Supply and the Law of Supply

3. New firms enter. At a low price only the most efficient producers can cover their costs. As the price rises, higher cost producers find it worth entering, so market supply rises for a reason that has nothing to do with any existing firm producing more.

4. Existing stocks are released. Where a good is storable, a higher price persuades holders to bring stock out of storage, as with the onion trader above.

The assumptions

The law holds other things being equal, and seven things are held constant. Naming them earns marks, because each of them, when it moves, shifts the whole curve.

1. The technique of production does not change.
2. The prices of the factors of production, that is the costs of labour, raw material, power and capital, do not change.
3. The prices of other goods the producer could make do not change.
4. The number of sellers does not change.
5. The goal of the firm, normally profit maximisation, does not change.
6. Government policy, meaning taxes, subsidies and controls, does not change.
7. Expectations about future prices do not change.

Movement along the curve against a shift of the curve

The same distinction as in [Demand and the Law of Demand], and examined just as often.

A movement ALONG the supply curve is caused by a change in the price of the good itself.

• Extension of supply: price rises, quantity supplied rises, the point moves up the curve to the right.
• Contraction of supply: price falls, quantity supplied falls.

A SHIFT of the whole supply curve is caused by anything other than the good's own price.

• Increase in supply: the curve shifts to the right, so more is offered at every price. Caused by better technology, cheaper inputs, a fall in tax or a rise in subsidy, more sellers, a good monsoon in the case of a crop, or a fall in the price of an alternative product.
• Decrease in supply: the curve shifts to the left. Caused by dearer inputs, a new tax, a natural calamity, or a rise in the price of an alternative product that draws producers away.

Elasticity of supply

The formula. Es equals the percentage change in quantity supplied divided by the percentage change in price. It is normally positive, because the two move together.

Worked calculation. The price of pots rises from 80 to 100 rupees, a rise of 25 per cent. Ravi's supply rises from 25 to 30, a rise of 20 per cent. Es is 20 divided by 25, that is 0.8, so supply is inelastic.

The five degrees, which mirror those for demand: perfectly elastic (infinite, a horizontal line), relatively elastic (greater than one), unitary (equal to one, a straight line through the origin), relatively inelastic (less than one), and perfectly inelastic (zero, a vertical line).

A useful geometrical fact. Any straight line supply curve passing through the origin has unitary elasticity at every point, whatever its slope. One that cuts the price axis above the origin is elastic throughout; one that cuts the quantity axis is inelastic throughout.

What determines elasticity of supply. Five determinants.

1. Time. The most important. Marshall's three periods are examinable in their own right and are set out below.
2. The nature of the good. Perishables have inelastic supply because they cannot be stored; durable goods have more elastic supply.
3. The cost of production as output rises. If costs rise steeply with output, supply is inelastic.
4. Whether inputs can be obtained easily. Supply of a good needing a rare mineral or a scarce skill is inelastic.
5. The ease of entry into the industry. Where licences, capital requirements or land make entry hard, supply is inelastic. This connects directly to the barriers to entry in [Market Structure: The Four Forms].

Marshall's three time periods

Alfred Marshall's answer to how supply responds is that it depends entirely on how long you allow. This is one of the most examinable ideas in the topic.

The market period, or very short period. So short that output cannot be changed at all. Supply is the existing stock and the supply curve is vertical, that is perfectly inelastic. Price is determined almost entirely by demand. A day's arrival of fish at a market is the standard example, and the price collapses in the evening because the fish cannot be kept.

The short period. Long enough to vary the variable factors, labour, raw material and hours worked, but not the fixed plant. Supply is somewhat elastic. A factory can run a second shift but cannot build a second factory.

The long period. Long enough to change everything, including plant and the number of firms in the industry. Supply is highly elastic and cost of production dominates price.

Marshall's own image is that demand and supply are like the two blades of a pair of scissors: it is idle to ask which blade cuts the paper. But the shorter the period, the more the work is done by demand; the longer the period, the more by supply and cost.

The exceptions to the law of supply

1. Fixed supply. Some things cannot be produced at all: land in a city, an old master's painting, a rare antique. The supply curve is vertical whatever the price.

2. Perishables, and a distress sale. A seller of fish or milk at the end of the day will accept a falling price and sell more rather than less, because the alternative is a total loss.

3. The backward bending supply curve of labour. This is the one an examiner most likes. As the wage rate rises, a worker offers more hours, up to a point. Beyond that point the worker is rich enough that another hour of leisure is worth more than another hour's pay, and the hours offered fall as the wage rises further. The income effect overtakes the substitution effect, exactly as it does for a Giffen good in [Demand and the Law of Demand].

4. Expectation of a further rise. If sellers expect the price to go on rising, a rise today can cause them to hold stock back and supply less, which is hoarding. Strictly this breaks the assumption about expectations rather than the law itself.

5. Agricultural output in the short run. A farmer who has sown cannot change the crop when the price moves. Within a season the supply curve is close to vertical.

6. A subsistence or target income producer. A weaver who needs a fixed income each month will work fewer hours when the price of cloth rises, because the target is reached sooner. The same logic as the backward bending labour supply curve.

A worked example: the potter, the price and the season

The facts. Ravi supplies 25 pots a week at 80 rupees. Three things then happen in successive months.

Month one: the price rises to 100 rupees because a festival is coming. Ravi works longer hours and hires his nephew. He supplies 30 pots. This is an extension of supply, a movement up the curve, and it is only possible at all because the period is long enough to vary labour, which makes it a short period response in Marshall's sense.

Month two: the price of clay doubles, though the price of pots is still 100 rupees. Ravi now supplies only 22 pots at that price. The whole curve has shifted left. This is a decrease in supply, caused by an input price, one of the seven things the law holds constant.

Month three: the price is back at 80 rupees, but Ravi buys an electric wheel. He now supplies 34 pots at 80 rupees, more than he ever offered at 100 before. This is an increase in supply caused by a change in technique, and it is a long period response, because it required a change in his fixed equipment.

What the example shows. The same producer, the same product, and three completely different answers, depending on which variable moved and how much time was allowed. That is why every statement of the law of supply carries both its assumptions and its time period.

What beginners get wrong

"Supply means the total quantity available." That is stock. Supply is the part of the stock offered for sale at a stated price in a stated period.

"A rise in supply and a rise in the quantity supplied are the same." They are not. A rise in the quantity supplied is a movement up the curve caused by a higher price. A rise in supply is a rightward shift caused by something else.

"Supply always slopes upward." In the market period it is vertical, and for labour it can bend backwards.

"A subsidy raises the price." A subsidy shifts the supply curve to the right, which lowers the price and raises the quantity. A tax does the opposite.

Limits and criticism

It assumes profit maximisation. Producers in Indian agriculture and in small household industry often work to a target income or to custom, and the law does not describe them well.

It ignores the time it takes to respond. The cobweb pattern in agriculture, where farmers sow this year on the basis of last year's price and so produce a glut and then a shortage in alternate years, is a well known failure of the simple statement.

It assumes the seller can get inputs. Where power, credit or raw material is rationed, a higher price produces no extra output at all.

Quick revision

1. Supply is the quantity offered for sale at a given price in a given period. It is not stock.
2. Law of supply: other things being equal, quantity supplied varies directly with price. Rise in price extends supply, fall contracts it.
3. Four reasons for the upward slope: the profit motive, rising marginal cost from diminishing returns, entry of new firms, and release of stocks.
4. Seven assumptions: unchanged technique, factor prices, prices of other goods, number of sellers, firm's objective, government policy, and expectations.
5. Movement along is extension or contraction; a shift is increase or decrease.
6. Elasticity of supply equals percentage change in quantity supplied over percentage change in price. A straight line through the origin has unitary elasticity throughout.
7. Marshall's three periods: market period, supply fixed and vertical, demand decides price; short period, variable factors only; long period, everything variable and cost decides price.
8. Exceptions: fixed supply, perishables and distress sales, the backward bending labour supply curve, expectations and hoarding, agriculture within a season, and target income producers.

Test yourself

1. Define supply and distinguish it from stock. Supply is the quantity of a commodity that sellers are willing and able to offer for sale at a given price during a given period of time. Stock is the entire quantity in existence at a moment. A trader with 500 quintals in a godown who offers only 100 quintals at today's price has a stock of 500 and a supply of 100. Every statement of supply must therefore carry a price and a period.

2. State the law of supply and its assumptions. Other things being equal, the quantity supplied of a commodity varies directly with its price, so a rise in price extends supply and a fall contracts it. The assumptions are that the technique of production, the prices of the factors of production, the prices of other goods the producer could make, the number of sellers, the objective of the firm, government policy on taxes and subsidies, and expectations about future prices all remain unchanged.

3. Why does the supply curve slope upward? Because a higher price widens the margin over cost and makes further production worth the effort and risk; because marginal cost rises as output expands against a fixed plant, so a producer will supply another unit only at a price that covers it; because higher cost producers who could not cover their costs at the low price now enter the market; and because holders of stock release it when the price rises.

4. Explain Marshall's three time periods and their effect on price. In the market period, output cannot be altered at all, so supply is perfectly inelastic and vertical, and price is decided almost entirely by demand. In the short period the variable factors such as labour and materials can be altered but not the plant, so supply is moderately elastic and both demand and cost influence price. In the long period every factor including plant and the number of firms can change, so supply is highly elastic and price tends to equal the cost of production. Marshall compared demand and supply to the two blades of a pair of scissors, with the shorter period giving more work to demand and the longer period more to supply.

5. What is the backward bending supply curve of labour? It is the observation that as the wage rate rises, a worker at first offers more hours, because leisure has become more expensive relative to income. Beyond a certain wage the worker's income is high enough that further leisure is valued more than further earnings, so the hours offered fall as the wage rises. The income effect has overtaken the substitution effect, which is the same mechanism that produces a Giffen good on the demand side.

6. Distinguish an extension of supply from an increase in supply, with an example of each. An extension of supply is a movement up the same supply curve caused by a rise in the price of the good itself, everything else being unchanged, as when a potter makes more pots because the price of pots has risen. An increase in supply is a rightward shift of the whole curve caused by something other than the good's own price, so that more is offered at every price, as when a fall in the price of clay or the purchase of an electric wheel lets the same potter offer more at the old price.

7. A straight line supply curve passes through the origin. What is its elasticity, and does its steepness matter? Its elasticity is exactly one at every point, and the steepness makes no difference to that. This follows because at any point on such a line the ratio of price to quantity equals the slope, so the two cancel in the elasticity formula. A straight line supply curve that cuts the price axis above the origin is elastic throughout, and one that cuts the quantity axis is inelastic throughout.