Theory of Production and Supply

Factors of Production
• Land: All kinds of natural resources. Rent is the
remuneration.
• Labor: Physical and intellectual labor. Wage is
remuneration.
• Capital: Anything produced by man and used in
further production. Interest is the remuneration.
• Organization: Bringing together all other factors of
production for facilitating production.
 Production Function
• Explains the functional relationship between input used
(Physical Inputs) and output produced (Physical
Outputs).
• A simple production function is as follows:
• Q= (K, L, R, T) i.e. resources, labor, capital, and
technology.
• Production function with one variable input- law of
variable proportions
• Two variable inputs: Iso quants
• All variable inputs: Returns to scale
 Law of variable proportions
• It is a production function with one variable
input i.e. one variable factor assuming all
other factors constant.
• As the proportion of one factor in a
combination of factors is increased, after a
point, first the marginal and then average
product of that variable factor will diminish.
 Assumptions
• Production technology remains constant
• Only one factor changes and rest remains
constant
• Factor proportions can be changed
• All variable factors are homogenous.
• Law applies to short run
 Three stages
• Law operates in three stages:
• First stage: increasing returns (Total, average and
marginal products increase)
• Second stage: constant returns (Total product
increases but average and marginal products
remain constant)
• Third stage: diminishing returns (average and
marginal products decline and total product
increases till marginal product is zero)
 Reasons
• Increasing returns
1. Indivisibility of inputs or factors
2. Specialization
3. Internal economies- benefits internal to a company
due to expansion
4. External economies- benefits to entire industry
• Diminishing returns
1. Diseconomies
2. Imperfect substitutes- E.g. technology vs labor
 Supply in Output Markets
• A supply schedule is a table showing how
CLARENCE BROWN'S
SUPPLY SCHEDULE much of a product firms will supply at
FOR SOYBEANS
different prices.
QUANTITY
SUPPLIED
PRICE (THOUSANDS
(PER OF BUSHELS • Quantity supplied represents the number of
BUSHEL) PER YEAR) units of a product that a firm would be willing
$ 2 0 and able to offer for sale at a particular price
1.75 10
during a given time period.
2.25 20
3.00 30
4.00 45
5.00 45
 The Supply Curve and
the Supply Schedule
• A supply curve is a graph illustrating how much
of a product a firm will supply at different prices.
CLARENCE BROWN'S 6

Price of soybeans per bushel ($)

SUPPLY SCHEDULE
FOR SOYBEANS 5
QUANTITY
SUPPLIED
4
PRICE (THOUSANDS
(PER OF BUSHELS
3
BUSHEL) PER YEAR) 2
$ 2 0
1.75 10 1
2.25 20
3.00 30 0
4.00 45
5.00 45 0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
 The Law of Supply
6 • The law of supply
Price of soybeans per bushel ($)

5 states that there is a

4
3
positive relationship
2 between price and
1 quantity of a good
0 supplied.
0 10 20 30 40 50
Thousands of bushels of soybeans • This means that
produced per year
supply curves
typically have a
positive slope.
Why supply curve slope is positive?
• Due to diminishing returns both in short and
long run
• A supplier supplies more only when there is an
assurance of higher price because additional
production costs more after certain point.
 Shifts vs. Movements Along the Supply Curve
• A change in the price of a good causes a movement
along the supply curve
– In Figure 4
• A rise (fall) in price would cause a rightward (leftward) movement
along the supply curve
• A drop in transportation costs will cause a shift in the
supply curve itself
– In Figure 5
• Supply curve has shifted to the right of the old curve (from Figure
4) as transportation costs have dropped
• A change in any variable that affects supply—except for the good’s
price—causes the supply curve to shift

12
 Figure 5: A Shift of The Supply Curve

Price per A decrease in transportation

Bottle costs shifts the supply curve for
maple syrup from S1 to S2. S1 S2
At each price, more bottles
are supplied after the shift
$4.00 J
G

60,000 80,000 Number of Bottles

per Month

13
Factors That Shift the Supply Curve
• Input prices
– A fall (rise) in the price of an input causes an increase
(decrease) in supply, shifting the supply curve to the right
(left)
• Price of Related Goods
– When the price of an alternate good rises (falls), the
supply curve for the good in question shifts leftward
(rightward)
• Technology
– Cost-saving technological advances increase the supply of
a good, shifting the supply curve to the right

14
 Factors That Shift the Supply Curve

• Number of Firms
– An increase (decrease) in the number of sellers—
with no other changes—shifts the supply curve to
the right (left)
• Expected Price
– An expectation of a future price increase
(decrease) shifts the current supply curve to the
left (right)

15
 Factors That Shift the Supply Curve

• Changes in weather
– Favorable weather
• Increases crop yields
• Causes a rightward shift of the supply curve for that crop
– Unfavorable weather
• Destroys crops
• Shrinks yields
• Shifts the supply curve leftward
• Other unfavorable natural events may effect all firms
in an area
– Causing a leftward shift in the supply curve

16
 Figure 6(a): Changes in Supply and in
Quantity Supplied
Price Price increase moves S
us rightward along
supply curve

P2

P1
Price increase moves
us leftward along
P3 supply curve

Q3 Q1 Q2 Quantity
17
 Figure 6(b): Changes in Supply and in
Quantity Supplied

Price Entire supply curve shifts S1

rightward when: S2
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↑
• technological advance
• favorable weather

Quantity
18
 Figure 6(c): Changes in Supply and in
Quantity Supplied

Price
Entire supply curve shifts S2
rightward when: S1
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather

Quantity
19
 Summary: Factors That Shift The Supply
Curve
• The short list of shift-variables for supply that we
have discussed is far from exhaustive
• In some cases, even the threat of such events can
cause serious effects on production
• Basic principle is always the same
– Anything that makes sellers want to sell more or less of a
good at any given price will shift supply curve

20
 A Change in Supply Versus
a Change in Quantity Supplied

• A change in supply is not the

same as a change in quantity
supplied.

• In this example, a higher price

causes higher quantity
supplied, and a move along
the demand curve.

• In this example, changes in determinants of supply, other than price, cause an

increase in supply, or a shift of the entire supply curve, from SA to SB.
 A Change in Supply Versus
a Change in Quantity Supplied

• When supply shifts to the

right, supply increases. This
causes quantity supplied to
be greater than it was prior to
the shift, for each and every
price level.
 A Change in Supply Versus
a Change in Quantity Supplied
To summarize:

Change in price of a good or service

leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of related goods and

services
leads to

Change in supply
(Shift of curve).
 From Individual Supply
to Market Supply

• The supply of a good or service can be defined

for an individual firm, or for a group of firms
that make up a market or an industry.
• Market supply is the sum of all the quantities
of a good or service supplied per period by all
the firms selling in the market for that good or
service.
 Market Supply
• As with market demand, market supply is the
horizontal summation of individual firms’
supply curves.
 Exceptions
• Backward bending supply curve: Supply curve
bends backwards after certain point.
• Labor Supply
• For e.g. a labor has target money income of
Rs. 1500 and given wage rate of Rs. 250 per
day, works for 6 days. If wage rate increases
to Rs. 300, works for 5 days and realizes same
amount of weekly income.
• Does 30 KG food grain at Rs. 30 reduces the
labor participation?
 Market Equilibrium
• The operation of the market
depends on the interaction
between buyers and sellers.
• An equilibrium is the condition
that exists when quantity supplied
and quantity demanded are equal.
• At equilibrium, there is no
tendency for the market price to
change.
Market Equilibrium
• Only in equilibrium
is quantity supplied
equal to quantity
demanded.
• At any price level
other than P0, the
wishes of buyers
and sellers do not
coincide.
Market Disequilibria
• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds quantity
supplied at the current
price.
• When quantity demanded exceeds
quantity supplied, price tends to
rise until equilibrium is restored.
Market Disequilibria
• Excess supply, or surplus, is
the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.

• When quantity supplied exceeds

quantity demanded, price tends to
fall until equilibrium is restored.
 Increases in Demand and Supply

• Higher demand leads to higher • Higher supply leads to lower

equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
Decreases in Demand and Supply

• Lower demand leads to • Lower supply leads to

lower price and lower higher price and lower
quantity exchanged. quantity exchanged.
Relative Magnitudes of Change

• The relative magnitudes of change in supply and demand determine the

outcome of market equilibrium.
Relative Magnitudes of Change

• When supply and demand both increase, quantity will increase, but
price may go up or down.
Supply-Demand Equilibrium

qD = 1000 - 100p
qS = -125 + 125p

Equilibrium  qD = qS

1000 - 100p = -125 + 125p

225p = 1125
p* = 5
q* = 500
35
 Supply-Demand Equilibrium

• A more general model is

qD = a + bp
qS = c + dp

Equilibrium  qD = qS

a + bp = c + dp

ac
p* 
d b
36
 Supply-Demand Equilibrium

A shift in demand will lead to a new equilibrium:

Q’D = 1450 - 100P

Q’D = 1450 - 100P = QS = -125 + 125P
225P = 1575
P* = 7
Q* = 750

37
 Example: rental apartment
• Demand & Supply rent($)
quantity
demanded
quantity
supplied
Diagram
800 30 10
• Equilibrium P & Q
• Why $1000 can not be 1000 25 14

equilibrium? 1200 22 17
• Effects from a tornado
1400 19 19
destroying some
apartments. 1600 17 21

1800 15 22
38
Demand for two bedroom rental apartment

39