Supply
The quantity of a good or service a firm (or multiple firms) is willing and able to produce for a given price in a given time period, ceteris paribus.
While in the real world, suppliers can be households or firms, we will focus on the product market.
This means that the suppliers will be firms that are selling goods or services to consumers.
The Law of Supply: relationship between price and quantity supplied
Law of Supply
There is a direct, positive relationship between price and quantity supplied.
The law of supply originates from the fact that:
- Producers are willing and able to supply more goods when prices rise because higher prices generally lead to higher profit margins and revenues.
- Conversely, when prices fall, producers supply less because profitability decreases per unit of good.
Let's say a firm supplies apples at a price $1$.
- If the price rises to $2$, for example, then they earn more now because they earn $2$ instead of $1$ for each apple!
- This acts as an incentive (encourages them) for them to produce more goods.
Assumptions underlying the Law of Supply (HL Only)
The law of supply is built on two critical assumptions:
- The law of diminishing marginal returns.
- Increasing marginal costs.
Both these concepts explain why firms require higher prices to supply more output.
Distinguishing short-run and long-run in microeconomics
- The short run is a time period during which at least one input is fixed and cannot be adjusted.
- Fixed inputs are resources that remain constant in quantity and quality, such as buildings, factories, and heavy machinery. These inputs cannot be changed quickly to respond to increases in production.
- Variable inputs, contrarily, can be adjusted in the short run. These include labor, raw materials, and tools that can be increased or decreased as needed.
- As long as at least one input remains unchanged, the firm is considered to be operating in the short run.
- The long run is a time period during which all inputs can be adjusted.
- In the long run, firms have the flexibility to expand or reduce all types of inputs, including fixed ones like factory size or machinery.
- In this period, firms can engage in large-scale adjustments such as constructing new facilities, upgrading machinery...
- If all input can be changed, the firm is considered to be operating in the long run.
In the short run, a firm aiming to increase production can hire more workers, but it cannot immediately expand the size of its factory.
However, in the long run, a firm can build additional factories, move to a larger production site, or upgrade to more advanced technology...
The Law of Diminishing Marginal Returns
Law of Diminishing Marginal Returns
As additional units of a variable input (e.g., labour) are added to fixed inputs (e.g., land), the marginal product increases by less and less each time, eventually decreasing.
Marginal Product
The additional output that results from adding one extra unit of a variable input (e.g., labour).
When firms add one more unit of variable input, the marginal product initially increases. This is because:
- Improved resource utilisation: adding variable inputs allows firms to better utilise existing fixed inputs.
- More specialisation: workers can divide tasks more efficiently, leading to higher productivity per unit of input.
In the beginning, more variable input leads to even more output.
However, as more and more of the variable input is added, the marginal product from each extra unit of input eventually starts to decline. This occurs because:
- Overcrowding of resources: as more variable inputs (like labor) are added, workers or machines may become overcrowded, leading to inefficiencies.
- Diminishing coordination efficiency: as the number of inputs increases, it becomes harder to manage and coordinate them effectively, leading to errors, mismanagement, and decreased productivity.
- Resource depletion: adding more variable inputs can overuse or exhaust the fixed resources, reducing their effectiveness.
At a certain point, more and more input leads to smaller and smaller increases in output (marginal product decreases).
ExampleImagine you run a pizza restaurant with two ovens (a fixed input).
- At first, hiring more chefs (a variable input) increases pizza production as tasks are divided efficiently.
- However, after a certain point, adding more chefs leads to overcrowding, and the extra pizzas produced by each additional chef begin to decline.
| Number of Workers (Variable Input) | Total Product (Total numer of Pizzas) | Marginal Product (Additional Pizzas for One Unit Increase in Workers) |
|---|---|---|
| 0 | 0 | 0 |
| 1 | 3 | 3 |
| 2 | 7 | 4 |
| 3 | 10 | 3 |
| 4 | 12 | 2 |
| 5 | 13 | 1 |
- Hiring the first worker increases the number of pizzas by 3, then the next worker increases the number of pizzas by 4.
- This shows how the marginal return (or marginal product) is increasing per worker
- However, after the third worker, the increase in number of pizzas is only 3. Then for the fourth, it is 2 and decreasing so on.
- This could happen due to overcrowding, because there are only two ovens and limited kitchen space where each additional worker adds less and less to the total output.
It is important for other inputs to stay fixed for the law of diminishing marginal returns to hold.
Why do diminishing marginal returns matter for supply?
The law of supply holds true under the underlying assumption that marginal returns are diminishing. This is because:
- As marginal returns diminish, the cost of producing each additional unit rises.
- Therefore, firms must charge higher prices to cover these rising costs and maintain profitability.
- This principle underpins the positive relationship between quantity supplied and price.
Diminishing Marginal Returns affects output (production), while diminishing marginal utility affects consumption. Don’t confuse the two!
Increasing Marginal Costs
Marginal Cost
The cost of producing an additional unit of output
As firms increase production, marginal costs typically rise due to:
- Inefficiencies: as explained earlier, adding more variable inputs leads to less efficient production.
- For every additional unit of output there is more input (higher costs).
- As seen by the law of diminishing marginal returns, for every additional unit of output lesser marginal product (lower return).
- Therefore, the cost per each additional unit of output increases.
- Scarcity of efficient resources: expanding production often requires using less efficient resources.
- For example, a factory might need to pay higher, overtime wages or use older, less efficient machinery to meet higher production targets.
Coming back to the pizza example above, let's say the cost of hiring a worker is USD $12$.
| Number of Workers | Total Pizzas Produced | Pizzas Produced by New Worker (Marginal Product) | Cost to Hire New Worker (USD) | Marginal Cost of Each Additional Pizza (USD) |
|---|---|---|---|---|
| 1 | 3 | 3 | 12 | 4 |
| 2 | 7 | 4 | 12 | 3 |
| 3 | 10 | 3 | 12 | 4 |
| 4 | 12 | 2 | 12 | 6 |
| 5 | 13 | 1 | 12 | 12 |
- Initially, you paid $12$ to hire $1$ worker, and this gave you an output of $3$ pizzas.
- This means that it initially costs $12$ dollars to make 3 pizzas, so on average a pizza cost $4$
- This can be thought of as the Marginal Cost of a Pizza in the beginning (when you have no workers)
Now you have $1$ worker, and you decide to hire the second.
- The second worker also costs you $12$ dollars but they increase the number of pizzas by $4$
- Hence on average, each pizza cost you $3$ dollars
- This can be thought of as the Marginal Cost of Pizza as well, but now when you have one worker
When you consider later in the process when you have $4$ workers, then to hire the $5^{th}$ worker...
- The cost is still $12$ dollars as we assumed but now the number of pizzas made is only $1$
- This means the Marginal Cost of the pizza has increased to $12$ dollars
While Marginal Returns Initially increase and then start diminishing after a certain point, the opposite happens to marginal costs.
- Marginal Costs initially decrease and then eventually start to increase more and more.
- In fact, as shown in the example above, Increasing Marginal Costs can be thought of as a consequence of Decreasing Marginal Returns (see Figure 2 below).
Why does increasing marginal costs matter for supply?
The law of supply holds true under the underlying assumption that marginal costs are increasing. This is because:
- Firms are willing to supply more only if they can charge higher prices to cover their increasing marginal costs.
- This explains the positive relationship between price and quantity supplied.
