 ###### Supply

The model of supply is an attempt to explain the amount supplied of any good or service.  The amount of a good or service a firm wants to sell and is able to sell per unit time.

## THE “STANDARD” MODEL OF SUPPLY

The DEPENDENT variable is the amount supplied.

The INDEPENDENT variables are:

the good’s own price

the prices of inputs used in its production

the technology of production

taxes and subsidies

## ​The supply function for tacos

QS (tacos) = S(Ptacos, Ptaco shells, Plettuce, Plabor,

Ptomatoes, . . ., technology, taxes &

subsidies)

THE SUPPLY CURVE

The supply curve for any good shows the quantity supplied at each price, holding constant all other determinants of supply.

The DEPENDENT variable is the quantity supplied.

The INDEPENDENT variable is the good’s own price.

THE LAW OF SUPPLY

The Law of Supply says that an increase in a good’s own price will result in an increase in the amount supplied, holding constant all the other determinants of supply.

The Law of Supply says that supply curves are positively sloped.

When drawing a supply curve notice that the axes are reversed from the usual convention of putting the dependent (y) variable on the vertical axis, and the independent (x) variable on the horizontal axis. ## ​

Other factors affecting supply

The question here is how to show the effects of changes in input prices, technology, and taxes.

The answer, of course, is that changes in input prices, technology, or taxes cause the supply curve to shift. ## Changes in input prices

Consider the supply of beer, and suppose the price of hops, a crucial input to beer, falls.  Beer firms now find that beer production is more profitable than it was before, and they respond to this be increasing the supply of beer. ## Change in technology

An improvement in technology makes it possible to produce a level of output with fewer inputs than before.

Because this lowers the cost of production, profits rise, and firms will try to supply more.

Note

Supply is a function of own price, input prices, and technology.

The supply curve shows supply as a function of own price, all else constant.

Changes in a good’s own price show up as movements along a supply curve.

Changes in input prices, technology, or taxes show up as shifts in the supply curve.

PRICE DETERMINATION IN MARKETS

The market demand curve shows the amount demanded at every price.

The market supply curve shows the amount supplied at every price.

The question now is whether there is some price at which the quantities supplied and demanded are the same.

EQUILIBRIUM PRICE DEFINED

a price at which quantity supplied equals quantity demanded.

a price at which excess demand equals zero. At the equilibrium price there is no net tendency for price to change.

Excess demand exists when, at the current price, the quantity demanded is greater than quantity supplied.

Excess supply exists when, at the current price, the quantity supplied is greater than the quantity demanded.

When there is EXCESS DEMAND for a good, price will tend to rise.

When there is EXCESS SUPPLY of a good, price will tend to fall.

When excess demand equals zero, price must be the equilibrium price, and we say the market is in equilibrium. If you want to find out the price at which a market is in equilibrium, then look for the price where the excess demand is zero.

Note

Market price serves as the adjustment mechanism to move markets to equilibrium.

Price changes in response to the existence of excess demand or excess supply.

Changes in demand and changes in supply lead to changes in equilibrium prices and quantities.

Why do people specialize in the production of a few goods or services and then trade?

Why don't people become self-sufficient instead, producing everything they need?

Example

Suppose there are two people, Sparks and Brown.

Both can produce Tacos and Spaghetti, but they are not equally adept.

Absolute advantage:  A person has an absolute advantage in the production of a good if he/she uses less inputs to produce a unit of the good.

Comparative advantage:  A person has a comparative advantage in the production of a good if that person can produce an extra unit of the good at lower opportunity cost.

Elasticity

Elasticity is the concept economists use to describe the steepness or flatness of curves or functions.

In general, elasticity measures the responsiveness of one variable to changes in another variable.

Measures the responsiveness of quantity demanded to change in a good’s own price.

The price elasticity of demand is the percent change in quantity demanded divided by the percent change in price that caused the change in quantity demanded

Note

It’s always a ratio of percentage changes.

That means it is a pure number -- there are no units of measurement on elasticity.

Price elasticity of demand is computed along a demand curve.

THERE ARE LOTS OF WAYS TO COMPUTE ELASTICITIES.  SO BEWARE!  THE DEVIL IS IN THE DETAILS.

## MOST OF THE AMBIGUITY IS DUE TO THE MANY WAYS YOU CAN COMPUTE A PERCENTAGE CHANGE.  BE ALERT HERE.  IT’S NOT DIFFICULT, BUT CARE IS NEEDED

Demand is ELASTIC when the numerical value of elasticity is greater than 1.

Demand is INELASTIC when the numerical value of elasticity is less than 1.

Demand is UNIT ELASTIC when the numerical value of elasticity equals 1.

NOTE:  Numerical value here means “absolute value.”

There is an important relationship between what happens to consumers’ spending on a good and elasticity when there is a change in price.  There is an easy way to tell whether demand is elastic or inelastic between any two prices.

If, when price falls, total spending increases, demand is elastic.

If, when price falls, total spending decreases, demand is inelastic.

Examples

Doctors through the AMA restrict the supply of physicians.  How does this affect the incomes of doctors as a group?

A labor union negotiates a higher wage.  How does this affect the incomes of affected workers as a group?

MSU decides to raise the price of football tickets.  How is income from the sale of tickets affected?

Airlines propose to raise fares by 10%.  Will the boost increase revenues?

MSU is considering raising tuition by 7%.  Will the increase in tuition raise revenues of MSU?

CATA recently raised bus fares in the Lansing area.  Will this increase CATA’s total receipts?

The answers to all of these questions depend on the elasticity of demand for the good in question.  Be sure you understand how and why!

The more substitutes there are available for a good, the more elastic the demand for it will tend to be. [Related to the idea of necessities and luxuries.  Necessities tend to have few substitutes.]

The longer the time period involved, the more elastic the demand will tend to be.

The higher the fraction of income spent on the good, the more elastic the demand will tend to be.

Spending on a good = P Q.

Because demand curves are negatively sloped, a reduction in P causes Q to rise and the net effect on PQ is uncertain and depends on the elasticity of demand. In principle, you can compute the elasticity between any two variables.

Income elasticity of demand

Cross price elasticity of demand

Elasticity of supply

Analysis of competitive market

In this section, we examine the social welfare implications of competitive markets.

The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus.

The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus.

Optimality of competitive markets

The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good.

A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum.

Key terms

Willingness to pay:  The maximum amount a buyer will pay for an amount of a good.

Consumer surplus:  A buyer's willingness to pay minus the amount actually paid.

Cost:  The value of everything a seller must give up producing an amount of a good.

Producer surplus:  The amount the seller receives for the good minus the cost.

Note

if the demand curve (willingness to pay) is a good measure of the value of a good, and

if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good,

then the best amount of the good to produce is where supply and demand are equal.

THEORIES OF THE FIRM

Theories of the firm are organized around the different kinds of market forms in which firms can operate.

In this course, the market forms are grouped this way:

Perfect competition

Monopoly

Monopolistic competition, and

Oligopoly

Perfect Competition

A market form with these characteristics:

1)  Large number of firms.

2)  Homogeneous product.

3)  Easy entry and exit of firms.

Some economists add to this list that consumers and firms also have cheap, accurate information about prices.

What the assumptions boil down to is that each firm in perfect competition is a price taker.

NO FIRM HAS ANY CONTROL OVER MARKET PRICE.

This means that the demand curve the firm sees for its product is infinitely elastic.

In competitive markets, market price is determined by supply and demand.

If a firm were to raise its price above market price it would lose all its sales.  It would never be silly enough to charge less because it can sell all it wants at the going market price.

MONOPOLY:  a market with only one seller of a product for which there are no close substitutes.

MONOPOLISTIC COMPETITION:  a market with many firms, easy entry, and product differentiation.  (Each firm produces a slightly different version of the product.)

OLIGOPOLY:  a market with a small number of firms.

Profit is the difference between total revenue and total cost, or Profit = TR - TC.

In economics class cost means OPPORTUNITY cost.

Because opportunity cost is often different from accounting cost, economic profit has a very special meaning and significance.

Monopolistic

A market form in which there is Product differentiation, many firms and easy entry and exit

The importance of monopolistic competition is that it seems to explain aspects of many important real-world markets. The demand curve facing a monopolistically competitive firm looks very much like that facing monopoly, but it is very elastic due to the presence of many companies

Note:

In the short-run firms choose price and output by setting MC = MR. In the long-run entry of new firms assures that profit will be zero Some economic inefficiency exists because in equilibrium price is higher than marginal cost.  Some economic inefficiency exists because in equilibrium price is higher than marginal cost.

Cost of production.

General principle:  If you know the technology of production (the production function or total product curve), and if you know the prices of the inputs to production, then you can find the firm’s costs at any level of output.

Costs are determined by the technology of production and input prices. Let’s start with the total product curve for tax preparation services from the last section and show how to get to costs of production.

THE TOTAL VARIABLE COST CURVE shows the total variable cost at each level of output.

In the total variable cost curve, the independent variable is OUTPUT, and the dependent variable is TOTAL VARIABLE COSTS.

If there are fixed costs (costs associated with inputs that can’t be changed), then we can add these to the total variable costs to get total costs.

Total Cost = Fixed Cost + Total Variable Cost

TC = FC  +  TVC Average cost:  Cost per unit of output.  Total cost divided by output.  TC/Q.

Average cost curve:  The curve that shows average cost as a function of output.  Output is the independent variable and average cost is the dependent variable. Marginal cost:  The change in total cost per unit change in output.  The increase in cost due to producing one more unit of output.  The slope of the total cost curve.  Δ TC / ΔQ.

Marginal cost curve:  The curve that shows marginal cost as a function of output.  The independent variable is output.  The dependent variable is marginal cost.

the marginal and average cost curves must conform to the usual rules about marginal and average curves.

1)  When the average is rising, the marginal quantity must be greater than the average quantity.

2)  When the average is falling, the marginal quantity must be less than the average quantity.

3)  When the average is neither rising nor falling (at a maximum or minimum), average and marginal are equal.

Note: Costs depend output, technology, and input prices. There are two ways to depict a firm’s costs: Total cost curves and   Average and marginal cost curves

An improvement in technology lowers the cost of producing each level of output.

Marginal and average costs of production will be lower as a result. Imposing a tax per unit of output will raise total cost by tQ, where t is the tax per unit and Q is the number of units of output sold. The tax will raise both average and marginal costs by exactly the amount of the tax per unit of output.

Note

Increases in the prices of inputs will raise the total, average, and marginal costs of production.

Improvements in technology lower total, average, and marginal costs of production.

A per unit tax of t will raise total costs by tQ, and will raise marginal and average costs by exactly t.

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