2.4: Supply and Demand
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Supply and Demand
Supply and demand affect prices in the market by interacting with one another. Supply is defined as the amount of a product that will be offered for sale at all the possible prices in the market. For this reason, supply is considered to be from the producer or seller’s point of view. More will be offered for sale at higher prices, and less will be offered for sale at lower prices, which is known as the Law of Supply. When a consumer enters into the marketplace, it is essential that he or she knows that the supplier is in business to make a profit, and even though there may be many products available to purchase, it is the informed consumer who gets the best value for his money. Changes in supply can be caused by several factors, including the cost of inputs, productivity, new technology, taxes, subsidies, expectations, government regulations, and the number of sellers in the market.
- The interaction between supply, demand, and price is illustrated by supply and demand graphs.
- How are the laws of supply and demand similar? How are they different?
- How do businesses react to changes in prices?
Before reading more about supply and demand, view the two introductory videos below by economics teacher Jacob Clifford.
Video: An Introduction to Demand
Video: An Introduction to Supply
All suppliers of economic products must decide how much to offer for sale at various prices, which is a decision made according to what is best for that individual seller. What is best depends on the cost of producing those goods and services. On the other hand, you as a consumer must determine what is best for you and how much you are willing to pay to acquire those goods and services.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply are held constant.
Supply vs. Quantity Supplied
A supply schedule is a table that shows the quantity supplied at different prices in the market. A supply curve shows the relationship between quantity supplied and price on a graph. The law of supply says that a higher price typically leads to a higher quantity supplied.
In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that can be illustrated with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.
[Figure 1] illustrates the law of supply, again using the market for gasoline as an example. Like demand, supply can be illustrated using a table or a graph. A supply schedule is a table, like [Table 1], that shows the quantity supplied at a range of different prices. Again, price is measured in dollars per gallon of gasoline and quantity demanded is measured in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
Price and Supply of Gasoline (Supply Schedule)
|Price (per gallon)||Quantity Supplied (millions of gallons)|
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.
Video: Demand vs. Supply
Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship.
Other Factors That Affect Supply
In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Changes in supply are affected by the cost of inputs, productivity, technology, taxes and subsidies, expectations, and the number of sellers. In addition, the cost of production may be affected by changes in weather or other natural conditions, natural disasters, and some governmental policies.
The cost of production for many agricultural products will be affected by changes in natural conditions. For example, the area of northern China which typically grows about 60% of the country’s wheat output experienced its worst drought in at least 50 years in the second half of 2009. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied; conversely, especially good weather would shift the supply curve to the right.
When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world was grown with these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.
Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Taxes are treated as costs by businesses. Higher costs decrease supply for the reasons discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace; complying with regulations increases costs.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right.
Video: Should the Government Subsidize... Silly Walks? (A Ridiculous Example of a Subsidy)
Shift in Supply
We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to a production cost increase.
Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. An example is shown in [Figure 2].
The supply curve can be used to show the minimum price a firm will accept to produce a given quantity of output.
Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the average cost of production, in this case, the cost of the pizza ingredients (dough, sauce, cheese, pepperoni, and so on), the cost of the pizza oven, the rent for the shop, and the wages of the workers. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as shown in [Figure 3].
The cost of production and the desired profit equal the price a firm will set for a product.
Step 3. Now, suppose that the cost of production goes up. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as shown in [Figure 4].
Because the cost of production and the desired profit equals the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.
Step 4. Shift the supply curve through this point. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve so that at any price, the quantities supplied will be smaller, as shown in [Figure 5].
When the cost of production increases, the supply curve shifts upwardly to a new price level.
Calculating the Price Elasticity of Supply
Assume that an apartment rents for $650 per month and at that price 10,000 units are rented as shown in [Figure 6]. When the price increases to $700 per month, 13,000 units are supplied into the market. By what percentage does apartment supply increase? What is the price sensitivity?
The price elasticity of supply is calculated as the percentage change in quantity divided by the percentage change in price.
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. Elasticity can be described as elastic (or very responsive), unit elastic, or inelastic (not very responsive). Elastic demand or supply curves indicate that quantity demanded or supplied respond to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.
Summing Up Factors That Change Supply
Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.
[Figure 7] summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
(a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.
Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. Factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.
Long-Run vs. Short-Run Impact
Elasticities are often lower in the short run than in the long run. On the demand side of the market, it can sometimes be difficult to change Qd in the short run, but easier in the long run. Consumption of energy is a clear example. In the short run, it is not easy for a person to make substantial changes in their energy consumption. Maybe you can carpool to work sometimes or adjust your home thermostat by a few degrees if the cost of energy rises, but that is about all. However, in the long-run you can purchase a car that gets more miles to the gallon, choose a job that is closer to where you live, buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run, but much more elastic in the long run.
[Figure 8] is an example, based roughly on historical experience, for the responsiveness of Qd to price changes. In 1973, the price of crude oil was $12 per barrel and total consumption in the U.S. economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC) cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with the U.S. support for Israel. OPEC did not bring exports back to their earlier levels until 1975—a policy that can be interpreted as a shift of the supply curve to the left in the U.S. petroleum market. [Figure 8(a)] and [Figure 8(b)] show the same original equilibrium point and the same identical shift of a supply curve to the left from S0 to S1.
The intersection (E0) between demand curve D and supply curve S0 is the same in both (a) and (b). The shift of supply to the left from S0 to S1 is identical in both (a) and (b). The new equilibrium (E1) has a higher price and a lower quantity than the original equilibrium (E0) in both (a) and (b). However, the shape of the demand curve D is different in (a) and (b). As a result, the shift in supply can result either in a new equilibrium with a much higher price and an only slightly smaller quantity, as in (a), or in a new equilibrium with only a small increase in price and a relatively larger reduction in quantity, as in (b).
[Figure 8(a)] shows inelastic demand for oil in the short run similar to that which existed for the United States in 1973. In [Figure 8(a)], the new equilibrium (E1) occurs at a price of $25 per barrel, roughly double the price before the OPEC shock, and an equilibrium quantity of 16 million barrels per day. [Figure 8(b)] shows what the outcome would have been if the U.S. demand for oil had been more elastic, a result more likely over the long term. This alternative equilibrium (E1) would have resulted in a smaller price increase to $14 per barrel and larger reduction in equilibrium quantity to 13 million barrels per day. In 1983, for example, U.S. petroleum consumption was 15.3 million barrels a day, which was lower than in 1973 or 1975. U.S. petroleum consumption was down even though the U.S. economy was about one-fourth larger in 1983 than it had been in 1973. The primary reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars, more efficient appliances and machinery, and other fuel-conserving choices, the demand curve for energy had become more elastic.
On the supply side of markets, producers of goods and services typically find it easier to expand production in the long term of several years rather than in the short run of a few months. After all, in the short run it can be costly or difficult to build a new factory, hire many new workers, or open new stores. But over a few years, all of these are possible.
Indeed, in most markets for goods and services, prices bounce up and down more than quantities in the short run, but quantities often move more than prices in the long run. The underlying reason for this pattern is that supply and demand are often inelastic in the short run, so that shifts in either demand or supply can cause a relatively greater change in prices. But since supply and demand are more elastic in the long run, the long-run movements in prices are more muted, while quantity adjusts more easily in the long run.
Consider how supply and demand factor in to the production of automobiles in these two news articles:
'Everybody's struggling': Fiat Chrysler's Windsor plant to lose 1,500 jobs, hit by industry slowdown and changing tastes
Ford will halt all production of its popular F-Series pickup
Self Check Questions
- What does the Law of Supply state? Do you believe this idea to be true? Why or why not?
- How does the seller/supplier determine how much to charge for a product? What factors must he/she take into account?
- How does the Law of Supply differ from the Law of Demand?
- How else can a supply schedule be presented?
- How can the Law of Supply apply to you, as a form of "labor"? What are you willing to do for a higher wage?
- What does the market supply curve show?
- Explain the difference between a supply curve and a market supply curve.
- What does a change in quantity supplied respond to?
- There are 7 factors that may cause a change in supply. List each one and give an example of how these changes impact supply.
- Supply elasticity responds to a change in price. Explain the 3 types of supply elasticity and price changes. How can a business determine its supply elasticity?
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