The Law of Supply, and What Shifts It

Law of Sup­ply

The law of sup­ply is a basic eco­nomic con­cept. It states that an increase in the price of goods or ser­vices results in an increase in their sup­ply. Sup­ply is defined as the quan­tity of goods or ser­vices that sup­pli­ers are will­ing and able to pro­vide to cus­tomers. The law works like this: Ris­ing prices mean that prod­ucts become more prof­itable, assum­ing other fac­tors such as pro­duc­tion costs remain con­stant. The prospect of higher prof­its there­fore moti­vates busi­nesses to sup­ply more of these prod­ucts. Exist­ing sup­pli­ers may increase the sup­ply of more prof­itable prod­ucts at the expense of less prof­itable ones. In addi­tion, new sup­pli­ers may enter the mar­ket, fur­ther increas­ing the over­all sup­ply.

Con­sider the exam­ple of a pizze­ria that sells pasta dishes as well as piz­zas. If the price of pizza rises, and with it the profit per pie, the busi­ness may focus its resources on increas­ing the pro­duc­tion of pizza — while decreas­ing the pro­duc­tion of pasta offer­ings. As the price keeps ris­ing, the pizze­ria con­tin­ues to increase the pizza sup­ply because it can increase its prof­its by doing so. This rela­tion­ship can be rep­re­sented graph­i­cally as a sup­ply curve, which shows the num­ber of piz­zas pro­duced at dif­fer­ent prices.

As prices and out­put con­tinue to increase, the sup­plier even­tu­ally reaches the max­i­mum quan­tity that it can pro­vide with its exist­ing equip­ment — it can't make any more piz­zas because its ovens are already full at all times. The pizze­ria may then decide to invest in an addi­tional pizza oven to increase its sup­ply. Mean­while, other entre­pre­neurs estab­lish new pizze­rias because the higher prices jus­tify the startup costs. This fur­ther increases the mar­ket sup­ply.

The law of sup­ply applies to ser­vices and labor as well as goods — a higher price can increase the sup­ply. For exam­ple, employ­ees may be more likely to work over­time if they're paid at a higher hourly rate. Pro­fes­sions that offer rel­a­tively high salaries, such as soft­ware engi­neer­ing, may attract more peo­ple to edu­ca­tional pro­grams that ulti­mately increase the sup­ply of qual­i­fied job appli­cants.

In prac­tice, prices are often deter­mined by the rela­tion­ship between sup­ply and demand. A related eco­nomic the­ory, the law of sup­ply and demand, describes how this works. Ris­ing demand for prod­ucts and ser­vices tends to drive up prices. This pro­vides an incen­tive for providers to increase the sup­ply. How­ever, as the price of those prod­ucts and ser­vices con­tin­ues to rise, fewer cus­tomers will buy them. The law of sup­ply and demand pre­dicts that as a result, free mar­kets move toward an equi­lib­rium point where the price and quan­tity of the sup­ply exactly matches cus­tomer demand.

Fac­tors that affect sup­ply

The law of sup­ply pre­dicts that ris­ing prices result in increases in the sup­ply of goods or ser­vices — but that's assum­ing all other fac­tors remain con­stant. In real­ity, many other fac­tors can affect sup­ply, and those fac­tors can change fre­quently. Here are 10 of the most com­mon.

• Price and demand fore­casts

Many busi­nesses base their pro­duc­tion plans on fore­casts of future demand and pric­ing, not just on what cus­tomers are cur­rently buy­ing. Enter­prise resource plan­ning soft­ware can help busi­nesses improve demand fore­casts by con­sid­er­ing fac­tors such as eco­nomic growth and sea­son­al­ity. Fur­ther­more, if a pro­duc­t's price is expected to increase, busi­nesses may hold back stock so they can make a larger profit in the future.

• Pro­duc­tion costs

The law of sup­ply assumes that com­pa­nies can increase prof­its by sell­ing more goods or ser­vices when prices rise, which pro­vides them with an incen­tive to increase the sup­ply. But if the price rises reflect increased pro­duc­tion costs, that may not be true. If a pizze­ria raises the price of a slice by 50 cents because the cost of the toma­toes used in the sauce went up by 50 cents, its profit is unchanged — so the price increase does­n't rep­re­sent an incen­tive to make more piz­zas. On the other hand, if pro­duc­tion costs fall and prices remain sta­ble, prof­its increase and so does the incen­tive to sup­ply more piz­zas.

• Com­pe­ti­tion

New sup­pli­ers may enter the mar­ket even if prices are not increas­ing and demand is sta­ble. Often, these new sup­pli­ers aim to offer prod­ucts at lower prices than exist­ing providers.

• Tech­nol­ogy

Tech­nol­ogy can enable com­pa­nies to make and sell more prod­ucts at a lower cost, thus increas­ing the avail­able sup­ply.

• Trans­porta­tion

Trans­porta­tion delays or ris­ing ship­ping costs can affect a com­pa­ny's abil­ity to increase its sup­ply of goods. If goods can't move from ware­houses to retail shelves, they can't be pur­chased by cus­tomers and don't count toward the mar­ket sup­ply.

• Avail­abil­ity of raw mate­ri­als and labor

A busi­ness may want to increase the sup­ply of a prod­uct but unable to do so because it can't pur­chase the raw mate­ri­als or hire the peo­ple required to pro­duce it.

• Gov­ern­ment reg­u­la­tions and sub­si­dies influ­ence sup­ply in some indus­tries

Com­pa­nies must meet strict reg­u­la­tory require­ments when intro­duc­ing cer­tain health­care prod­ucts, for exam­ple, which can limit the sup­ply of these prod­ucts regard­less of the demand. On the other hand, gov­ern­ment sub­si­dies sup­port the sup­ply of some local trans­porta­tion ser­vices.

• Weather and nat­ural dis­as­ters

For many agri­cul­tural goods, the weather has a major impact on sup­ply. A dry sea­son or flood­ing can greatly reduce crop yields.

• Com­pa­ra­ble goods

A change in the sup­ply of one good can affect the sup­ply of other goods. For exam­ple, if the mar­ket price of corn increases, farm­ers may ded­i­cate more land to grow­ing corn. As a result, they use less land for grow­ing squash, so the sup­ply of squash decreases.

• Busi­ness objec­tives

Com­pa­nies may adjust the sup­ply of prod­ucts to achieve spe­cific objec­tives. For exam­ple, some busi­nesses intro­duce lim­ited-edi­tion col­lectibles in small quan­ti­ties to increase their desir­abil­ity and value. At the other extreme, com­pa­nies some­times sup­ply prod­ucts in large quan­ti­ties to build mar­ket pres­ence and brand aware­ness, even if increas­ing the sup­ply does­n't gen­er­ate higher prof­its.

Types of Law of Sup­ply

There are five types of sup­ply — mar­ket sup­ply, joint sup­ply, com­pos­ite sup­ply, short-run sup­ply and long-run sup­ply. Here's how to dis­tin­guish them.

• Mar­ket sup­ply

The mar­ket sup­ply is the total sup­ply from all pro­duc­ers. If a town has three pizze­rias that pro­duce 30, 40, and 25 pies a day, respec­tively, at $20 apiece, the mar­ket sup­ply at the $20 price level is 95 pies a day.

• Joint sup­ply

Joint sup­ply occurs when mul­ti­ple goods are pro­duced from a sin­gle source. For exam­ple, cows can be used to pro­duce milk as well as leather.

• Com­pos­ite sup­ply

Com­pos­ite sup­ply occurs when goods are intrin­si­cally linked and sold only as a bun­dle. For exam­ple, a car man­u­fac­turer typ­i­cally offers air con­di­tion­ing and audio sys­tems only as part of a bun­dled pack­age with the pur­chase of a new vehi­cle.

• Short-run sup­ply

Short-run sup­ply is the total sup­ply that com­pa­nies can pro­vide with­out addi­tional invest­ment in busi­ness expan­sion. It's also known as short-term sup­ply.

• Long-run sup­ply

Long-run sup­ply, also known as long-term sup­ply, includes fac­tors such as sup­pli­ers' invest­ment in new pro­duc­tion capac­ity. It also con­sid­ers that new sup­pli­ers may enter the mar­ket while older firms exit.

Excep­tions to Law of Sup­ply

Not every busi­ness sce­nario is deter­mined by the law of sup­ply. There are many excep­tions — sit­u­a­tions where the sup­ply of goods and ser­vices isn't deter­mined by the pric­ing.

• Economies of scale (EOS)

When a pro­ducer becomes large enough, it may be able to apply economies of scale to reduce the cost of pro­duc­ing goods and ser­vices. As a result, it may be able to increase its sup­ply while keep­ing prices sta­ble or even reduc­ing them.

• Shift in busi­ness plan (BP)

If a busi­ness is shift­ing its mar­ket focus and plans to cease pro­duc­tion of some prod­ucts, it may tem­porar­ily increase the sup­ply of those prod­ucts at a low price to elim­i­nate any remain­ing stock and raw mate­ri­als. A busi­ness may also use this approach as an emer­gency mea­sure if it needs cash in a hurry.

• Monop­oly

When there's only a sin­gle sup­plier of a good or ser­vice, the com­pany may be able to increase or decrease its sup­ply or pric­ing irre­spec­tive of exter­nal fac­tors.

• Com­pet­i­tive pric­ing

In a highly com­pet­i­tive mar­ket, busi­nesses may increase the sup­ply of their prod­ucts while reduc­ing the price to cap­ture mar­ket share.

• Expir­ing or dated goods

If per­ish­able goods near their expi­ra­tion date, a busi­ness may increase their sup­ply early to try to recoup some of the pro­duc­tion costs before the goods become unsellable.

• One-of-a-kind goods

Hand­made art or other rare goods can­not be eas­ily repro­duced, so the sup­ply can­not expand even if the price rises.

• Inelas­tic sup­ply

For many goods, includ­ing agri­cul­tural prod­ucts, it is dif­fi­cult to quickly adjust the sup­ply even if the price rises. It can take months or even years for crops to reach matu­rity and become avail­able to cus­tomers. For exam­ple, an apple farmer who adds trees to their orchard won't be able to har­vest the fruit for sev­eral years.

Sup­ply Elas­tic­ity

There are five types of elas­tic­ity of sup­ply(ES).

1. Rel­a­tively elas­tic sup­ply

The co-effi­cient of elas­tic sup­ply is greater than 1(Es > 1). One per­cent change in the price of a com­mod­ity causes more than one per cent change in the quan­tity sup­plied of the com­mod­ity.

2. Uni­tary elas­tic sup­ply

The coef­fi­cient of elas­tic sup­ply is equal to 1 (Es = 1). One per­cent change in the price of a com­mod­ity causes an equal ( one per cent) change in the quan­tity sup­plied of the com­mod­ity.

3. Rel­a­tively inelas­tic sup­ply

The coef­fi­cient of elas­tic­ity is less than one (Es < 1). One per­cent change in the price of a com­mod­ity causes a less than one per cent change in the quan­tity sup­plied of the com­mod­ity.

4. Per­fectly inelas­tic sup­ply

The coef­fi­cient of elas­tic­ity is equal to zero (Es = 0). One per­cent change in the price of a com­mod­ity causes no change in the quan­tity sup­plied of the com­mod­ity.

5. Per­fectly elas­tic sup­ply

The coef­fi­cient of elas­tic­ity of sup­ply is infin­ity. (Es = α ). One per­cent change in the price of a com­mod­ity causes an infi­nite change in the quan­tity sup­plied of the com­mod­ity.

Deter­mi­nants of Elas­tic­ity of Sup­ply

Mar­ginal Cost(MC)- As the cost of pro­duc­ing one more unit is ris­ing with out­put or Mar­ginal Costs (which are the increased costs related to each addi­tional unit pro­duced) are ris­ing rapidly with out­put, then the rate of out­put pro­duc­tion will be lim­ited, i.e Price Elas­tic­ity of Sup­ply will be inelas­tic., which means that the per­cent­age of quan­tity sup­plied changes less than the change in price. How­ever, if Mar­ginal Cost rises slowly, then Sup­ply will be elas­tic.

Time- As the price elas­tic­ity of sup­ply increases over time, pro­duc­ers would increase the quan­tity sup­plied by a greater per­cent­age than the price increases.

Num­ber of Firms- It is more likely that the sup­ply will be elas­tic when there are a large num­ber of firms. This occurs because other firms can step in to fill the sup­ply gap.

Mobil­ity of Fac­tors of Pro­duc­tion- When the fac­tors of pro­duc­tion are mobile, then the price elas­tic­i­ties of sup­ply are higher. This means that labor and other man­u­fac­tur­ing inputs may be imported from other regions to quickly increase pro­duc­tion.