The Idea of Supply

Supply is the seller’s side of a market. For any good or service, supply describes the quantity that producers are willing and able to offer for sale at each possible price during a specified period while other influences are held constant. Willing means that the price provides enough incentive to cover costs and to provide the required return. Able means that firms have access to the necessary inputs and capacity to produce and deliver the good. Because production and sales take time, statements about supply always relate to a period such as a week or a month rather than to a single instant.

A firm is an organisation that brings together land, labour, capital, and enterprise in order to produce output. Firms operate under a variety of legal forms. A sole trader owns and runs the business and takes all profit and risk. A partnership shares ownership and obligations across partners. Private and public joint stock companies raise finance by issuing shares and possess a legal identity that is separate from the shareholders, which allows large scale operation while requiring formal governance. Whatever the legal form, managers compare the revenue they expect to gain from selling units at the going price with the costs of producing those units, and this calculation determines the quantity they are willing to supply.

In a competitive market a single firm cannot influence the market price because many firms sell the same product or close substitutes. Each firm takes the price as given, and then chooses how much to supply at that price. When the price is higher, more planned units cover their costs and become profitable to sell, and the firm is willing to supply a larger quantity. When the price is lower, fewer units cover their costs, and the firm is willing to supply a smaller quantity. Plotting price on the vertical axis and quantity on the horizontal axis produces an upward sloping supply curve that shows this positive relationship between price and quantity supplied.

To find the quantity that would be supplied at a particular price, start at that price on the vertical axis, move horizontally until you reach the supply curve, then drop vertically to the horizontal axis to read the quantity. To find the price that would be needed to elicit a particular quantity, start at the quantity on the horizontal axis, move up to the curve, then cross to the vertical axis to read the price.

Individual supply and market supply

There is an important difference between the supply of one firm and the supply of all firms together. Individual supply shows the quantities that a single firm is willing and able to supply at each price in a period. Market supply is the horizontal sum of all individual supplies at each price. Because market supply adds the quantities offered by firms, the number of firms in the market directly affects the position of the market supply curve. If new firms enter, market supply increases at every price and the curve shifts to the right. If firms leave, market supply decreases at every price and the curve shifts to the left. This remains true even if each firm’s own supply relationship is unchanged.

Movements along the supply curve

It is essential to distinguish movements along a fixed curve from shifts of the entire curve. When the price of the good itself changes and all other influences remain unchanged, the point moves along a single supply curve. A rise in price causes an extension of supply, and a fall in price causes a contraction of supply. The conditions of production did not change in this case, and only the reward per unit changed.

What influences supply

When any other determinant of supply changes, the whole relationship changes and the curve shifts. An increase in supply is a rightward shift, which means that at every price producers are willing to supply more than before. A decrease in supply is a leftward shift, which means that at every price producers are willing to supply less than before. Use extension and contraction only for movements caused by the goods’ own price, and use increase and decrease only for shifts caused by non-price factors.

Six determinants change the quantity that firms are willing to supply at a given price, and therefore each one shifts the entire supply curve. The determinants are production costs, technology, taxes and subsidies, the prices of other goods through competitive supply or joint supply, expected prices, and the number of firms in the market.

Production costs: Capital, Land, and Labour

Firms hire labour, use land and raw materials, and operate capital equipment, and these costs determine how many units are worthwhile to produce at a given price. If money wages rise generally in the industry or if the price of energy or a crucial component increases, then unit cost rises. At the same market price fewer units now cover their costs, and firms are willing to supply less than before, so the supply curve shifts left. If any of those costs fall, the argument works in reverse, and the curve shifts right because more units become worthwhile at each price. It is useful to remember the rewards to the factors of production when reasoning about costs. Land earns rent, labour earns wages and salaries, capital earns interest and for company owners dividends, and enterprise earns profit. If any of these required returns increase generally, unit cost rises and supply tends to shift left.

Technology

A technological improvement allows the same output to be produced with fewer inputs or allows more output to be produced with the same inputs. This lowers unit cost and changes the number of units that are worthwhile to produce at a given market price. The supply curve shifts right because at every price the firm is willing to supply more than before. If a process becomes outdated or a piece of equipment becomes unreliable, the effective technology worsens, and the curve would shift left for the opposite reason.

Taxes and subsidies

A tax on production raises cost by a fixed amount per unit, and with the market price unchanged, fewer units now cover costs, so supply shifts left. A subsidy reduces the effective cost per unit, and with the market price unchanged, more units now cover costs, so supply shifts right. In both cases the vertical distance between the original curve and the new curve at any given quantity equals the tax or subsidy per unit, which is why a pair of parallel curves is often drawn in this situation.

Prices of other goods: Joint and Competitive Supply

Two distinct mechanisms link the price of other goods to the supply of the good under consideration. In competitive supply, a firm can use the same labour, machinery, and space to produce alternative products, and a rise in the profitability of one product draws resources toward it, so the supply of the original product shifts left. In joint supply, one productive activity generates more than one output at the same time (for example, leather and meat), and when total processing increases in response to a higher price for one output, the supply of the companion output increases as well, so its curve shifts right. These two concepts explain how changes in other prices move a product’s supply even though its own price has not changed.

Expected prices

Production and sales are planned ahead, and in many industries output can be stored for later sale. If firms expect higher prices in the future, and if storage is feasible, they may hold back some output today and release it later, which reduces current supply. If firms expect lower prices in the future, they may sell more now while the price is higher, which increases current supply. Expectations therefore shift the curve across time, even before any change occurs in current demand or costs.

Number of firms in the market

Market supply is the sum of the quantities that active firms are willing to supply at each price. If more firms enter, market supply shifts right even if every firm’s own curve is unchanged. If some firms leave, market supply shifts left. Entry and exit usually reflect profit conditions, which in turn depend on demand, costs, technology, and policy, but the effect on the market curve is immediate and mechanical because there are more or fewer sellers.

Producer surplus

Producer surplus is the difference between the price received by firms for a good or service and the price at which they would have been prepared to supply that good or service. The supply curve can be interpreted as showing the minimum price that would cover the cost and required return for each marginal unit. At the market price, the last unit supplied is just worthwhile. All earlier units would have been supplied at lower prices, so the firm receives extra benefit on those units. The total producer surplus equals the area above the supply curve and below the horizontal price line up to the traded quantity. If the curve is a straight line from the origin, the area is a triangle. If the curve is not linear, the area is still the correct measure because it adds up unit by unit the difference between price and the minimum acceptable price.

A change in price alters producer surplus in a predictable way. When price rises, producer surplus increases for two reasons. First, all units that would have been supplied before now earn a larger difference between the price line and the supply curve, which increases the surplus on those units. Second, there is an extension along the supply curve and extra units are supplied, and these new units also generate some surplus because their minimum acceptable price is below the new higher price. When price falls, producer surplus decreases for the reverse reasons. The magnitude of the change depends on how responsive quantity supplied is to price. If supply is very responsive, the extension is large and the added surplus from new units is large for a given rise in price. If supply is less responsive, both the extension and the added surplus are smaller.

Shifts of the supply curve at a fixed price also change producer surplus. If supply shifts right because of lower input costs or better technology, the supply curve lies lower relative to the price line, and the area above the curve is larger, so producer surplus rises. If supply shifts left because of higher costs or a new tax, the curve lies higher relative to the price line, and the area above the curve is smaller, so producer surplus falls.

Consumer and producer surplus on one diagram

It is often useful to show demand and supply on the same axes so that both surplus areas are visible. The market price and quantity occur where the two curves intersect. Consumer surplus is the area below the demand curve and above the price line up to the traded quantity. Producer surplus is the area above the supply curve and below the price line up to the same quantity. The two areas together represent the gains from trade at that outcome and provide a clear picture of how policy or market conditions affect buyers and sellers.