MP = 13 units).
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The 1st stage is called as the law of increasing returns because when the
producer increases the quantity of variable factors, intensive and
effective utilization of fixed factors become possible leading to higher
output. The efficiency of variable factors is increased as it creates
opportunity for division of labour and specialization resulting in higher
output.
Stage 2: The law of diminishing returns: In this case as the
quantity of variable inputs are increased to a given quantity of
fixed factor, output increases less than proportionately. In this
stage, TP increases at a diminishing rate since both AP and MP are
declining continuously. The 2nd stage comes to an end at the point
where TP is the highest at the point E and MP is zero at the point B. (At
the 9th input in the illustration, TP is 72 units and MP is zero).
Diminishing returns arises due to:
The proportions of variable factors are greater than the quantity of fixed
factors. Hence both AP and MP decline
Total output diminishes because there is a limit to the full utilization of
indivisible factors and introduction of specialization
Diseconomies of scale will operate beyond the stage of optimum production
Diminishing returns are bound to appear as long as one or more factors is
fixed and cannot be substituted by the others
Stage 3: Negative Returns
In this case, as the quantity of variable input is increased to a given

quantity of fixed factors, output becomes negative (<0). During this stage,
TP starts diminishing, AP continues to diminish and MP becomes negative
at 10th unit of input in the illustration. The negative returns are the result of
excessive quantity of variable factors to a constant quantity of fixed
factors.
The 1st and 3rd Stage is described as Non-Economic Region or Uneconomic

Region or irrational phase of production since 1st stage results in under
utilization of fixed inputs and plant capacity, whereas 3rd stage results in
over utilization of fixed factor inputs and plant capacity. Hence the
producer will select the 2nd stage (which is also called the most economic
region) since he can maximize the output. The 2nd stage represents the
employment of the most ideal combination of factor inputs.
Uses in Decision making:
1. It helps to work out the most ideal combination of factor inputs or the
least cost combination of factor inputs
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2. It is useful to a businessman in the short run production planning at
the macro level
3. The law gives guidance that by making continuous improvements in
science and technology, the producer can postpone the occurrence of
diminishing returns.
Production Function with 2 variable inputs:
Meaning of ISO-Quant and ISO-Costs:
The prime concern of a firm is to workout the cheapest or lowest cost

method to produce a given output out of several alternative methods open
to it. The term ISO Quant has been derived from ISO meaning equal and
Quant meaning quantity. Hence ISO-Quants are also called as Equal
Product Curve or Product Indifference Curve or constant product curve. An
ISO-Product curve represents all the possible combinations of two
factor inputs which are capable of producing the same level of
output. According to Prof. Keirstead “ISO-Product curve represents all
possible combinations of two factors that will give the same total product”.
Each ISO-Quant represent only one particular level of output. If there are
different ISO-Quant Curves they represent different ISO-Quant curves they
represent different levels of output. Any point on an ISO-Quant Curve
represent same level of output. Since each point indicates equal level of
output, the producer becomes indifferent with respect to any one of the
combination. An ISO-Quant Curve shows the exact physical units of output
produced by different combinations of two factors. Hence the
measurement of output is possible.
Example:
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ISO – Quant Map: A number of ISO-Quants representing different amount

of output are known as ISO-Quant Map.
Marginal Rate of Technical Substitution: It may be defined as the rate

at which a factor of production can be substituted for another at the margin
without affecting any change in the quantity of output.
Combinations Factor X Factor Y MRTS of x:y

A 12 1 Nil
B 8 2 4:1
C 5 3 3:1
D 3 4 2:1
E 2 5 1:1
In the above example, in the second combination the producer is
substituting 4 units of X for 1 unit of Y. Hence in this case, MRTS is 4:1.
MRTS will be diminishing. In the above table, we can observe that as the
quantity of factor Y is increased relative to the quantity of X, the number of
units of X that will be required to be replaced by one unit of factor Y will
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diminish, quantity of output remaining the same. This is known as the law
of Diminishing Marginal Rate of Technical Substitution (DMRTS).
Properties of ISO-Quant:
Properties of ISO-Quant Curve are similar to those of indifferent curves:

1. An IQ Curve slope downwards from left to right
2. It is convex in origin
3. No two ISO-Product Curves intersect each other
4. An ISO-Product Curve lying to the right represents higher output and
vice-versa.
5. IQ Curves need not be parallel to each other
6. It will not touch either x or y – axis
ISO-Cost Line or Curve:
It is a parallel concept to the budget or price line of the consumer. It

indicates the particular combinations of the two inputs which the
firm can purchase at given prices with a given outlay. It shows two
things (a) price of two inputs (b) total outlay of the firm. Each ISO-Cost Line
will show various combinations of 2 factors which can be purchased with a
given amount of money at the given price of each input.
For Ex.
A producer has Rs.3000 to spend. If he purchases commodity/factor X at

Rs.100 per unit he can purchase 30 units for Rs.3000 whereas he can
purchase 60 units of commodity/factor Y for Rs.3000. When 30 units are
pointed on y axis and 60 units are pointed on x axis and the points are
joined, we get AB ISO-Cost Line. This line represents the different
combinations of factor X and Y.
The ISO-Cost line will shift to right if the producer increases the outlay from
Rs.3000 to Rs.4000. On the contrary, if his outlay decreases to Rs.2000,
there will be backward shift in the position of ISO-Cost Line.
The slope of the ISO-Cost line represents the ratio of the price of a unit of
factor X to the price of a unit of factor Y. In case, the price of any one of
them changes there would be corresponding change in the slope and
position of ISO-Costline.
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Producers Equilibrium:
(Optimum factor combination or least cost combination)
The optimal combination of factor input may help in either minimizing cost
for a given level of output or maximum output with a given level of
investment expenditure. In order to explain producer equilibrium, the
producing firm requires two instrument: (1) Its ISO-Quant Map (2) its ISO-
Cost line to hit upon the optimum (or minimum cost) factor combinations.
The intention of the producer is to maximize profits. This will become

possible when he produces optimum output at the lowest cost of
production. Hence, the producer selects the least cost combination of the
factors of production. The following diagram explains how the producer
reaches the position of equilibrium.
In the diagram the producer will reach the position of equilibrium at the
point E where the ISO-Quant line IQ and ISO-Cost line AB are tangent to
each other. With a given total of Rs.5000, the producer will be producing
the optimum output of 500 units by employing 25 units of factor X (at point
A in X axis) and 50 units of factor Y A(at point B in Y axis) (assuming
Rs.2500 is spent for each factor and the price per unit of factor X is Rs.100
and Y is Rs.50).
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He will not reach the position of equilibrium at E1 and E2 because they are
on higher ISO-Cost line. Similarly he cannot move to the left side of E, as
they are on the lower ISO-Cost line and he will not be able to produce 500
units of output with any combination of input other than E.
Thus, the point at which the ISO-Quant is tangent to the ISO-Cost line
represents the minimum cost or optimum factor combination for producing
a given level of output. At the point, MRTS between the two points is equal
to the ratio between the prices of the inputs.
Economies of Scale:
The study of economies of scale is associated with large scale production.

“The advantages or benefits that accrue to a firm as a result of
increase in its scale of production are called Economies of scale”.
They help in reducing production cost and establishing an optimum size of
a firm. According to Prof. Marshall these economies are of two types viz.,
Internal Economies and External Economies.
Internal Economies:
Internal economies are those economies which arise because of the actions
of an individual from to economise its cost. They arise due to increased
division of labour or specialization and complete utilization of indivisible
factor inputs. According to Prof. Cairn cross “Internal economies are
those which are open to a single factory or a single firm
independently of the action of other firms”. They result from an
increase in the scale of output of a firm and cannot be achieved unless
output increases. The following are some of the important aspects of
internal economies:
1. They arise within or inside a firm

2. They arise due to improvements in internal factors
3. They arise due to specific efforts of one firm
4. They are particular to a firm and enjoyed by only one firm
5. They arise due to increase in the scale of production
6. They are dependent on the size of the firm
7. They can be effectively controlled by the management of a firm
8. They are called as “Business Secrets” of a firm
Classification of Internal Economies:
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1. Technical Economies: These economies arise on account of
technological improvements and its practical application in the field
of business.
a. Economies of superior techniques: When the size of firm
grows, it becomes possible to employ bigger and better types
of machinery and increase production, thereby reducing cost.
For e.g., use of computer instead of human labour etc.
b. Econimies of increased dimension: A large firm avoids
wastage of time and by the use of increased dimension will
reduce cost of production. For e.g., use of double decker
instead of two separate buses.
c. Economies of linked process: By linking the various
processes of production a large firm saves the expenses
incurred on intermediaries thereby reducing unit cost of
production.
d. Economies arising out of research and by product: A firm
can invest adequate funds for research and the benefits of
research and its costs can be shared by all other firms.
Similarly large firm can make use of its wastes as by-products
in the most economical manner by producing other products.
e. Inventory Economies: A big firm can save a lot of money by
adopting latest inventory management techniques. For e.g.,
J.I.T. or zero level inventory techniques. The rationale of the
Just In Time technique is that instead of having huge stocks
worth of lakhs and crores of rupees, it can ask the seller of the
inputs to supply them just before the commencement of work
in the production department each day. Thus it can save a lot
of money by avoiding huge stocks of input which lie idle leading
to dead investment.
f. Economies of increased specialization: A large firm is able
to reap economies by dividing its production process into sub
processes thereby leading to greater division of labour and
increased specialization.
2. Managerial Economies: They arise because of better, efficient and
scientific management of a firm.
a. Delegation of details: Delegation of powers and functions to
trained or specialized personnel by the general manager of the
firm, will enable him to bring about improvements in production
process and in bringing down the cost of production.
b. Functional specialization: By dividing the work of
management into several separate departments specialized in
various functions, will lead to higher efficiency and reduction in
the cost of production.
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3. Marketing or Commercial Economies: These economies will arise
on account of buying and selling goods on large scale basis at
favourable terms. A large firm can buy raw materials and other
inputs in bulk at concessional rates. A firm can have its own sales
agency and channel.
4. Financial Economies: They arise because of the advantages
secured by a firm in the mobilizing huge financial resources. A large
firm has wider reputation and greater influence in the money and
capital market which helps in securing sufficient funds more easily
and cheaply.
5. Labour Economies: These economies arise as a result of employing
skilled, trained, qualified and highly experienced persons by offering
higher wages and salaries. All measures will definitely raise the
average productivity of a worker and reduce the cost per unit output.
6. Transport and Storage Economies: They arise on account of the
provision of better organized and cheap transport and storage
facilities and their complete utilization.
7. Over Head Economies: The expenses on establishment,
administration, book-keeping etc., are more or less the same whether
production is carried on small or large scale. Hence cost per unit will
be low if production is organized on large scale.
8. Economies of Vertical Integration: Because of vertical
integration, most of the costs become controllable costs which help
an enterprise to reduce cost of production.
9. Risk bearing or survival economies: These economies will arise
as a result of avoiding or minimizing several kinds of risks and
uncertainties.
a. Diversification of output by producing more than one product
b. Diversification of market by selling in different markets
c. Diversification of source of supply for inputs so that even if
person fails to supply, a firm can buy from several sources
d. Diversification of the process of manufacture for the same
commodity so as to avoid the loss arising out of the failure of
any one process
External Economies: External Economies are those economies which

accrue to the firms as a result of the expansion in the output of whole
industries and they are not dependent on the output level of individual
firms. In the words of Stonier and Hague “External Economies are those
economies in production which depend on increase in the output of the
whole industry rather than increase in the output of the individual firm”.
The following are some of the important aspects of external economies:
1. They arise outside the firm
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2. They arise due to improvements in external factors
3. They arise due to collective efforts of an industry
4. They are general and common and enjoyed by all firms
5. They arise due to overall development, expansion and
growth of an industry or region
6. They are dependent on the size of industry
7. They are beyond the control of management of a firm
8. They are called as “open secrets” of a firm
Classifications of External Economies:
1. Economies of concentration or localization of industry or

Agglomeration: They arise because in a particular area a very
large number of firms which produce the same commodity are
established. The benefits are better and cheap labour, trained and
skilled labour, quicker transport and communication, financial
assistance at cheaper rate of interest, marketing facilities etc which
result in reducing the cost of operation of a firm.
2. Economies of information: These economies will arise as a result
of getting quick latest and upto date information from various
sources. Since large number of firms are located in a region, it
becomes possible for them to exchange their views frequently by
discussions, lectures, seminars etc. Revolution in the field of
computers, internet, mobile, publication of journals, magazine etc.,
have strengthened inter-firm communication network thereby
reducing cost.
3. Economies of disintegration: These economies will arise as a
result of dividing one big unit into different small units for the sake of
convenience of management and administration. It leads to internal
economies of large scale production. All the firms in the industry will
be able to get the work done at a low cost instead of attempting to
meet their own needs by carrying it out themselves on a small scale
at high cost.
4. Economies of Government Action: These economies will arise as
a result of positive support and assistance given by the government
to stimulate production in the private sector units. For e.g., tax-
concessions, tax-holidays, subsidies
5. Economies of physical Factors: These economies will arise due to
availability of favourable physical factors or environment. For e.g.,
climate, weather conditions, fertility of the soil etc.
6. Economies of Welfare: These economies will arise on account of
various welfare programs under taken by an industry to help its own
staff. For e.g., health care units, training units, education institutions,
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concessions etc. Tall these measures would help in raising the
overall efficiency to productivity of labourers.
Diseconomies of Scale:
When a firm expands its size of operation and output beyond the optimum
limit, the economies scale turns out to be diseconomies of scale. These
diseconomies of scale by raising the average cost of production, acts as a
limiting factor on the further expansion of the firm. These limitations arise
because of human, technical, economic an other factors in production.
Hence additional output is to be obtained at higher cost. The following are
the major diseconomies of scale:
1. Financial Diseconomies: As there is over growth, the required

amount of finance may not be available for a firm.
2. Managerial Diseconomies: Excess growth leads to loss of
effective supervision leading to wastages, indiscipline and rise in
production and operating costs.
3. Marketing Diseconomies: Excess production leads to mismatch
between demand and supply, thereby leading to stock pile up and fall
in price, sales, revenue and profits.
4. Technical Diseconomies: When output is carried beyond the plant
capacity, per unit cost and operation cost will go up.
5. Diseconomies of Risk-Bearing: If output expands beyond a limit,
investment increases, stocks pile up. Business risks appear in all
fields of activities. Supply of factor inputs may become inelastic
leading to higher prices.
6. Labour Diseconomies: In a larger firm, contact between
management and employees is limited. Labourers may demand
higher wages, bonus, perquisites etc. Industrial disputes may arise.
Labour unions may not cooperate with the management.
7. External Diseconomies: When several business are concentrated
only in one place or locality, it may lead to congestion, environmental
pollution, scarcity of water, houses, schools etc. leading to higher
production and operational costs.
Hence there should be proper check on the growth and experience of either
one firm or an industry. Otherwise instead of benefits, they have to face
innumerable problems.
Supply:
Supply is made by the producer. It is the opposite of demand. Supply of a

product basically depends on cost of production and management decision.
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Hence it covers such problems like where to sell, when to sell, for whom to
sell and how much to sell and at what price to sell etc.
According to Prof. Macconnel, Supply may be defined as “supply may be

defined as a schedule which shows the various amounts of a product which
a producer is willing to and able to produce and make available for sale in
the market at each specific price in a set of possible prices during some
given period.
Difference between stock and supply:
Stock refers to total quantity of output kept in a warehouse which can be

offered for sale in the market by the seller. On the other hand, the term
supply refers to the amount that is actually offered for sale in the market at
a price per unit of time. Hence supply is a part of stock.
Supply Schedule:
Change in supply consequent upon changes in price, when

represented in a tabular column constitutes a supply schedule. It
represents the functional relationship between quantity supplied
and price. No producer wants to charge cost price to customers since the
producer has to gain profit. Hence supply is zero at cost price. It is called
the reserve price. Reserve price is a minimum price below which a
seller will not sell his commodity.
Individual Supply schedule is the supply schedule for an individual

buyer.
Price in Quantity
Rs. supplied in
units
5 500
4 400
3 300
2 200
1 100
0.75 00
Market Supply Schedule:
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The total quantity of commodity supplied at different prices in a
market by the whole body of sellers is called as market supply
schedule. It refers to the aggregate behaviour of the market rather than
mere totaling of all individual supply schedule.
Quantity supplied in units Total

Price in Rs.
A B C (A + B + C)
5 500 600 700 1800
4 400 500 600 1500
3 300 400 500 1200
2 200 300 400 900
1 100 200 300 600
The market supply schedule help a firm to formulate its sales policy by
manipulating the prices. It helps to know how much sales can be increased
by raising the price without loosing the demand for a product.
Supply Curve:
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The law of supply:
“Other things remaining constant, the quantity supplied varies

directly with the price i.e. when the price falls, supply will contract
and when price rises, supply will extend”. According to S.E. Thomas,
“A rise in price tends to increase supply and a fall in price tends to reduce
supply. Mathematically S=F(P). Supply is the function of price. It does not
have universal validity. It is conditional in nature. The other things that
should remain constant when we study law of supplies are:-
1. Number of firms, the scale of production and the speed of production

2. Availability of other inputs
3. Techniques of production
4. Cost of production
5. Market prices of other related goods
6. Climate and weather conditions
Special features of law of demand:
1. Direct Relation: There is a direct relationship between price and

supply i.e. higher the prices higher would be the supply and vice
versa.
2. Price is an independent variable and supply is a dependent
variable: In this case we analyse the effect of price on supply only.
3. Importance of the qualifying phrase other things being equal:
The applicability of the law is conditioned by the phrase “Other things
being equal”. Thus the law is not universal in nature.
4. Qualitative statement: It tells us only the direction of change in
price and supply but does not indicate the quantitative changes in
both price and supply.
5. Upward sloping curve: Supply curve normally slopes upwards
from left to right.
Exceptions to the law of demand:
In certain circumstances, inspite of rise in price supply may not expand or

even at a lower rate more quantity may be sold. This will happen under
exceptional situations. In this case, the supply curve slopes backward.
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The following are some of the exceptions to the law of supply:

1. If the seller is badly in need of money, he will sell his product even at
lower prices
2. If the seller wants to get rid of his products, then also he will sell his
products at reduced rates.
3. When further heavy fall in prices is anticipated the seller may become
panic and sell at a lower price
4. In case of auction, the auctioneer is not interested in maximizing
profits by selling more units at a higher price. Thus, an auction sale
is an exception to the law of supply.
Changes or shifts in supply:
When supply of a product change only due to change in the price of that
product alone, it is called as expansion or contraction in supply. Expansion
in supply means, the more quantity is supplied at a higher price and
contraction in supply means, less quantity is supplied at a lower price. In
this case, the supply curve shows a upward direction from left to right.
In the above diagram, 20 units are purchased at Price Rs.6 and 30 units are
purchased even after price increase to Rs.8.
Increase or decrease in supply:
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If supply changes not because of changes in price, but because of
changes in other determinations, then, it will be a case of either
increase or decrease in supply.
Increase in supply: It implies more supply at the same price or same

quantity supplied at a lower price. In this case a new supply curve is drawn
as given below:
Decrease in supply: It implies that less quantity is supplied at the same

price or same quantity is supplied at a higher price. In this case, also we
have to draw a new supply curve.
Managerial uses of law of supply:

1. it helps in deciding what and when to produce and sell, what quantity
to sell, At what price to sell, when and where to sell
2. Helps in maintaining a balance between stock and supply
3. Helps in preparing sales budget policy
4. Helps in estimating the present and future expected revenue and
profit levels
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5. Helps to analyse the effects of taxes on total sales in the market
6. Helps to analyse the impact of various government policies on the
supply of a product
7. Helps in identifying the factors which affect supply of a product
Determinants of supply:
1. Natural Factors: Favourable natural factors like good climatic
conditions, adequate rainfall etc., helps in higher production and
expansion of supply, whereas adverse factors like floods etc., will
decline the production and supply.
2. Changes in techniques of production: Primitive techniques result
in lower production and supply. Improvements in technology or
sophisticated machines and equipment result in higher production
and supply.
3. Cost of production: If the cost of production rises due to higher
wages, interest etc., the supply decreases and vice versa.
4. Prices of related goods: If prices of related goods fall, the seller of
a given product will supply more units in the market even though the
price of his commodity has not fallen.
5. Government policy: When the government follows a positive policy
like granting of subsidies etc., it encourages production in the private
sector. Whereas if the government follows a negative policy like
withdrawal of all concessions etc., the supply reduces.
6. Monopoly power: Supply tends to be low in monopolist market or
when there are few sellers as in oligopoly. Supply is more under
competitive conditions.
7. Number of sellers or firm: Supply would be more when there are
a large number of sellers and vice versa.
8. Complementarity of goods: In case of joint demand, the
production and sale of one product may lead to production and sale
of other product also.
9. Discovery of new sources of inputs: Discovery of new sources of
inputs helps the producers to supply more at the same price and vice
versa.
10. Improvements in transport and communication: this will
facilitate free and quick movements of goods and service from
production centres to marketing centres.
11. Future rise in prices: When sellers anticipate a further rise in
price, in that case supply tends to fall and vice versa.
Thus the firm should have a thorough knowledge of all these factors before
preparing its production plan or sales strategy.
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Supply Function: Supply of a product, apart from price changes also
depends upon many factors. When we analyse the influence of these
factors on supply, supply schedule will be converted into supply function.
Supply function is a comprehensive one as it analyses the causes for
changes in supply in a detailed manner. Mathematically a supply function
can be represented in the following manner:
Sx = f(Pf, T, Cp, Gp, N……..etc)
Where Sx = Supply of a given product x

Pf = Price of factor output
T = Technology
Cp = Cost of production
Gp = Government policy
N = Number of firms etc
Supply function is also called as shifts
Distinction between Demand and Supply:
Sl.
No Demand Supply
.
1 It is concerned with the study It is concerned with the study of
of consumer’s behaviour producer’s behaviour
2 The basic objective of a The basic objective of a producer is
consumer is maximization of profit maximization
satisfaction
3 Demand basically depends on Supply of a product depends
the utility of a product or basically on the cost of production
service
4 A consumer wants to buy at A seller wants to sell at the highest
the lowest price in the market price in the market
5 A consumer wants to save A producer wants to earn more
more money money
6 There is an inverse There is a direct relationship
relationship between price between supply and price
and demand
7 Demand Curve slope Supply curve slopes upwards from
downwards from left to right left to right
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Effects of supply on cost of production: When supply of factor inputs
is elastic to a producer, he can buy them at lower prices. On the other
hand, if they are inelastic to a producer, he can buy them at lower prices.
On the other hand, if they are inelastic in supply, then he has to pay a
higher price for them leading to higher production cost either in the short
run or in the long run. Thus, the supply of factors of production in the
market affects production cost of different goods and services.
Elasticity of Supply:
It refers to the sensitiveness or responsiveness of the supply to a

given change in price. In short, it measures the degree of adjustability
of supply to a given change in price. The formula to calculate elasticity of
supply is as follows:
Percentage change in supply 8%
ES = -------------------------------------------= ------ = 4
Percentage change in price 2%
It implies that at the present level with every change in price, there will be
a change in supply four times directly.
Types of elasticity of supply:
Just like elasticity of demand, elasticity of supply is also equal to infinity,

zero, greater than one, lower than one and equal to one.
1. Perfectly Elastic Supply: Supply is said to be perfectly elastic

when a slight change in price leads to immeasurable change in
supply. Hence supply curve would be a horizontal and parallel line to
OX axis.
2. Perfectly Inelastic Supply: When supply of a commodity remains

constant and does not change whatever may be the change in price,
it is said to be absolutely or perfectly inelastic supply. Here the
supply curve tends to be a vertical straight line (ES = 00 Zero).
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3. Relatively Elastic Supply: If the change in supply is more than

proportionate to the change in price, in that case, elasticity of supply
is greater than one.
4. Relatively Inelastic Supply: If the supply is less than

proportionate to a given change in price then, elasticity of supply is
said to be less than one.
5. Unitary Elastic Supply: If proportionate change in supply is exactly

proportionate to change in price, then elasticity of supply is equal to
one.
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Factors determining Elasticity of supply: (Determinants)
1. Time Period: Generally supply tends to be inelastic in the short run

because time available to organize and adjust supply to demand is
insufficient. Supply would be more elastic in the long run.
2. Availability and mobility of factors of production: When factors
of production are available in plenty and freely mobile from one
occupation to another, supply tends to be elastic.
3. Technology improvements: Modern methods of production,
expands output and hence supply tends to be elastic. Old methods
reduce output and supply tends to be inelastic.
4. Cost of production: If cost of production rise rapidly as output
expands, then there will not be much incentive to increase output as
the extra benefit will be choked off by increase in cost. Hence supply
tends to be inelastic and vice versa.
5. Kinds and nature of markets: If seller is selling his product in
different markets, supply tends to be elastic in any one of the market
because, a fall in the price in one market will induce him to sell in
another market. Again if he is producing several types of goods and
can switch over easily from one to another, then each of his product
will be elastic in supply.
6. Political conditions: Political conditions may disrupt production of
a product, in this case, supply tends to become inelastic.
7. Number of sellers: Supply tends to become more elastic if there
are more sellers freely selling their products and vice versa.
8. Prices of related goods: A firm can charge a higher price for its
products, if prices of other products are higher and vice versa.
9. Goals of the firm: If the seller is happy with small output, in that
case supply tends to be inelastic and vice versa.
Practical importance of Elasticity of supply:
1. The concept of elasticity of supply is of great importance to the

finance minister while formulating the taxation policy of the country.
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If the supply is inelastic, the imposition of tax may not bring about
any change in the supply. If supply is elastic reasonable tax may be
levied.
2. The price of commodity depends upon the elasticity of demand and
supply
3. The concept has a theoretical value. It is used in the theory of
incidence of taxation. The money burden of taxation is shared by the
tax payers and the sellers in the ratio of elasticity of supply and
demand.
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26

Unit 5 - Law of Supply

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Unit 5 - Law of Supply

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Business Economics Unit 5 – The Theory of Production B.

Com 1st Sem

The term production means transformation of physical inputs into physical

Production always results in either creation of new utilities or addition of

Inputs Transformati Output

Entry into Transformati Exit out of

It helps an individual to fulfill his requirements or wants by consuming

A production function expresses the technological or engineering

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 1 of

Mathematically production function is:

Thus rate of output Q is thus, a function of the factor inputs L, N, K etc.,

Inputs factors are of 2 types:

Fixed Factors: They remain constant irrespective of the level of output.

Production Function is of 2 types:

Improvements in production function can be brought about as

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 2 of

Uses of Production Function:

Thus production functions of immense utility to the mangers and

Production Function: One variable input case

The law of variable proportions or the law of non-proportional output will

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 3 of

Average Product or Output (AP): It is obtained by dividing total output

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 4 of

Stage 1: The law of increasing returns: In this case, as the quantity

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 5 of

Stage 3: Negative Returns

In this case, as the quantity of variable input is increased to a given

The 1st and 3rd Stage is described as Non-Economic Region or Uneconomic

Uses in Decision making:

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 6 of

Production Function with 2 variable inputs:

Meaning of ISO-Quant and ISO-Costs:

The prime concern of a firm is to workout the cheapest or lowest cost

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 7 of

ISO – Quant Map: A number of ISO-Quants representing different amount

Marginal Rate of Technical Substitution: It may be defined as the rate

Combinations Factor X Factor Y MRTS of x:y

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 8 of

Properties of ISO-Quant Curve are similar to those of indifferent curves:

ISO-Cost Line or Curve:

It is a parallel concept to the budget or price line of the consumer. It

A producer has Rs.3000 to spend. If he purchases commodity/factor X at

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 9 of

The intention of the producer is to maximize profits. This will become

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 10 of

The study of economies of scale is associated with large scale production.

1. They arise within or inside a firm

Classification of Internal Economies:

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 11 of

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 12 of

External Economies: External Economies are those economies which

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 13 of

Classifications of External Economies:

1. Economies of concentration or localization of industry or

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 14 of

1. Financial Diseconomies: As there is over growth, the required

Supply is made by the producer. It is the opposite of demand. Supply of a

M.S. Ramaiah Degree College (MSRCASC) M. Maliny Page Number: 15 of

According to Prof. Macconnel, Supply may be defined as “supply may be

Difference between stock and supply:

Stock refers to total quantity of output kept in a warehouse which can be

Change in supply consequent upon changes in price, when