Markets:  Demand and Supply

Supply Analysis

Reading Assignment: None

The Supply Side.  In the output market, this defines the behavior of sellers,

Initial assumption.  Firm owners value money - so we assume they are at least in large part motivated by the profit motive.

Some definitions (review the economist's time frames): 

    short run

    long run

If the firm is in the short run, it is constrained by increasing marginal costs -

or the law of diminishing marginal returns -

Example, consider conditions under which you would produce for sale quartz lamps from your uncle's shack in Southern Montana.  As the amount of variable inputs (quartz and workers) increases, the room will become “crowded,” and unit costs should increase as more variable inputs (labor especially) are added to the fixed input.

The supply curve: A schedule showing the varying quantities of a good or service that sellers are willing and able to place on the market at varying prices, per unit of time, other things constant.  The supply curve is upward sloping due to the law of diminishing marginal returns (increasing marginal costs) and a change in the ability to buy resources (increasing marginal opportunity costs).

1.  Ability to buy resources:

    Remember, the price of a resource is determined by it's opportunity cost -- which is ultimately determined by consumers.  With more supply, marginal opportunity cost increases as the supplier dips into more resources and pulls them away from other possible production processes.

2.  Law of DMR - diminishing marginal returns or increasing marginal opportunity costs:

Important elements

a. Schedule of intentions: supply curve is an estimate

b. Price/Quantity relationship:  Price is the most important determinant of quantity.

c.

            Willing: Is a reasonable use of resources - given opportunity costs of the owners,

            Able:  Has productive means

d. Per unit of time:  Time must be specified, as it affects DMR - in the long run we don't have DMR but economies or diseconomies of scale:

e. other things constant.

Determinants of supply:  Things other than the price that affect supply.  As a class, these are things that affect production costs

 Technology

 Factor or resource prices.

 Price of complements in production

 Price of substitutes in production

 Number of sellers

 Price and/or profit expectations (e.g. hold grain in silo if price is expected to increase next year).

            Taxes (excise, for example) - really anything that changes the cost of supplying the good

Changes in supply vs. changes in quantity supplied.

 Definition. (As with demand):  A change in quantity supplied occurs in response to a change in the price of a good, all other things held constant.

 A change in supply occurs in response to a change in something other than price.

 Again, price is, by definition, the one thing that cannot change supply.

Some examples - graphs:

Producer Surplus.

Like the notion of consumer surplus, in a market where a single price is charged for all transactions, producers typically receive more from a sale than is necessary to induce them to offer a unit to the market.

 Graph:

The producer surplus for the market is the triangle bounded by the vertical axis, the production cost (supply curve), and the price.

-Producer surplus is not the same as profit.  We will talk about this more later, when we discuss the theory of the firm.

-There are ways for a savvy purchaser to extract producer surplus in making purchasing decisions.  Similar to demand, this is typically accomplished via bulk purchases.  Since the supply curve is basically the marginal cost curve of a firm -- as MC is lower, then the firm can supply more at any given price -- supply the same at a lower price.

An analytical example. 

Again, as with demand, let's say we have been selling laser-light paper erasers for some time and have asked our data gathering people to find the best relationship from the data regarding the price of the good and how many we are willing and able to sell.  They fit this data to a linear "best fit" supply curve.

Consider the market supply schedule for small laser-light paper erasers.  The supply function is given by

Q_s = -44 + 20P

P = the price of the erasers (note the positive sign because as price increases, so does quantity supplied - due to ?.....).

Why the negative sign on the 44?  Remember, when the price is zero, this is where the supply curve will cross the Qs axis -- with a zero price, suppliers will not be willing to supply a positive amount.  So the -44 tells us (theoretically) how many units would be supplied at a price of zero - obviously, this would not be a positive amount (given that we are assuming a for-profit firm).

So at what price would suppliers supply just zero? 

0 = -44 + 20P

44 = 20P

44/20 = 2.20

    Price would be $2.20.

Graph:

Now lets add:

Q_s = -44 + 20P - 4W - 2M,

W = the average hourly wage for labor

M = an index measuring materials costs.

Why the negative signs?

If W = 10 and M = 8, what is the market supply curve or Quantity supplied?

Q_s        =         -44 + 20P - 4(10) -2(8)

            =          -100 + 20P, thus

So if the price = 5.25

Qs = -100 + 20(5.25)

Qs = 5 

Plotting in a table

Graph:

Now, suppose that M increases to 18, then what happens to supply, or to quantity supplied?

Q_s        =         -44 + 20P - 4(10) -2(18)

            =          -120 + 20P, thus

There is a change in supply

To find out what price would have to be charged to supply 5 units:

5 = -120 + 20P

125 = 20P

125/20 = P

6.25 = P

Chart the data:     

Show on graph  - does it make sense that the supply curve would shift to the left?  Why?

Price

                                                     Quantity

Given that Qs = -120 + 20P

What is producer surplus at a price of $7?

Graph (including all points of the triangle).

In Class Exercise Four