No Such Thing as a Free Lunch: Principles of Economics (Part 13)

Economics, politics, and personalities are often inseparable.

Charles Edison

Demand, Supply, and Market Equilibrium

(Part E)

by

Charles Lamson

Supply in Product/Output Markets

In addition to dealing with household demands for outputs, economic theory deals with the behavior of business firms, which supply in output markets and demand in input markets (see Figure 1). Firms engage in production, and we assume that they do so for profit. Successful firms make profits because they are able to sell their products for more that it costs to produce them.

Supply decisions can thus be expected to depend on profit potential. Because profit is the simple difference between revenues and costs, supply is likely to react to changes and revenues and changes in production costs. The amount of revenue earned by a firm depends on the price of its product in the market and on how much it sells. Costs of production depend on many factors, the most important of which are (1) the kinds of inputs needed to produce the product, (2) the amount of each input required, and (3) the price of inputs.

The supply decision is just one of several decisions that firms make to maximize profit. There are usually a number of ways to produce any given product. A golf course can be built by hundreds of workers with shovels and grass seed or by a few workers with heavy earth-moving equipment and sod blankets. Hamburgers can be individually fried by a short-order cook or grilled by the hundreds on a mechanized moving grill. Firms must choose the production technique most appropriate to their products and projected levels of production. The best method of production is the one that minimizes cost, thus maximizing profit.

Which production technique is best, in turn, depends on the prices of inputs. Where labor is cheap and machinery is expensive and difficult to transport, firms are likely to choose production techniques that use a great deal of labor. Where machines or resources to produce machines are readily available and labor is scarce or expensive, they are likely to choose more capital-intensive methods. Obviously, the technique ultimately chosen determines input requirements. Thus, by choosing an output supply target and the most appropriate technology, first determine which inputs to demand.

With the caution that no decision exists in a vacuum, let us begin our examination of firm behavior by focusing on the output supply decision and the relationship between quantity supplied and output price, ceteris paribus.

Price and Quantity Supplied: The Law of Supply

Quantity supplied is the amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period. A supply schedule shows how much of a product a firm will sell at alternative prices. Table 3 itemizes the quantities of soybeans that an individual farmer such as Clarence Brown might sell at various prices. If the market paid $1.50 or less a bushel for soybeans, Brown would not supply any soybeans. For one thing, it costs more than $1.50 to produce a bushel of soybeans; for another, Brown can use his land more profitably to produce something else. At $1.75 per bushel, however, at least some soybean production takes place on Brown's farm, and a price increase from $1.75 to $2.25 per bushel causes the quantity supplied by Brown to increase from 10,000 to 20,000 bushels per year. The higher price may justify shifting land from wheat to soybean production or putting previously follow land into soybeans, or it may lead to more intensive farming of land already in soybeans, using expensive fertilizer or equipment that was not cost-justified at the lower price.

Generalizing from Farmer Brown's experience, we can reasonably expect an increase in market price, ceteris paribus, to lead to an increase in quantity supplied. In other words, there is a positive relationship between the quantity of a good supplied and price. This statement sums up the law of supply: An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied.

The information in a supply schedule may be presented graphically in a supply curve. Supply curves slope upward. The upward, or positive, slope of Brown's curve in Figure 6 reflects this positive relationship between price and quantity supplied.

Note in Brown's supply schedule, however, that when price rises from $4 to $5, quantity supplied no longer increases. Often an individual firm's ability to respond to an increase in price is constrained by its existing scale of operations, or capacity, in the short run. For example, Brown's ability to produce more soybeans depends on the size of his farm, the fertility of his soil, and the types of equipment he has. The fact that output stays constant at 45,000 bushels per year suggests that he is running up against the limits imposed by the size of his farm, the quality of his soil, and his existing technology.

In the longer run, however, Brown may acquire more land, or technology may change, allowing for more soybean production. The terms short run and long run have very precise meanings in economics; we will discuss them in detail a later post. Here it is important only to understand that time plays a critical role in supply decisions. When prices change, firm's immediate response may be different from what they are able to do after a month or a year. Short-run and long-run supply curves are often different. 

Other Determinants of Supply

Of the factors we have listed that are likely to affect the quantity of output supplied by a given firm, we have thus far discussed only the price of output. Other factors that affect supply include the cost of producing the product and the prices of related products.

The Cost of Production Regardless of the price that a firm can command for its product, revenue must exceed the cost of producing the output for the firm to make a profit. Thus, the supply decision is likely to change in response to changes in the cost of production. Cost of production depends on a number of factors, including the available technologies and the prices and quantities of the input needed by the firm (labor, land, capital, energy, etc.).

Technological change can have an enormous impact on the cost of production over time. Consider agriculture. The introduction of fertilizers, the development of complex farm machinery, and the use of bioengineering to increase the yield of individual crops have all powerfully affected the cost of producing agricultural products.

When a technological advance lowers the cost of production, output is likely to increase. When yield per acre increases, individual farmers can and do produce more.

The Prices of Related Products Firms often react to changes in the prices of related products. For example, if land can be used for either corn or soybean production, an increase in soybean prices may cause individual farmers to shift acreage out of corn production and into soybeans. thus, an increase in soybean prices actually affects the amount of corn supplied.

To summarize:

Assuming that its objective is to maximize profits, a firm's decision about what quantity of output, or product, to supply depends on 

1. The price of the good or service

2.  The cost of producing the product, which in turn depends on 

1. The price of required inputs (labor, capital, and land)

2.  The technologies that can be used to produce the product

3.  The prices of related products 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 55-57*

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