Supply: Competitive Market

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In a previous column, it was shown that demand for a single product in a competitive market, where there are many consumers or buyers, is a schedule in which the lower the price the larger the quantity purchased. What about the supply — or sellers — side of the same market? The market supply is the sum of all the sellers in that market and each seller’s supply is rooted in production analysis that need not detain us here. A common proposition is that the higher the price, the larger the quantity that sellers are willing to provide. This applies to any commodity sold on a competitive market. Table 1 below provides a hypothetical relation between price of milk and the quantity of milk supplied, called a supply schedule.

Table 1

The Market supply of Milk

Point

Price of Milk

(Dollars per Gallon)

Quantity of Milk Supplied

(Millions of Gallons)

A

$1

10

B

$2

20

C

$3

30

Points A, B and C show three price-quantity combinations in the table. It shows a direct relation between the price and the quantity suppled: the higher the price, the greater the quantity supplied as sellers are willing to part with a greater quantity of the product. If we allow enough time for adjustment, the increase in quantity as the price rises can be even greater. This is because farmers can increase the size of their herds in the case of milk or the size of their plantations in the case of apples. Readers that are comfortable with geometric setting can draw the table on a two-dimensional graph where price is shown on the vertical axis — by tradition — and quantity on the horizontal axis. The outcome will show a curve sloping upward and to the right, known as a supply curve or schedule.

As in the case of demand analysis, the most important analysis in case of supply is the distinction between movement along the supply schedule and shift in the entire schedule. Movement along the schedule shows by how much the quantity supplied increases (decreases) for a given increase or decrease in the commodity’s own price. A shift in the schedule shows how much the quantity supplied increases or decreases at each price. An increase in supply means a rise in quantity at each price, and a decrease in supply shows a decline in quantity. A hypothetical increase in supply is shown in Table 2.

Table 2

An Increase in the Supply of Milk

Point

Price of Milk

(Dollars per Gallon)

Quantity of Milk Supplied

(millions of Gallons)

A-1

$1

20

B-1

$2

30

C-1

$3

40

 

What might cause a change in the supply schedule of any commodity?

Improvement in Technology: In the case of milk, it may be a more productive way of raising cows; in the case of oil production, it may be an improved drilling technology; in the case of machinery, it may be new lubricating methods, and so on. These factors have the effect of reducing production costs of the commodity supplied and inducing sellers to increase the quantity supplied at every price. Given enough time it may also induce new firms, whose production costs were too high before, to come into the business and further increase supply. That is, in fact, how an industry expands.

Changes in the prices of a productive factor (inputs): Suppose farm wage rates decline because of the availability of new migrant labor. Then production becomes profitable at lower prices and that would raise the quantity offered at current prices. Conversely, if the cost of labor rises, say because a renegotiated union contract, supply declines. The same applies to the cost of all factors of production: wages (labor), rent (land and natural resources), interest (capital) and profit (enterprise). Anything that reduces (raises) production costs through either productivity advance or reduction of pay increases (decreases) supply. Another way of looking at this: A cost reduction makes it possible to offer the current level of supply at a lower price, so greater supply can be offered at a higher price.

Supply can expand or shrink in the long run more than in the short run, because production facilities (e.g. farms, factories) are fixed in the short run and only the intensity of their utilization can change in either direction; whereas, in the long run, the size of the facilities themselves can change in either direction, and companies can enter or leave the industry.

Changes in Prices of Other Goods

Suppose a manufacturer could use his production equipment to produce tennis balls or racquet balls. The two types of balls are different and serve different games. But they are substitutes in production, in the sense that output of one can be expanded at the expense of the other by switching production equipment to it. The production of our primary interest is racquet balls. A rise in the price of tennis balls would induce producers to switch facilities from racquet ball to tennis ball production. At any given price of racquet balls, fewer of them would be supplied. The supply of racquet balls would decrease.

The analysis above illustrates a relation between two goods that are substitutes in production: The production of one can be expanded at the expense of the other. In contrast, products can be complementary in production, in the sense that they are produced jointly. For example, beef and liver are produced jointly and in fixed proportions. Suppose that liver is the commodity of our primary interest, and there has been a rise in the price of beef. More beef would be produced. But as a direct consequence, there would be an increase in the supply of liver: At any given price of liver, a greater quantity of it would be supplied.

In sum, when two goods are substitutes in production, a rise (decline) in the price of one reduces (increases) the supply of the other; when two goods are complements in production (produced jointly), a rise (decline) in the price of one increases (decreases) the supply of the other.

Addendum to last months column: Last month’s column dealt with the four types of industry structures. I would like to add a sub-category of oligopoly called duopoly. It is a two firm industry. The example often cited is the production of large jet-passenger planes by Boeing Co. of the U.S. and the European Airbus of four European countries combined. The conventional wisdom is that the world market cannot support more than two such companies.

 

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Mordechai E. Kreinin

Mordechai E. Kreinin

Mordechai Kreinin is a University Distinguished Professor of Economics, emeritus at Michigan State University and past President of the International Trade and Finance Association. He is the author of about 200 articles and books about economics, including the widely used text, International Economics. He can be reached at kreinin@msu.edu or by cell phone at (517) 488-4837

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