• Chapter 5: Supply

    Lesson 1: Vocabulary

    Content Vocabulary
    • supply
    • Law of Supply
    • supply schedule
    • supply curve
    • market supply curve
    • quantity supplied
    • change in quantity supplied
    • change in supply
    • subsidy
    • supply elasticity
    Academic Vocabulary
    • various

    What are the basic differences between supply and demand?

    Supply is the amount of a product that would be produced, grown, or acquired and offered for sale at all possible prices that could prevail in the market. Demand is how much buyers want an item or service. Sometimes, though, other factors influence production.

    Suppose that as a Student Council officer, your job is to obtain custom logo T-shirts for every member of your class. Because you want to get the best possible price, you plan to make inquiries, meet with suppliers, and finally ask for bids. You are also going to ask for quotes at three different price levels, but you want the same quality shirt to be supplied at each price. You haven't done the work yet, and you only have a $1,000 budget, but the more you think about it, the more you think that you can predict the outcome.

    Introduction to Supply

    Why do supply and demand curves slope in opposite directions?

    All producers must decide how much of a product to offer for sale at various prices—a decision made according to what is best for the individual seller. What is best depends upon the cost of producing the goods or services. These results can be illustrated in the form of a table or a graph.

    The Supply Schedule

    The supply schedule is a listing of the various quantities of a particular product that a producer would supply at all possible prices in the market. 

    Panel A of Figure 5.1 presents a hypothetical supply schedule for burritos at a certain price. It shows the quantities of burritos that will be supplied at various prices, all other things being equal. If you compare it to the demand schedule in Panel A of Figure 4.1, you will see that the two are remarkably similar.

    Supply schedule

    The main difference between Figure 5.1 and Figure 4.1 is that for supply, the quantity goes up when price increases, rather than down as in the case of demand. This is because a high price is an incentive for a producer to offer more, whereas a low price is an incentive to produce less.

    The Individual Supply Curve

    The data presented in the supply schedule can also be illustrated graphically as the upward-sloping line in Panel B of Figure 5.1. To draw it, all we do is transfer each of the price-quantity observations in the schedule over to the graph, and then connect the points to form the curve. The result is a supply curve, a graph showing the various quantities supplied at all possible prices that might prevail in the market at any given time. Of course the prices and quantities in Figure 5.1 are a bit unrealistic, but the numbers are used to keep the graph simple.

    The main thing to remember is that all normal supply curves have a positive slope that goes up when you read the diagram from left to right. This shows that if the price goes up, the quantity supplied will go up too.

    While the supply schedule and curve in Figure 5.1 represent the voluntary decisions of a single, hypothetical producer of burritos, remember that supply is a very general concept. In fact, you are a supplier whenever you look for a job and offer your services for sale. Your economic product is your labor, and you would probably be willing to supply more labor for a higher wage than you would for a lower one.

    Supply curve

     

    A Change in Quantity Supplied

    The quantity supplied is the amount that a single producer or all producers bring to market at any given price. A change in quantity supplied is the change in the amount offered for sale in response to a change in price. In Figure 5.2, the supply curve shows 24 million burritos are supplied when the price is $5, and 36 million are supplied when the price goes up to $7. These changes illustrate a change in the quantity supplied, which—just like demand—shows as a movement along the supply curve.

    Note that the change in quantity supplied can be an increase or a decrease, depending on whether more or less of a product is offered. 

    In a market economy, producers react to changing prices in just this way. Take oil as an example. If the price of oil falls, the producer may offer less for sale or even leave the market altogether if the price falls too low. If the price rises, the producer may offer more oil for sale to take advantage of the better prices.

    It makes no difference whether we are talking about an individual supply curve or a market supply curve. In either case, a change in quantity supplied only takes place if there is a change in price. Also, a change in quantity supplied will not shift the supply curve to the left or the right—only the amount of output offered for sale along an original supply curve is affected by the change in price.

    Change in Supply

    What might happen to make a producer decrease his or her supply of a product?

    Sometimes something happens to cause a change in supply, a situation where suppliers offer different amounts of a product for sale at all possible prices in the market.

    Comparing a Change in Quantity Supplied to a Change in Supply

    The change in quantity supplied in Figure 5.3 is not the same as the change in supply. This is because the change in quantity supplied occurs only when there is a change in price. When we have a change in supply, we are looking at situations where all quantities change even though the price remains the same.

    For example, the supply schedule in the figure shows that producers are now willing to offer more burritos for sale at every price. Where 24 million burritos were offered at a price of $5, now there are 36 million offered. Where 36 million were offered at a price of $7 before, 50 million are now offered, and so on for every price that could prevail in the market.

    Change in Supply

    When both old and new quantities supplied are plotted in the form of a graph, it appears as if the supply curve has shifted to the right, showing an increase in supply. For a decrease in supply to occur, fewer products would be offered for sale at all possible prices, and so the supply curve would shift to the left.

    Factors that Can Cause a Change in Supply

    Changes in supply, whether they are increases or decreases, can occur for the reasons discussed below.

    • Cost of Resources A change in the cost of productive inputs such as land, labor, and capital can cause a change in supply. Supply might increase because of a lower cost of inputs such as labor or packaging, enabling suppliers to produce more at every price—thereby shifting the supply curve to the right.
      An increase in the cost of inputs has the opposite effect. A higher cost of inputs would force producers to offer fewer products for sale at every price—shifting the supply curve to the left.
    • Productivity Productivity increases whenever more output is produced with the same amount of inputs. When management trains or motivates its workers, productivity usually goes up because more is produced with the same amount of inputs—resulting in a supply curve that shifts to the right.
      But if workers fall behind on training, become unmotivated, or are unhappy, then productivity could decrease. Fewer goods would be produced at every possible price—shifting the supply curve to the left.
    • Technology The introduction of a new machine or industrial process can lower the cost of production, which increases productivity. For example, improvements in jet aircraft fuel efficiencies have lowered the fuel cost of air passenger service. When production costs go down, a firm can produce more at every possible price—thereby shifting its supply curve to the right.
      New technologies do not always work at first, of course, and so at first the supply curve may briefly shift to the left. However, firms expect new technologies to be beneficial, or they would not have adopted them in the first place.

     

    • Taxes Firms view taxes as a cost of production, just like raw materials and labor. This is one reason why businesses almost always lobby for lower taxes. If a company pays fewer taxes, it can produce more at each possible price—shifting its supply curve to the right.
      However, if taxes go up, its production costs go up and it will produce less at each and every price—thereby shifting its supply curve to the left. 
    • Subsidies A subsidy is a payment to an individual, business, or other group to encourage or protect a certain type of economic activity. Today, many farmers in the milk, cotton, corn, wheat, sugar, and soybean industries receive subsidies to support their incomes—which shifts the supply curves of their products to the right.
      When subsidies are repealed, production costs go up, and firms will either leave the market entirely or produce less at each possible price—something that shifts their supply curves to the left.
    • Government Regulations If government decides to reduce its regulations on business, production costs go down and firms are able to produce more output at all possible prices—thereby shifting individual supply curves to the right.
      More often, however, government increases its regulations, which raise a typical business’s cost of production.  For example, when the government requires new auto safety features such as air bags, emission controls, or higher collision safety standards, cars cost more to produce. Manufacturers then adjust to the higher production costs by producing fewer cars at every possible price—shifting the market supply curve to the left.
    • Number of Sellers Most markets are fairly active, with firms entering and leaving all the time. You often see this where you live, especially when one store closes and another opens in its place. Whenever an industry grows because more firms are coming in, the market supply curve shifts to the right. Or if the industry is shrinking because firms are leaving, fewer products are offered for sale at the same prices as before, which shifts the market supply curve to the left. A change in the number of sellers is different from the other factors listed above, because this is the only factor that can affect the market supply curve without affecting the supply curve of any individual firm.
    • Expectations Expectations can affect the decisions a firm makes. These expectations may affect anything from the cost of inputs to the demand for the firm’s products. Unless we know more about these expectations, however, it is not possible to make any generalizations about the way in which they affect a firm’s supply curve.

    As you can see, there are many factors that can cause a change in supply and consequently cause the market supply curve to shift to the left or to the right. However, only a change in price—which was discussed in the previous section—can cause a change in quantity supplied, which is a movement along a stationary supply curve.

     

    Elasticity of Supply

    How does the production of a product affect the elasticity of supply?

    Just as demand has elasticity, so does supply. Supply elasticity is a measure of the degree to which the quantity supplied responds to a change in price.

    As you might imagine, there is very little difference between supply and demand elasticities. If quantities of a product are being purchased, the concept is demand elasticity. If quantities of a product are being produced and offered for sale, the concept is supply elasticity.

    Three Cases of Supply Elasticity

    Supply and demand each have three cases of elasticity. The three examples of supply elasticity are illustrated in Figure 5.4. In each case, we look to see how the quantity supplied, the dependent variable, responds to a change in price, which is the independent variable.

    • Elastic Supply The supply curve in Panel A is elastic because the change in price causes a proportionally larger change in quantity supplied. Doubling the price from $1 to $2 causes the quantity supplied to triple from two to six units. Again, the prices and numbers are unrealistically simple, but that is to make the diagrams easier to understand.
    • Inelastic Supply  Panel B shows an inelastic supply curve. In this case, a change in price causes a proportionally smaller change in quantity supplied. When the price doubles from $1 to $2, a 100 percent increase, the quantity supplied goes up only 50 percent, or from two units to three units.
    • Unit Elastic Supply  Panel C shows a unit elastic supply curve. Here, a doubling, or a 100 percent change, in price causes a proportional change in the quantity supplied. As the price goes from $1 to $2, the quantity supplied also doubles.

    What Determines Supply Elasticity?

    The elasticity of a producer’s supply curve depends on the nature of its production. If a firm can adjust to new prices quickly, then supply is likely to be elastic. If the nature of production is such that adjustments take much longer, then supply is more likely to be inelastic.

    The supply curve for nuclear power, for example, is inelastic in the short run. No matter what price is being offered, electric utilities will find it difficult to increase nuclear power output because of the huge amount of engineering, capital, and technology needed—not to mention the issue of extensive government regulation—before nuclear production can be increased.

    However, the supply curve is likely to be elastic for many toys, candy, and other products that can be made quickly without large amounts of capital and skilled labor. If consumers are willing to pay more for any of these products, most producers will be able to gear up quickly to significantly increase production.

    Unlike demand elasticity, only production considerations determine supply elasticity. If a firm can react quickly to a changing price, then supply is likely to be elastic. If the firm takes longer to react to a change in price, then supply is likely to be inelastic.

    LESSON 3
    Cost, Revenue, and Profit Maximization

    Lesson 3: Vocabulary

    Content Vocabulary
    • fixed costs
    • overhead
    • variable cost
    • total cost
    • marginal cost
    • average revenue
    • total revenue
    • marginal revenue
    • profit-maximizing quantity of output
    • break-even point
    • e-commerce
    Academic Vocabulary
    • YTC
    • generates
    • conducted

    How do companies determine the most profitable way to operate?

    All businesses, including nonprofit organizations, face the challenge of being successful enough to stay in operation. Even better, most hope to operate in a way that maximizes profits. What decisions does a business need to make to achieve these goals?

    1. What are the costs of the lease, the utility bills, the purchase and repair of equipment, and other daily expenses for doing business?
    2. What is the cost of paying employee salaries and benefits?
    3. What is the cost of producing each good or providing each service?

    In a paragraph or two, explain why the manager of this organization needs to answer these questions to develop a business plan that will enable the organization to continue in business.

    Finding Marginal Cost

    What is the difference between a fixed cost and a variable cost?

    Because businesses want to produce efficiently, they need to consider several measures of cost. But which is the most useful if they want to maximize profits? To find out, we will examine them one by one.

    Fixed Costs

    The first measure is fixed costs—the costs that an organization incurs even if there is little or no activity. When it comes to this measure of costs, it makes no difference whether the business produces nothing, very little, or a large amount. Total fixed costs, sometimes called overhead, remain the same.

    Fixed costs include salaries paid to executives, interest charges on bonds, rent payments on leased properties, and state and local property taxes. Fixed costs also include depreciation—the charge for the gradual wear and tear on capital goods because of their use over time. A machine, for example, will not last forever, because its parts will wear out slowly and eventually break.

    Suppose fixed costs are $50 for the firm with the hypothetical production function shown in Figure 5.5 in the previous lesson. To keep all of our numbers together, Figure 5.6 shows the same production function in the first three columns, along with total fixed costs in column four. As you can see, the total fixed cost is $50 for every level of output, even if nothing is produced.

    Variable Costs

    The second measure is variable cost, the cost that changes when the business’s rate of operation or output changes. While fixed costs are generally associated with machines and other capital goods, variable costs are usually associated with labor and raw materials. For example, wage-earning workers may be laid off or asked to work overtime as output changes. Other examples of variable costs include electric power to run machines and freight charges to deliver the final product.

    For most businesses, the largest variable cost is labor. If a business wants to hire one worker to produce seven units of output per day, and if the worker costs $90 per day, the total variable cost is $90. If the business wants to hire a second worker to produce additional units of output, then its total variable cost is $180, and so on. These are the numbers shown in column five of the figure. 

    Total Cost

    Figure 5.6 shows the total cost of production, which is the sum of the fixed and variable costs. Total cost takes into account all the costs a business faces in the course of its operations. If the business decides to use six workers costing $90 each to produce 110 units of total output, then its total cost will be $590—the sum of $50 in fixed costs plus $540 (or $90 times six) of variable costs.

    Marginal Cost

    Variable, fixed, and total costs are necessary to compute the most useful measure of cost, marginal cost—the extra cost incurred when producing one more unit of output.

    To find marginal cost, we have to divide the additional cost of adding each worker by the additional output the worker generates. To find the marginal cost of the first worker, we divide the additional cost of $90 by the additional output of 7 to get $12.86. To find the marginal cost of the second worker, we divide the additional cost of $90 by the additional output of 13 to get $6.92, and so on. All of these values are shown in column seven of Figure 5.6.

    As we will see next, marginal revenue is the most useful measure of revenue because it helps us with profit maximization.

     

     

    Finding Marginal Revenue

    Why is marginal revenue more important than the average revenue?

    The second important measure a business needs to find is its marginal revenue. Before we get to it, however, we deal with two other measures of revenue.

     

    Average Revenue

    The average revenue is simply the average price that every unit of output sells for. For example, if the company whose costs and revenues represented by the table in Figure 5.6 sells every unit of output for $15, its average revenue is $15. This would remain unchanged at $15 if it sold 10, 100, or 1,000 units. Of all the revenue measures, average revenue is the least useful, even though it is perhaps the easiest to understand. For this reason, the table in Figure 5.6 does not have a column for average revenue.

    Total Revenue

    The total revenue is all the revenue that a business receives. In the case of the firm shown in Figure 5.6, total revenue, shown in column eight, is equal to the number of units sold multiplied by the average price of $15 per unit. So, if one worker is hired and seven units are produced and sold at $15 each, the total revenue is $105. If 10 workers are hired and their 148 units of total output sell for $15 each, then total revenue is $2,220. The calculation is the same for any level of output in the table. Total revenue is shown in column eight of Figure 5.6.

    Marginal Revenue

    The most important measure of revenue is marginal revenue, the extra revenue a business receives from the production and sale of one additional unit of output. You can find the marginal revenue in Figure 5.6 by dividing the change in total revenue by the change in total output, or by the marginal product.

    For example, when the business employs five workers, it produces 90 units of output and generates $1,350 of total revenue. If a sixth worker is added, output increases by 20 units and total revenues increase to $1,650. If we divide the change in total revenue ($300) by the marginal product (20), we have marginal revenue of $15.

    As long as every unit of output sells for $15, the marginal revenue earned by the sale of one more unit will always be $15. For this reason, the marginal revenue appears to be constant at $15 for every level of output in Figure 5.6. In reality, this is not always the case, as businesses often find that marginal revenue varies, especially if they sell some of their output at different prices.

     

    Profit Maximization and Break-Even

    What cost advantage does e-commerce offer businesses?

    The fixed costs of building a store are usually much lower, so marginal costs will also be much lower and profits higher.

     

    Profit Maximization

    Suppose the firm in Figure 5.6 wanted to experiment to find the level of output which maximized profits. The business would hire the sixth worker, for example, because the extra output would cost only $4.50 to produce while generating $15 in new revenues. This means that each of the 20 additional units produced would generate $10.50 of profit, increasing total profits from $850 to $1,060.

    Having made a profit with the sixth worker, the business would hire the seventh and eighth workers for the same reason. While the addition of the ninth worker neither adds to nor takes away from total profits, the firm would have no incentive to hire the tenth worker. If it did, it would find that profits would go down, and it would go back to using nine workers.

    Eventually, the profit-maximizing quantity of output—the volume of production where marginal cost and marginal revenue are equal—is reached, as shown in the last column in Figure 5.6. Other levels of output may generate equal profits, but none will be more profitable.

    The firm in Figure 5.6 found this level of output by using trial and error, but it could have saved some time by looking for the level of output, 144 units using nine workers, where marginal cost in column seven is exactly equal to marginal revenue in column nine. This is why we computed the marginal cost and revenue measures in the first place.

    Break-Even Analysis

    Sometimes a firm may not be able to sell enough to maximize its profits right away, so it may want to know how much it must sell just to cover its costs. This is when the firm needs to find its break-even point, the level of production that generates just enough revenue to cover its total operating costs.

    For example, the firm in Figure 5.6 could not cover all its costs if it employed one worker and produced seven units. This is because total costs were $140, while total revenue only amounted to $105. However, if it employed two workers and could sell 20 units, the company would cover all of its costs. The result is that two workers would have to be hired to break even. Or if the number of workers in the first column were in thousands, the break-even point would be more than one but less than two.

    However, the break-even point only tells the firm how much it has to produce to cover its costs. Most businesses want to do more—they want to maximize the amount of profits they can make, not just cover their costs. To do this, they would have to compute their marginal costs and marginal revenues to find the level of output where they were equal.

    Costs and Business Operation

    For reasons largely related to costs, stores are increasingly selling online, making it one of the fastest-growing areas of business today. Stores do this because the overhead, or the fixed costs of operation, on the Internet is so low. Another reason is that a firm does not need as much inventory. And if a business can lower its fixed or variable costs, it also helps its break-even point by lowering the amount of sales it needs to cover its total costs.

    People engaged in e-commerce—an electronic business conducted over the Internet—do not need to spend a large sum of money to rent a building and stock it with inventory. Instead, for just a fraction of the cost of a typical store, the e-commerce business owner can purchase Web access along with an e-commerce software package that provides everything from Web catalog pages to ordering, billing, and accounting software. Then, the owner of the e-commerce business store inserts pictures and descriptions of the products for sale into the software and loads the program.

    When customers visit the “store” on the Web, they see a range of goods for sale. In some cases, the owner has the merchandise in stock; in other cases, the merchant simply forwards the orders to a distribution center that handles the shipping. Either way, the fixed costs of operation are significantly lower than they would be in a typical retail store—and the break-even point of sales is much lower.