Module II Supply and Elasticity of Supply

• Law of supply, elasticity of supply and its practical applications, market equilibrium

• Production, factors of production, production functions (one variable, two variable, all variable
and Cobb-Douglas

Meaning of Supply

The amount of commodity that its sellers offer for sale

▪ At a given price
▪ Per unit of time

Market supply is the sum of market supplies of a commodity made by all individual forms or their agents
✓ Supply is function of price and production cost.
Q = f (price, technology, input cost etc)
✓ Cost of production determines the minimum price of a commodity
or
Supply

The (1) willingness and ability of sellers to produce and offer to sell different quantities of a good (2) at
different prices (3) during a specific period of time.

Determinants of Supply

• Price – directly proportional

• Natural conditions – directly proportional
• State of Technology-directly proportional
• Transport conditions-directly proportional
• Cost of production-inversely proportional
• Government policy
• Non-economic factors (labor –strikes, flood, communal riots, epidemics etc)
Law of Supply

The supply of product increases with the increase in price and decreases with decrease in its price, other things
remaining constant.
Or

As the price of a good rises, the quantity supplied of the good rises; and as the price of a good falls, the quantity
supplied of the good falls.

Changes in Quantity Supplied versus Changes in Supply

•Changes in Quantity Supplied: a movement along the supply curve. This happens because of change
in commodity’s own price.

•Changes in Supply: a shift in the supply curve. This happens because of change in any of the factors
affecting supply, other than commodity’s own price.
• Increase in supply: a shift to the right.
• Decrease in supply: a shift to the left.
Assumptions underlying the law of supply

• Cost of production is unchanged

• No change in techniques of production
• Fixed scale of production
• Government policies are unchanged
• No change in transportation costs
• The price of other goods are held constant

Elasticity of supply

Movement / response/reaction of supply with respect to its determinants

Price Elasticity of Supply

• A measure of the extent to which the quantity supplied of a good change when the price of the
good changes, and all other factors affecting supply remaining the same (ceteris paribus).

Price Elasticity of Supply (Es)

= % Change in Quantity Supplied

% Change in Price

Price Elasticity of Supply

• Perfectly Elastic Supply – When the quantity supplied changes by a very large percentage in
response to an almost zero increase in price
• Elastic Supply – When the % change in the quantity supplied > the % change in the price
• Unit Elastic Supply – When the % change in the quantity supplied = the % change in price
• Inelastic Supply – When the % change in the quantity supplied is < the % change in price
• Perfectly Inelastic Supply – When the quantity supplied remains the same as the price changes
Factors determining of price elasticity of supply

•Own Price
•Price of related goods
•Cost of Production
•State of Technology
•Goal & objectives of producer
•Number of Sellers
•Degree of competition
•Expectations of Future Price
•Taxes and Subsidies
•Government’s taxation and other policies
•Means of transportation, Communication, Banking & insurance
•Natural factors – rain, fertility of land, climatic conditions, irrigation facilities, floods, drought,
earthquake etc.
Production

Production may be defined as the “transformation of inputs into output”. for example ; inputs of raw cotton,
capital & labour result in the production of cloth. Production refers not only to physical things – wheat cloth,
etc. but also to the production of services.

Production function

Production function explains the relationship between factor inputs & output under given technology. Thus with
a particular period of time ,production function refers to the relationship between factor input and output to the
quantity of a commodity that can be produced with given amount of inputs. Symbolically it can be written
under .
Q = f (f1 ,f2,---fn).
Where Q is the physical quantity of a certain produce and f1,f2,--- fn stand for various input needed to produce
Q.

Fixed Factor

These refer to those factors which cannot be changed during short period e.g land, machinery, plant, equipment,
factor building etc. these factor rather remain fixed during short – period but can be changed in the long period
.

Variable Factor
These refer to those factor of production which can be varied or changed e. g raw material, labour, power fuels
etc. the difference between fixed factor and variable factors disappears in the long run. In the long run all the
factors of production will be come variable factors.

Short Run
Short run refers to that period of time in which some of the factor of production remain fixed and some are
variable. Quantity of fixed factor of production can not be increased in the short run . Therefore if the firm
wants to increase its production in short run, it can do so by increasing the quantity of variable factors only but
this can be possible only to the extent of total production capacity of the firm. Thus a firm can not go beyond
its production capacity in short run.
Long Run
Long run refers to that period in which all the factors of production can be changed according its requirement .
If the demand of a product is more in market ,produces can get new building constructed , can purchase new
machines and can all other factor of production required on the if the demand of a product
less in market , the producers can divert their engaged in the production of other products for which
there is a demand in the market .Thus all the factors of production are variable in long run and the quantity of
production can go firm zero to infinite during this period.
Short Run law of Production
In short run ,we take only variable L, Keeping other input K is fixed ,e.g Q = F (L) .

Law of Variable Proportions ( applicable for short run)

Law of variable proportion applies in the short period . In the short period we can increase production by
increasing only the variable factor of production. It is because of change in proportion between variable factor
and fixed factors. That the law is called law of variable proportion. This law explains the relationship between
the fixed and variable factors on the one hand and between the input and the output on the others.
The law of variable proportion state that when more and more units of a variable factors are applied with
fixed factors , then beyond a certain limit, the marginal product inially increase and then declining and after that
negative returns. Suppose when more and more labours (variable factors) applied with fixed quantities of other
factor (say of capital),we get total product as shown below.
Fixed factor labor unit MP TP AP
4 1 4 4 4
4 2 6 10 5
4 3 8 18 6
4 4 6 24 6
4 5 4 28 5.6
4 6 2 30 5
4 7 0 30 4.2
4 8 -2 28 3.5
 Show these stages of increasing , diminishing and negative returns . three stages of law
Stage 1
In this stage TP,AT and MP increase .TP increases at an increasing rate. This stage comes to an end when AP is
maximum and also AP=MP. It is the stage of increasing return.
Stage 2
In this stage TP rises but at diminishing rate. This stage begins when AP is maximum and ends when TP is
maximum or MP is equal to zero. During this stage AP and MP fall. This stage is called the stage of
diminishing return . In this stage that a firm decades its level of production.
Stage 3
It starts when MP=0 and TP is maximum. In this stage TP start falling and slope of TP become negative.
MP becomes negative. This stage is called the stage of negative returns.
The firm does not stop in the first stage because it is getting increasing returns. A rational firm chooses its
volume of production in stage 2. The firm can not operate in the third stage where MP is negative and TP starts
declining.

Relationship between TP,AP and MP

In the beginning TP,AP and MP all increase but the increase in MP is greater than AP.
When AP is maximum and constant , MP= AP
Both MP and AP falls after but MP is lesser than AP. MP can be zero and negative but AP and TP becomes
maximum
If the quantity of variable factors of production is increased after marginal product has become zero, it will
not increase total product , rather it will start to decline . At this stage marginal product will be negative.
At the initial stage of production , TP increase at an increasing rate. At the ultimate stage of production ,TP
increases at a diminishing rate.
The AP rises when the marginal product rises MP is greater than the Ap.
The AP is at its maximum when the MP is equal to the Ap.
AP falls when MP is less than AP.

Do Increasing return occur as we go on increasing a variable factor of production…….

(1) Indivisibility of factor → Because of application of more units of a variable factor to fixed indivisible
factor (like machine) results in increasing returns.
(2) Specialization and division of labour → It increase output at an increasing rate.
(3) Economies of large scale production → Internal and external economies became available in large scale
production leading to higher production.
 Why do diminishing return occur as we go on increasing a variable factor----------
(1) Use beyond optimum capacity→After achieving optimum combination of variable and fixed factors ,
when more units of a variable factor are employed, marginal product starts falling.
(2) Lack of perfect substitution between factors → up to a certain limit, factors of production can be
substituted for one another e.g more labour can be employed instead of machinery but beyond a certain
stage, this is not possible . The factor became imperfect substitutes leading to diminishing returns.

Long Run law of Production------------

In long run we assume that both inputs are variable.

Isoquant curve --------

An isoquant curve is lowers of points representing various combination of two input – capital and
labour – yielding the same out put
Isoquant curves are drawn on the basis of the following assumption.
(1) these are only two inputs ie ; labour (L) and capital (C) to produce a commodity X.
(2) the two inputs – land K – can substitute each other but at a diminishing rate.
(3) The technology of production is given

The points A,B,C and D on the isoquant IQ show four different combination of input, K and L yielding .
the same output - 100 units movement sum A to D indicates decreasing quantity of K and increasing
number of L.
Capital Labour Combination and output
---------------------------------------------------

Points Input combination out put

K + L
A ok4 + ol1 =100
B ok3 + ol2 =100
C ok2 + ol3 =100
D ok1 + ol4 =100

Properties of Isoquant
(1) Isoquant slop down ward from Left to Right→Isoquant have negative slop. this is so because, when the
quantity of one factor (say x) is increased , the quantity of other factor (say y) must be reduced , so that
total product remain constant .
(2) Isoquant curve never intersect each other→ intersection of isoquant showing different level of output is
a logical
(3) Isoquant are convex to origin→
This property of isoquant is based upon the principle of diminishing marginal rate of technical
substitution . Employment of each successive unit of one factor (say , labour) will be required to compensate for
smaller and smaller sacrifice of the other factor (say, capital) so as to maintain the same level of output.
(4) Upper isoquant represent higher level of output→
Between any two isoquant , the upper one represent a high level of output then lower one.

Law of Returns to Scale (Applicable for long run )

Return to scale applies in the long period. In the long period all the factor of production became variable.
Return to scale explains the of output when quantities of all input are changed in the same proportion. In
other word responsiness of output to change in all the inputs at the same rate is called returns to scale.
Three stages →When all the inputs are increased in the same ratio, the following three stage in output are
noticed :
(1) Increasing return to scale→
When proportionate increase in the total out put is more than the proportionate increase in all inputs.
(2) Constent Return to scale→
When the proportionate increase in total output is the same as the one in increasing all the input
(3)Diminishing return to scale →
When proportionate increase in total out put is less than the proportionate increase in all inputs
 Three Stages of Return to Scale
Scale of Inputs Total Prod Marginal Prod Stage
1 Labour +1 Machine 10 10
2 Labour +2 Machine 30 20 Increasing Return
3 Labour +3 Machine 60 30
4 Labour +4 Machine 100 40
5 Labour +5 Machine 140 40 Constant Return
6 Labour +6 Machine 180 40
7 Labour +7 Machine 210 30
8 Labour +8 Machine 230 20 Diminishing Return
9 Labour +9 Machine 240 10

Economies of scale and Diseconomies of scale →

Economies :→ Economies are the advantage or the benefit which a producer (firm) gets by expanding its
scale of production. When a firm expand its scale of production small scale to large scale, the firm
experience the following internal and external economies (benefits) of production leading to increasing
return.

Internal Economies→ these refers to the advantage which accrue to a firm by internal factors on expansion
of its scale of production . These benefits are confined and internal to the concerned and depend upon the
size of the firm internal economies are as under:
(a) Technical Economies : These involve use of better and more efficient machinery. Economies form
process based division of labour and spealisation which increase production of labour .
(b) Managerial Economies : These involve delegation of duties and functional specilisation in management.
(c) Marketing Economies : These involve purchase of raw material at a lower price and sale of
manufactured goods at higher price.
(d) Finacial Economies : These involve of more loan facilities at lower rate interest.
(e) Risk bearing economies : These involve diversification of output , market and sources of supply.
External Economies : These refers to those economies are enjoyed by all the and as a refute of growth of
industry as a whole. These advantage are common to all the in a locality and industry. For instance , when
an area is developed transport and communication became available. Roads and raw ways are built.
Specialized labour became available. Services of post telegraph, bank, ware houses, insurance facilities are
available. More subsidiary industries start in the neighbourhood . All there economies of localization add to
the productivity and bring increasing return to a firm.

Diseconomies of scale →
A firm experiences decreasing returns due to diseconomies of scale. Expansion of a firm beyond a
point may cause internal and external diseconomies. During production a stage is when diseconomies
replaies the economies of production. One important diseconomies is production beyond optimum capacity
of the machinery used by a firm like wise, beyond a point a firm may be compelled to buy raw material at a
higher cost, pay higher wages to attract more labour, non – availability of sufficient and face financial and
traffic problems . more over with increase in scale of production, management and coordination becomes
difficult. Again beyond a certain unit factor of production can not be substituted for each other ie; beyond
the optimum unit if the factor become imperfect subsitutes.
Factors of production (Inputs) :
- Land
- Labour
- Machinery
- Capital
- Entrepreneur
Cobb-Douglas Production Function:
Cobb and Douglas made a stastical inquery into some Manufacturing industries in America and other
countries. To the empirical relation changes in physical inputs and the resulting out put. From their a
generalized form of production function with two variable input e.g labour and capital has been evolved which
is as follows :

Q= aLbK1-b
Where Q is the quantity of out put, L and K stand for the quantites of labour and capital respectively while a
and b are positive constent.
The above state production function is a unequal and homogeneous function of, one which establishes constant
returns to the scale.