CA Foundation Business Economics Study Material Chapter 2 Theory of Demand and Supply – Supply
Supply of a commodity refers to the quantity of commodity offered for sale at a particular price during a given period of time. Thus, the supply of a commodity may be defined as the amount of commodity which the sellers or producers are able and willing to offer for sale at a particular price, during a given period of time.
Thus, defined, the term supply shows the following features:
- Supply of a commodity is always with reference to a PRICE,
- Supply of a commodity is to be referred to IN A GIVEN PERIOD OF TIME.
- Supply of a commodity depends on the ABILITY OF SELLER TO SUPPLY A COMMODITY. However, ability of a seller to supply a commodity depends ON THE STOCK available with him.
- Supply of a commodity also depends on the WILLINGNESS OF SELLER TO SUPPLY A COMMODITY. A seller’s willingness to supply a commodity depends ON THE DIFFERENCE BETWEEN THE RESERVATION PRICE and the PREVAILING MARKET PRICE.
- E.g. A dairy farm’s daily supply of milk at the price of Rs. 12 per litre is 600 litres
Determinants of Supply
Supply of a commodity depends on many factors like price of the commodity, price of related goods, prices of factors of production, technology, etc. All determinants of supply can be expressed in the form of supply function as follows-
Sx = f(Px, Pr, Pf, T, O …….. )
Where – Sx = Quantity supplied of commodity x
f = function of (depends on)
Px = Price of commodity x
Pr = Price of related commodities
Pf = Prices of factors of production.
T = Technology
O = Objectives/Goals of the firm
Price of the commodity:
- Other things being equal the supply of a commodity is DIRECTLY related with its price.
- It means that, larger quantity of a commodity is offered for sale at higher price and vice versa.
- This is because the profits of the firm increases if the price of its product increases.
Price of the related commodities:
- The supply of a commodity also depends on the prices of related commodities i.e. substitute goods and complementary goods.
- Other things being equal, if the price of a substitute goes up, the firms will be tempted to produce that substitute to get higher profits. E.g. – If the price of coffee rises, the firm would reduce the quantity supplied of tea.
- On the other hand, other things being equal/if price of a complementary good goes up, the supply of the product in question also rises. E.g.- If the prices of fountain pens rise, it may cause an increase in the supply of ink.
Prices of factors of production:
- Supply of a commodity depends on the cost of production. The cost of production itself depends upon the prices of various factors of production.
- So, if the price of any factor of production rises, the production costs would be higher for the same level of output (and vice versa), Hence the supply will tend to decrease.
- Conversely, a fall in the cost of production tends to increase the supply.
State of technology:
- A change in technology affects the supply of commodity.
- A technological progress and improvement in the methods of production increases productivity, reduce the cost of production and increases the profits. As a result more is produced and supplied.
- Also discoveries and innovations bring new variety of goods.
Objectives of the firm:
- The objectives of the firm and business policy pursued by it also affect the supply of the product produced by it.
- Some firms believes in higher margin of profits and lower turnover while others believe in lower margin of profit and higher turnover (i.e. sales) to capture the market or to improve status, goodwill and prestige in the market.
- The supply of a commodity is also affected by the economic policies followed by the Government.
- The Government may impose taxes on commodities in the form of excise duty, sales tax and import duties or may give subsidies.
- Any increase in such taxes will raise the cost of production and so the quantity supplied will fall. Under such conditions supply will increase only when its price in the market rises.
- Subsidies reduce the cost of production and thus encourages firms to produce and sell more.
- Supply is a function of time also.
- In a short period, it is not possible to adjust supply to the conditions of demand.
- If the time period is sufficiently long, all possible adjustments can be made in the production apparatus and the supply can be fully adjusted to demand.
Number of firms:
If the number of firms producing a product increases, the market supply of the product will also increase and vice-versa.
Supply of a commodity also depends upon Natural conditions like rainfall, temperature, etc.; industrial and foreign policies, infrastructural facilities; War; market structure; etc.
Law of Supply
- The Law of Supply express the nature of functional relationship between the price of a commodity and its quantity supplied.
- It simply states that supply varies DIRECTLY to the changes in price i.e. supply of a commodity expands when price rises and contracts when price falls.
- “The Law of Supply states that the higher the price, the greater the quantity supplied or the lower the price the smaller the quantity supplied, other things remaining the same.” (Dooley)
- Thus, there is DIRECT RELATIONSHIP between supply and price.
- It is assumed that other determinants of supply are constant and ONLY PRICE IS THE VARIABLE AND INFLUENCING FACTOR.
Thus, the law of supply is based on the following main assumptions:-
- Cost of production remains unchanged even though the price of the commodity changes.
- The technique of production remains unchanged.
- Government policies like taxation policy, trade policy, etc. remains unchanged.
- The prices of related goods remains unchanged.
- The scale of production remains unchanged etc.
The law can be explained with the help of supply schedule and a corresponding supply curve.
- The supply schedule shows that when price rises from Rs.10 per unit to Rs. 20 per unit, the supply also rises from 20 units per week to 30 units per week and so on.
- Thus, it shows a direct relationship between price and quantity supplied other things being equal.
- A supply curve is the supply schedule depicted on the graph. The supply curve shows the same information as the supply schedule.
- In the diagram, the supply curve is sloping upwards from left to right showing a direct relationship between the price and quantity supplied.
- A single point on supply curve show a single price supply relationship E.g. – Point ‘C’ show that if price is Rs. 30, quantity supplied is 40 units.
- The law of supply states that, supply of a commodity varies directly with its price.
But, in some cases, this may not hold true. Hence, the law of supply has the following EXCEPTIONS.
- When the seller expects a further rise in the prices in future, he may hoard stock of commodity. So the supply at present will fall and vice versa.
- At higher wage rates, there is tendency among labourers to prefer more leisure than work. As a result when wages rise, labour supply falls.
- In the case of rare commodities like paintings, coins, etc. the supply is fixed. Whatever the price, it cannot change.
- In an auction or in all those cases where the seller wants to get rid of his goods, he will sell the goods at whatever price they fetch.
Changes in Quantity Supplied OR Expansion & Contraction of supply OR Movement along a supply curve
- When supply of a commodity changes only due to change in the price of commodity other determinants remaining unchanged, it is called changes in quantity supplied.
- Changes in quantity supplied thus means -expansion of supply & contraction of supply
- When price of a commodity rises, quantity supplied also rises. This is called expansion of supply.
- When price of a commodity falls, quantity supplied also falls. This is called contraction of supply.
As other determinants of supply like price of related commodities, prices of factors of production, state of technology, etc. are assumed to be constant, the position of the supply curve remains the same. The seller will move upwards or downwards on the same supply curve.
In the figure above –
- At price OP quantity supplied is OQ
- With a rise in price to OP1 the quantity supplied rises from OQ to OQ1 The co-ordinate point moves up from E to E1 This is called ‘a rise in quantity supplied’.
- With a fall in price to OP2 the quantity supplied falls from OQ to OQ2 The co-ordinate point moves down from E to E2 This is called ‘a fall in quantity supplied’.
Changes in supply OR Increase and decrease in Supply OR Shift in Supply curve
- When there is change in supply due to change ‘ in factors other than price of the commodity, it is called changes in supply.
- It is the result of change in technology, govt, policies, prices of related goods etc.
- Change in supply means- increase in supply & decrease in supply.
- Price remaining the same when supply rises due to change in factors other than price, it is called increase in supply.
- Likewise, price remaining the same when supply falls due to change in factors other than price, it is called decrease in supply.
In this case the supply curve shifts from its original position to rightward when supply increases and to leftward when supply decreases. Thus, change in supply curve as a result of increase and decrease in supply, is technically called shift in supply curve.
In the figure above-
- Original supply curve is SS. At OP price, OQ quantity is being supplied.
- As the supply changes, the supply curve shifts either to the right (S1S1)or to the left (S2S2)
- At S1S1, OQ1, quantity is being supplied at the price OP. This shows increase in supply. More quantity is being supplied at same price. It is denoted by rightward shift in supply curve.
- At S2S2, OQ2 quantity is being supplied at the price OP. This shows decrease in supply. Less quantity is being supplied at same price. It is denoted by leftward shift in supply curve.
Elasticity of supply
- Price elasticity of supply measures the degree of responsiveness of quantity supplied of a commodity to a change in its own price.
- In other words, the elasticity of supply shows the degree of change in the quantity supplied in response to change in the price of the commodity.
- Elasticity of supply can be defined “as a ratio of the percentage change in the quantity supplied of a commodity to the percentage change in its own price”.
- It may be expressed as follows –
- Since the law of supply establishes positive relationship between price and quantity supplied, the elasticity of supply would be positive.
- However, in case of decreasing cost industry elasticity of supply is negative.
- The value of elasticity co-efficient will vary from zero to infinity.
The elasticity of supply, according to its degree, may be of following types:-
1. Perfectly Inelastic Supply: Es = 0:
When a change in the price of a commodity has no effect on its quantity supplied, then supply is perfectly inelastic.
E.g. – If price rises by 20% and the quantity supplied remains unchanged then Es = 0/20 = 0. In this case, the supply curve is a vertical straight line curve parallel to Y-axis as shown in the figure.
The figure shows that, whatever the price quantity supplied of the commodity remains unchanged at OQ.
2. Perfectly Elastic Supply: (Es = ∞):
When with no change in price or with very little change in price, the supply of a commodity expands or contracts to any extent, the supply is said to be perfectly elastic. In this case, the supply is a horizontal straight line and parallel to X-axis.
The figure shows (Es = ∞) that, at given price supply is ever increasing.
3. Unit Elastic Supply : (Es =1):
When the percentage change in price is equal to percentage change in quantity supplied, then the supply is said to be unit elastic.
E.g. – If price rises by 10% and the supply also rises by 10% then, Es = 10/10=1
In this case the straight line supply curve SS when extended will pass through origin.
4. Relatively/More Elastic Supply: (Es >1):
When a small change in price leads to big change in quantity supplied, then the supply is said to be relatively or more elastic. E.g. – If price rises by 10% and supply rises by 30% then,
Es = 30/10 = 3>1. The coefficient of elasticity would be somewhere between ONE and INFINITY. The elastic supply curve is flatter as shown below-
Supply curve SS is flat suggesting that the supply is more elastic. In this case the supply curve SS when extended will pass through Y-axis.
5. Relatively Inelastic Or Less Elastic Supply: (Es<1).
When a big change in price leads to small change in quantity supplied, then supply is said to relatively inelastic or less elastic.
E.g. – If price rises by 30% and supply rises by 10% then, Es = 10/30 = 1/3 < 1. The coefficient of elasticity would be somewhere between ZERO and ONE. The supply curve in this case has steep slope as shown below –
Supply curve SS is steeply sloped suggesting that supply is less elastic. In this case the supply curve SS when extended will pass through X-axis.
Measurement of Elasticity of Supply
The different methods of measuring price elasticity of supply are:
- The Percentage or Ratio or Proportional Method,
- The Point or Geometric Method, and
- The Arc Method
1. The Percentage Method:
Thus method is based on the definition of elasticity of supply. The coefficient of price elasticity of supply is measured by taking ratio of percentage change in supply to the percentage change in price. Thus, we measure the elasticity by using the following formula-
- If the coefficient of above ratio is equal to ONE, the supply will be unitary.
- If the coefficient of above ratio is MORE THAN ONE, the supply is relatively elastic.
- If the coefficient of above ratio is LESS THAN ONE, the supply is relatively inelastic.
2. The Point Or Geometric Method:
In point elasticity method, we measure elasticity at a given point on a supply curve.
We can measure E at point ‘R’ in the following manner
- Extend the supply curve ‘S’ towards the extension of X-axis so that it cuts X-axis at T.
- Draw a perpendicular from ‘R’ cutting X-axis at ‘M’
- Take the ratio of intercepts MT and OM.
Es = MT/OM
In the figure MT > OM, elasticity is GREATER THAN ONE.
In the adjoining figure, supply curve when extended meets X-axis to the right of the point of origin so that
Es = MT/OM < 1
i.e. MT<OM and so elasticity is LESS THAN UNITY
In the adjoining figure, supply curve when extended meets X-axis exactly at the point of origin so that
Es = MT/OM = 1,
i.e. MT = OM and so elasticity of supply is EQUAL TO UNITY/ONE.
3. The Arc Elasticity Method:
Under this method we measure elasticity of supply over an ARC of the supply curve. The arc elasticity is a measured of the “average elasticity” i.e. elasticity at MID-POINT that connects the two points on the supply curve. Thus, an arc is a portion of a curved line, hence a portion of supply curve. The formula used is
- Equilibrium means a market situation where the quantity demanded is equal to quantity supplied. Thus, the two factors determining equilibrium price are market demand and market supply.
- Equilibrium price is the price at which the sellers of a good are willing to sell the quantity which buyers want to buy. Thus, equilibrium price (also called market clearing price) is the price at which demand and supply are equal.
- At equilibrium price both sellers and buyers are satisfied.
- At equilibrium price, there is neither SHORTAGE nor SURPLUS. So at equilibrium price, market is said to be CLEARED.
The following table and figure explains the equilibrium price.
- Equilibrium is struck a point E where the demand and supply curve intersect each other.
- At E, equilibrium price is OP i.e. Rs. 3 and equilibrium quantity is OQ ie. 300 units.
- When the price is Rs. 5 per unit, the quantity demanded is 100 units and quantity supplies is 500 units. It is situation where market demand < market supply and there is excess supply i.e., surplus supply. At a given price, sellers are willing to sell more than what buyers are ready to buy. As a result of pressure of excess supply the market price falls to Rs. 4.
- At a price of Rs. 4, the pressure of excess supply still continues and hence the price falls further to Rs. 3.
- At a price of Rs. 3, the market is CLEARED as the quantity demanded and supplied are equal to each other. There, is no SURPLUS.
- Thus, we can conclude that pressure of excess supply (surplus) reduces the price.
- Similarly, if the price is Rs. 1, the quantity demanded is 500 units and quantity supplied is 100 units. It is a situation where market demand > market supply and there is excess demand or SHORTAGE of supply. As a result of excess demand or SHORTAGE of supply the market price will rise. So long as pressure of excess demand continues price will rise i.e. till point E. At point E, excess demand is eliminated and quantity demand and supplied are equal to each other. The market has CLEARED.
- Thus, we can conclude that pressure of excess demand (shortage of supply) increases the price.
- The equilibrium price is determined by the intersection between demand and supply therefore, it is also called as the MARKET EQUILIBRIUM.