Supply

The law of supply

The law of supply states that as the price of a good rises, the quantity supplied increases as the firms are willing to produce more units of a good at higher prices. The reverse is also true. As the price of a good falls, the quantity supplied decreases as the firms are willing to produce fewer units of a good at lower prices. This relationship explains why the supply curve is upward sloping.

Figure 1 illustrates a supply curve. On the horizontal axis, there is the quantity supplied. On the vertical axis, there is the price. The curve is upward sloping as the firms are prepared to supply more units of a good or service at higher prices.

Fig. 1 - Supply curve

The main assumption behind the supply curve is that each firm’s main objective is profit maximisation. This means that the firm will continue to supply a good or service only until it makes a profit on the last unit sold. When the profit on the last unit sold becomes zero, the firm will stop producing.

Total revenue vs profit

The assumption that all firms are profit maximisers underpins the microeconomic analysis behind firms’ choices.

The total revenue of a firm is not the same as its profit. The profit is the total costs of production subtracted from the total revenue.

If the firm doesn’t grow and utilise economies of scale, increased output will lead to increased production costs. The firm can only cover those costs if it raises the price for subsequent units of output. This results in an upward-sloping supply curve.

This is known as the law of diminishing marginal returns. In the short run, the marginal cost, or the cost of an additional unit of output produced increases as the firm’s output increases. A firm's marginal cost can be shown graphically. In a perfectly competitive market, the marginal cost curve is the firm’s supply curve. Thus, the firm will reach a point at which it will not be able to cover the increased costs unless it raises the price at which it sells its output.

To learn more about firms’ supply curve in a perfectly competitive market check out our explanation on the Market Structures.

Supply curves and supply function

The supply curve is a curve that shows which quantity the firms are prepared to supply at various price levels.

The supply curve is usually drawn as an upward-sloping straight line. It slopes upwards due to the law of supply, which states that the firms are prepared to supply more units of a good at higher prices. In some cases, the curve won’t be straight or linear, hence the name: the supply curve. In this explanation, we will stick to linear supply curves.

Supply curve diagram

We can represent the supply curve for a good or service on a diagram. Figure 2 below depicts a market supply curve. On the vertical axis, there is the price, and on the horizontal axis, there is the quantity supplied. At price P1 the quantity that firms on the market are prepared to supply is Q1. As the quantity supplied is directly proportionate to the price of a good, then an increase in the price from P1 to P2 will increase the quantity that the firms are prepared to supply from Q1 to Q2.

Fig. 2 - The supply curve and a price increase

A numerical example of the supply curve

There is a general equation for the linear supply curves.

The linear supply function is:

Price (P) = c + d * Quantity supplied (Q) or

P = c + d * Q

where c and d are constants.

Constant c accounts for non-price factors that shift the supply curve, whilst constant d accounts for the slope of the supply curve.

Consider the following equation, illustrated in Figure 3 below:

P = 10 + 2*Q

It follows that: c = 10 and d = 2

Fig. 3 - A numerical example of the supply curve

The supply curve crosses the vertical axis at point A where the price P=10 and the quantity supplied Q=0.

A general way of finding where the supply curve crosses the vertical axis is:

set Q=0 and find P from the equation. Alternatively, set P=c (where c is a constant from the general equation for P).

You can find any point on the supply curve by inserting the known variables into the supply equation. For example, if the market price is P=50, then the quantity that the firm will be prepared to supply is equal to Q=(P-10)/2=(50-10)/2=20.

What is the difference between changes in supply and changes in quantity supplied?

Supply is not the same as the quantity supplied. As we said before, when the economists use the term ‘supply’ they refer to a range of quantities supplied at various price levels. The supply curve illustrates the supply. The quantity supplied is a single quantity that can be ‘read off’ the supply curve at a particular price level.

Movements along and shifts of the supply curve

Various factors that affect the supply curve. Changes in the price will lead to a movement along the supply curve, whilst changes in all other factors will lead to parallel shifts in the supply curve.

Movement along the supply curve

Supply is affected by many factors, but these are kept constant when the supply curve is drawn as a function of price (ceteris paribus condition). Subsequently, any changes in the price will lead to a movement along the supply curve.

When the price decreases, the quantity supplied decreases leading to a movement along the supply curve known as a contraction of supply. Figure 4 illustrates the contraction of supply.

Fig. 4 - Contraction of supply

When the price increases, the quantity supplied increases leading to a movement along the supply curve known as an extension of supply. The extension of supply is illustrated in Figure 5 below.

Fig. 5 - Extension of supply

Parallel shifts in the supply curve

When non-price factors (also known as the conditions of supply), which are normally held constant when drawing the supply curve, change the supply curve shifts.

A shift to the right is known as an outward shift. It occurs when any factor affecting supply causes an increase in the quantity supplied at each price level. As Figure 6 shows, the initial supply curve S1 shifts in parallel to the right to S2. At a fixed price level P the quantity supplied increases from Q1 to Q2. The same is true for any other price level due to the parallel nature of the shift.

Fig. 6 - Outward shift of supply curve

A shift to the left is known as an inward shift. It occurs when any factor affecting supply causes a decrease in the quantity supplied at each price level. As Figure 7 shows, the initial supply curve S1 shifts to the left (S2). At a fixed price level P the quantity supplied decreases from Q1 to Q2. The same is true for any other price level due to the parallel nature of the shift.

Fig. 7 - Inward shift of supply curve

Multiple factors affecting the supply curve simultaneously

If there are multiple factors affecting the supply curve at once, the final supply curve will be a sum of all these factors together, taking their magnitude into account.

Consider Figure 8. Imagine there is an outward shift in the supply curve (think of a factor that could cause that). The supply curve shifts from S1 to S2, which results in more quantity supplied (Q2 compared to Q1) at any given price level P.

However, there is also a negative factor that suppresses supply and shifts it inwards. The magnitude of this negative shock is greater than that of the positive shock. The supply curve shifts from S2 to S3 resulting in less quantity supplied (Q3 compared to Q2) at any given price level P. Overall, the resulting shift in the supply curve is negative (S3 is to the left of S1) due to the magnitude of the negative shock being greater than that of the positive shock.

Fig. 8 - Multiple factor shift of supply curve

What are the main supply determinants?

Supply determinants (also known as supply conditions) are all the other factors that affect supply apart from the price.

The main supply determinants

The most prominent supply conditions (or supply determinants) are listed below in two categories: production costs and other factors.

Production costs (often firm-specific)

1. Cost of labour. If the wages of workers employed by the firm increase, the firm’s supply curve will shift inwards.
2. Cost of raw materials. If the price of raw materials increases, the firm’s supply curve will shift inwards.
3. Cost of energy. If the price of energy decreases, the firm’s supply curve will shift outwards.
4. Borrowing costs. Businesses often have to borrow money from a bank to finance their expenditures. If there is a decrease in the interest rate on the bank loan, the firm’s supply curve will shift outwards.
5. Labour productivity. If the productivity of labour increases, the firm’s supply curve will shift outward as they will produce more output per unit of time

Other factors (often affect the market supply)

1. Technology. An improvement in technology will shift the market supply curve outwards, as new technology often introduces improvements and efficiency into the production processes.
2. Taxes and subsidies. If the government raises corporate tax, the market supply curve would shift inwards. However, if the government provides a subsidy to a particular sector of the economy, the market supply curve for that sector would shift outwards.
3. Natural conditions. Natural conditions are important for industries such as agriculture. If there are significant adverse weather conditions in a particular year, the market supply curve for agricultural output will shift inwards.