Unit 3 Lecture : 5 and 6

Theory of Supply
Introduction
Objectives
Main Content
Supply and Price: A Link
Supply Curve
Factors Affecting Supply of Commodity
Movement and Shift on the Supply Curve

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 Supply and Law of Supply
• Introduction
Relationship between price and quantity demanded is
referred to as demand. The opposite of this is known
as supply. The relationship between the price and
quantity of a good offered to the market for sale is
known as supply i.e. Supply means the amount
offered for sale at a given price and time.

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 Supply and Law of Supply
Objectives
At the end of this unit, you should be able to:
explain supply of a commodity in relation to changes
in price
 elucidate on factors that determines quantity
supplied
 enumerate the movement and shift on the supply
curve.
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 Supply and Law of Supply
• Supply and Price: A Link

When the price of a commodity is high may be as a

result of the demand for it, which informed the firm’s
decision to produce more. Then the quantity supply to
the market will increase. Firm’s decision to increase
number of output of the product requires that the firm
put in additional input. These additional inputs shall
increase the firm’s cost of production.
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 Supply and Law of Supply

For instance, increase in wages to the labour for

overtime work to meet the targeted number of output
and other cost on factor of productions. Therefore,
consumers should be ready to buy at the new price if the
firm is to supply outputs that will meet their market
demands. The increase in price however indicates that
the firm which has incurred additional cost of
production should have additional profit.
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 Supply and Law of Supply

Consequently, firm shall be encouraged to produce

more so as to earn more profit. Meanwhile, as prices fall
in the market; may be as a result of over- supply by
many firms who wants to make more profit while
meeting the market demand; then supply will fall. This
is known as the ‘Law of Supply’.

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 Supply and Law of Supply

According to law of supply , when other things remain

constant, the higher the price the higher the quantity
supplied, the lower the price the lower the quantity
supplied.
The relationship between supply and demand can be illustrated
like this:
Supply Demand Price
Constant Rises Rises
Constant Falls Falls
Increases Constant Falls
Decreases Constant Increases
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 SELF-ASSESSMENT EXERCISE

 State supply and the law of supply.

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 supply
1. Individual supply is the quantity of goods a single
producer is willing to supply at a particular price and
time in the market. In economics, a single producer is
known as a firm.

2. Market supply is the quantity of goods supplied by

all firms in the market during a specific time period
and at a particular price. Market supply is also known
as industry supply as firms collectively constitute an
industry.

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 Supply Function and Supply Equation

Supply Function : Supply has a functional relationship

with price. So we can say,
Qs= f(p), Other things are remaining the same.

Supply Equation : A hypothetical supply equation is –

Qs= - c + dp
A numerical supply equation is -
Qs= - 5 + 2p

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 Supply Schedule
Supply schedule therefore is a table showing the different
quantities of a good and services a producer is willing and
able to produce and sell at different prices over a given
period of time.
Combinations Price(per dozen) Tk. Quantity supplied (in dozen)
A 7 9
B 6 7
C 5 5
D 4 3
E 3 1
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 Supply curve
However, relationship between quantity supplied and prices
shown in a demand schedule can be graphically presented
with price on the vertical axis and quantity supplied on the
horizontal axis. Supply curve is a graphical representation of
supply schedule. A graphical representation showing the
relationship between price and quantity supplied of a good at
a particular point in time is called supply curve.

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The following curve
Price
represent the supply
curve.
Conclusion : Along
with the supply
A S´
curve SS´, the price 7
and quantity 6 B
5 C
supplied are 4
positively related, D
3 E
so the supply curve S
is upward sloping.
0
1 3 5 7 9
Quantity supplied
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 Factors Affecting Supply of Commodity

Just as factors other than the price of the good can

change the relationship between price and quantity
supplied, non-price factors can change the relationship
between price and quantity supplied, causing the supply
curve to shift. The non-price factors are :

1. Price of Related Goods

2. Price of the Factors of Production
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 Factors Affecting Supply of Commodity

3. State of Technology

4. Number of sellers

5.Expectation for future prices

6. Natural conditions

7. Transportation conditions

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1. Price of Related Goods

Let’s say that the price of wheat rises. Hence, it

becomes more profitable for firms to supply
wheat as compared to corn or soya bean. So , the
supply of wheat will rise, whereas the supply of
corn and soya bean will experience a fall.

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 Explanation
2. Cost of production
Higher cost of production may bring down the profit of
the firm. Hence a cut back on such product due to higher
cost of production. This will reduce the quantity the firm
can supply to the market and will shift the supply curve
to the left. Factors affecting production cost are: input
prices, wage rate, government regulation and taxes, etc.

2
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3. Technology:

Technological improvements help reduce production

cost increase profit, thus stimulate higher supply.
4. Number of sellers:
More sellers in the market increase the market supply.
5. Expectation for future prices:
If producers expect future price to be higher, they will
try to hold on to their inventories and offer the products
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to the buyers in the future, thus they can capture the
higher price.
6. Natural conditions

The supply of certain products is directly influenced by

climatic conditions. For instance, the supply of
agricultural products increases when the monsoon
comes well on time.

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7. Transportation conditions

Better transport facilities result in an increase in the

supply of goods. Transport is always a constraint to the
supply of goods. This is because goods are not available
on time due to poor transport facilities.

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 SELF-ASSESSMENT EXERCISE
The cost of input for a firm’s first product has become
so high making the production of that product
unattractive because of low profit on it. The firm
decided to switch to increase in production of substitute
whose cost of production is cheaper and hence profit on
it is higher.

Classify this scenario under one or two factors that

can affect quantity supply. Briefly give reasons for your
answers.

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 SELF-ASSESSMENT EXERCISE
 Bread industry became so attractive as a result of
government control price on flour that brought the
flour price down drastically. Many firms come into
the market to take advantage of the cheaper cost of
production by producing bread and hence enjoying
the good profit.
What do you think will happen to the supply curve of
bread if the demands for bread remain the same?

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 Equilibrium
• At the end of this unit, you should be able to
know:

 Equilibrium
 Types of equilibrium
 Equilibrium of demand and supply
 Numerical and Graphical representation of
equilibrium price and quantity
 Changes in Demand or Supply (Mathematically)

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 Equilibrium
The term ‘ equilibrium’ has often to be used in economic
analysis. Equilibrium means a state of balance between
two forces. When forces acting in opposite directions are
exactly equal, the object on which they are acting is said to be
in a state of balance.
Types of equilibrium :

Stable equilibrium : There is stable equilibrium, when the

object concerned, after having been disturbed, tends to
resume its original position.

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Thus, in the case of a stable equilibrium, there is a
tendency for the object to revert to the old position.

Unstable equilibrium : The equilibrium is unstable

when a slight disturbance evokes further disturbance, so
that the original position is never restored. In this case,
there is a tendency for the object to assume newer and
newer positions once there is departure from the
original position.
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Neutral equilibrium

It is neutral equilibrium when the disturbing forces

neither bring it back to the original position nor do they
drive it further away from it. It rests where it has been
moved. Thus, in the case of a neutral equilibrium, the
object assumes once for all a new position. after the
original position is disturbed.

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 Equilibrium of demand and supply
Equilibrium means the state of balance between two forces.
The market equilibrium means the state of balance
between demand and supply. The market equilibrium
comes at that price and quantity where the forces of
demand and supply are in balance. At the equilibrium
price, the amount that buyer want to buy is just equal to
the amount that sellers want to sell.

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The reason we call this an equilibrium is that, when the
forces of demand and supply are in balance, there is no
reason for price to rise or fall, as long as other things
remain unchanged.

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 Analysis : Numerical and Graphical

Numerical Analysis : The following table shows the

numerical analysis of equilibrium of demand and supply.
Quantity demanded Quantity supplied
Price (per gallon)
(millions of gallons) (millions of gallons)
$1.00 800 500
$1.20 700 550
$1.40 600 600
$1.60 550 640
$1.80 500 680
$2.00 460 700
$2.20 420 720

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Graphical analysis:

The demand curve (D) and the supply curve (S) intersect
at the equilibrium point E, with a price of $1.40 and a
quantity of 600. At a price above equilibrium like
$1.80, quantity supplied exceeds the quantity
demanded, so there is excess supply. At a price below
equilibrium such as $1.20, quantity demanded
exceeds quantity supplied, so there is excess demand.

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The figure shows the
equilibrium of demand
and supply.
The equilibrium is
the only price
where quantity
demanded is equal
to quantity
supplied.

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In the figure, the equilibrium price is $1.40 per gallon of
gasoline and the equilibrium quantity is 600 million
gallons. If a market is at its equilibrium price and
quantity, then it has no reason to move away from
that point. However, if a market is not at
equilibrium, then economic pressures arise to move
the market toward the equilibrium price and the
equilibrium quantity. At any above-equilibrium price,
the quantity supplied exceeds the quantity demanded.
We call this an excess supply or a surplus.

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With a surplus, gasoline accumulates at gas stations, in
tanker trucks, in pipelines, and at oil refineries. This
accumulation puts pressure on gasoline sellers. If a
surplus remains unsold, those firms involved in making
and selling gasoline are not receiving enough cash to
pay their workers and to cover their expenses. In this
situation, some producers and sellers will want to cut
prices, because it is better to sell at a lower price than
not to sell at all. So, if the price is above the equilibrium
level, incentives built into the structure of demand and
supply will create pressures for the price to fall toward
the equilibrium.

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When the price is below equilibrium, there is excess
demand, or a shortage—that is, at the given price the
quantity demanded, which has been stimulated by the
lower price, now exceeds the quantity supplied, which
had been depressed by the lower price. In this situation,
eager gasoline buyers mob the gas stations, only to find
many stations running short of fuel. Oil companies and
gas stations recognize that they have an opportunity to
make higher profits by selling what gasoline they have
at a higher price. As a result, the price rises toward the
equilibrium level.

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 Price Ceiling Vs. Price Floor
Price Ceiling
Price ceiling also referred to as Upper Price Limit
occurs when the government set a maximum price that
can be charged for a product in the market.
Price Floor
Price floor is the direct opposite of price ceiling. This is
when the government interferes in the market by setting
a minimum price that can be charged on a particular
product or services.

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 SELF-ASSESSMENT EXERCISE
Price of Wheat Demand for Wheat Supply of Wheat
( $ per Bushel ) (millions Bushel) (millions Bushel)

5 35 15

6 25 17

7 20 20

8 10 25

9 52 27

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 SELF-ASSESSMENT EXERCISE
 From the Table above, answer the following
questions.

• 1. What is the equilibrium price?

• 2. What is the equilibrium quantity demanded and
supplied?
• 3. If the government fixed a price ceiling of wheat per
bushel at $8,
will there be surplus or shortage in the market? Give the
surplus or shortage figure in million bushels.

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 SELF-ASSESSMENT EXERCISE
• 4. If the price floor is $5,
will there be surplus or shortage in the wheat market?
Give the surplus or shortage in million bushels.

• 5. When wheat was selling at $6 per Bushel, the

quantity demanded was 25 million bushels and
quantity supply was 17 million bushels. What is the
market condition? (State whether there is surplus or
shortage?).

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 Changes in Demand or Supply
Q D = a + bP ( Market demand equation)
Q S = d + eP ( Market supply equation with no tax)
i)Find the equilibrium P and Q.
(ii) How does a per unit tax t affect
outcomes?
(iii) What is the equilibrium P and Q
if unit tax t ?
Solution:
At equilibrium
QD = QS, P=? Q=?

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• Comparative Statics: effect on P and Q
of ↑t
Price consumers pay – price suppliers receive
= total tax t

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 Example
Suppose
QD = 50 – P (i)
Q S = 20 + 2P (ii)
Set QD = QS
50 – P = 20 + 2P
3P = 30 Consumer Price P = 10
Knowing P, find Q
Q = 50 – P
= 50 - 10 = 40
Check the solution
i) 40 = 50 – 10 and (ii) 40 =20 + (2*10)
In both equations if P=10 then Q=40

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 Changes in Demand or Supply
Impose a tax t on suppliers per unit
sold...
with tax t on suppliers
Q D = 50 – P, and QS = 20 + 2P becomes
Q S = 20 + 2(P-t)
Set QD = QS
50 – P = 20 + 2(P-t)
30 = 3P - 2t
3P = 30 + 2t
Consumer Price P = 10 + 2/ 3t

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Knowing P, find Q
Q = 50 – P
= 50 – (10+2/ 3t)
=40 – 2/ 3t
Comparative Statics: effect on P and Q
of ↑t
(i) As ↑ t, then ↑ P paid by consumers by
2/ 3t
⇒ remaining tax (1/3) is paid by suppliers
total tax t = 2/ 3t + 1/ 3t

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Suppose t = $3
Consumer P: $12 (pre-tax eq. p + 2 /3t)
Supplier P: $9 (pre-tax eq. p – 1 /3 t)
Price consumers pay – price suppliers receive = total tax t
(ii) and ↓ Q by 2/ 3t, reflecting a shift to the
left of the supply curve
Q = 40 – 2/ 3t
=40-2/3*3
=38

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 SELF-ASSESSMENT EXERCISE
• Tax Problem....
Q D = 132 – 8P
QS = 6 + 4P

(i) Find the equilibrium P and Q.

(ii) How does a per unit tax t affect
outcomes?
(iii) What is the equilibrium P and Q
if unit tax t = 4.5?

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 Thanks

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