Theory of Supply
Topic Six

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Concept of Supply

Supply is defined as the total amount of a specific good or service that firms are able to produce and offer for sale.  It is the total amount of a product (good or service) available for purchase at any specified price.

Like the demand side where there is a difference between demand and quantity demanded, there is also a difference between supply and quantity supplied.  Supply is shown as a shift of the entire supply curve while quantity supplied is shown as a movement along the supply curve.  Quantity supplied is influenced only by price while supply is influenced by such factors as cost of production;  (the lower is the cost of production, the higher will be supply and so the entire supply curve will shift to the right while the higher is the cost of production, the lower will be supply and the supply curve will shift to the left); number of consumers (the more consumers there are in a particular market, the higher will be supply and again the entire supply curve will shift to the right while the less consumers there are, the less will be supply and the supply curve will shift to the left); the state of technology (the more advance is the state of technology, the higher will be supply and the supply curve will shift to the right and the less advance is the state of technology, the less will be supply and the supply curve will shift to the left).

Law of Supply – Movement along the Supply Curve

Quantity supplied is that amount of goods that firms supply at a particular price level.  When the price of the product rises, for example, from $3.00 to $6.00, quantity supplied will increase from 6 units to 12 units which will be depicted as an upward movement along the supply curve from e0 to e1 as can be shown in the following graph.  On the other hand, when there is a fall in price, profits can be negatively affected and the quantity supplied by sellers will fall resulting in a downward movement along the supply curve.  

Figure 1

Law of Supply – Shifts in the Supply Curve

As stated above, quantity supplied is affected mainly by price and is shown as a movement along the supply curve.  On the other hand, supply is determined by other factors or market factors and these are represented by a shift of the entire supply curve.  These factors are cost of production, number of customer and state of technology.

Cost of production – when costs of production for pizzas increase, this will make it expensive for producers to produce and so supply will fall.  This will cause the supply curve to shift to the left from S0 to S1 with the supply of pizzas falling from 10 pizzas to 5 pizzas as shown in the following graph.  Eventually price will increase from $20.00 to $40.00 due to the reduced supply of pizzas.

Figure 2

On the other hand, when cost on production of hamburgers falls, this will cause an increase in supply of hamburgers and the supply curve for hamburgers will shift to the right from S0 and S1with supply increasing from 36 hamburgers to 50 hamburgers as shown in the following graph.  Price of the hamburgers will then fall from $20.00 to $10.00 due to the excess supply of hamburgers on the market.  

Figure 3

Number of Consumers – the smaller are the number of consumers for mangoes, the smaller will the market be for mangoes and so the less will be the supply of mangoes.  Assuming the supply curve for mangoes was at S0, the supply curve will now shift up to the left to S1 with supply falling from 12 mangoes to 4 mangoes.  Because there is less mangoes on the market, the price of mangoes will now rise from $2.00 to $3.00 as shown in the following graph.

Figure 4

On the other hand, the larger is the number of consumers or the larger is the market for hotdogs, the larger will be the supply of hotdogs and the supply curve for hotdogs will shift to the right from S0 to S1.  This will cause an increase in the supply of hotdogs from 36 hotdogs to 60 hot dogs. Due to this increased supply of hotdogs, there could be a surplus on the market and so price may now fall from $14.00 to $8.00 a hotdogs as shown in the following graph.

Figure 5

State of Technology – favourable technology will shift the supply curve down to the right while unfavourable technology will shift the supply curve up to the left.

Individual and Market Supply Curve

The market supply curve, like the market demand curve, is derived by summing the individual supply curves as shown in the following graph. For simplicity, we are assuming that there are just two suppliers (Firm 1 and Firm 2) in the market for ear phones.  When the price for an ear phone is $4, quantity supplied by Firm 1 will be 3 and quantity supplied by Firm 2 will be 6 ear phones.  This results in a market supply of 9 ear phones. Now if the price of ear phones increases to $8, we will expect to see a positive response by both suppliers and so quantity supplied by Firm 1 will increase to 6 ear phones and quantity supplied by Firm 2 will rise to 9 ear phones.  This will give rise to a market supply of 15 ear phones.

Figure 6

The Impact of Taxes and Subsidies on Supply

An increase in tax will result in an increase in prices and so supply will fall.  This will have the effect of shifting the supply curve up to the left.  On the other hand, if the tax rate is low, then price will be low and so supply will tend to increase which will shift the supply down to the right.  Subsidies also affect supply in that when the government gives a subsidy, the price of the product will be lower and consumers will demand more of the product and then suppliers will want to increase supply.  This will have the effect of shifting the supply down to the right.

There are two types of indirect tax; specific and ad valorem.  A unit tax is a set amount of tax per unit sold, such as a $1.00 tax per packet of cigarettes. In contrast, an ad valorem tax is a percentage tax based on the value added by the producer.  The imposition of either type of indirect tax has an effect similar to a rise in production costs. This means that a firm's supply curve will shift up.  

A specific unit tax

A specific unit tax will shift up the supply curve by the full amount of the tax, so that the new supply curve is parallel to the original one as shown in the following graph.  In this case, there was a $5.00 tax on cigarettes.  The price of the product will be more expensive to both the supplier and the consumers by the $5.00 tax.  In this case, supply will in fact fall and the supply curve will now shift from S0 to S1 where quantity supplied falling from 18 packs of cigarettes to 5 packs of cigarettes while price will increase from $10.00 a pack for cigarettes to $15.00 a pack for cigarettes.

Figure 7

An ad valorem tax or an indirect tax

The imposition of an ad valorem tax will shift the supply curve upwards by a certain percentage, meaning that the new supply curve will not be parallel to the original.  In the case of the ad valorem tax, the change will be a percentage which is based on the value added or output of the supplier.  If the ad valorem tax is 20 percent of the price of donuts, then the new  price for a donut that cost $15.00 will be $18.0 ($15.0 + $3.00).  The final result of imposing an ad valorem tax on donuts is that price of donuts will rise from $15.0 to $18.0 and supply of donuts will fall from 8 donuts to 6 donuts as seen in the following graph; the supply curve will shift from S0 to S1 but it will not be a parallel shift.

Figure 8

The Impact of a Subsidy

The case of a subsidy is the opposite to that of a tax.  With a tax, cost of production increases and so output will fall and price will increase.  With a subsidy, cost of production reduces and so it becomes cheaper to produce and supply goods and services. As a result, the supply curve will shift down to the right causing price to fall and quantity supplied to increase as can be seen in the following graph.  For example, if health care is subsidised by the government where the subsidy is 20 percent of the price of the health care that was $40.00, the subsidy will be $8.0 and so the price of the health care will decrease by $8.00.  The new price will now be $32.0 and quantity supplied of the health care will increase from 80 units to 120 units.

Figure 9

Who Bears the Burden of Tax Incidence?

Who actually pays the tax (i.e., the tax incidence) does not depend on who the tax is levied on.  When the tax is levied on consumers, producers have to reduce the price they charge consumers to get them to buy their product given the new tax. Conversely, when the tax is levied on producers, they pass a portion of this additional cost onto consumers in the form of higher prices. The tax incidence will depend on the price elasticities of supply and demand.

When the price elasticity of demand is lower (meaning that it is inelastic) than the price elasticity of supply, the tax burden or incidence will fall mainly on consumers than on producers as is seen in the following graph.  The red shaded area represents the burden on the consumers while the green shaded area represents the burden on the producers.

Figure 10

When the price elasticity of demand is higher (meaning that it is elastic) than the price elasticity of supply, the tax burden or incidence will fall mainly on the producers as is seen in the following graph. The red shaded area represents the burden on the consumers while the green shaded area represents the burden on the producers.

Figure 11

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