CHAPTER 2 –THEORY OF DEMAND AND SUPPLY

UNIT III - SUPPLY

MEANING:

• It refers to what a firm offer for sale in the market, not necessarily to what they succeed in selling.
• It is a flow concept as it can be identified for a specific time period.
• It is ‘so much’ per unit of time, per day, per week or per year.
• It refers to amount of commodity that firms are able and willing to offer for sale in the market in a given
period of time and at a given price.

DETERMINANTS OF SUPPLY:

1. PRICE OF THE GOOD: Other things being equal, higher the price of a good the greater the quantity of it
that will be supplied.

2. PRICE OF RELATED GOODS: If the price of other goods rise, they become relatively more profitable to the
firm to produce and sell than good in question. Example, if price of wheat rises the farmers may shift their
land to wheat production away from corn and soya beans.

3. PRICE OF FACTORS OF PRODUCTION :A rise in price of factor of production leads to increase in cost of
producing good and leading to less profit thus reducing supply and vice versa.

4. STATE OF TECHNOLOGY: The use of new technology in an industry (such as automation) increases
production efficiency and reduces production cost. Thus innovations and inventions tend to make it
possible to produce more and better goods with same resources. Thus with such advancements it
becomes easy to increase the supply.

5. GOVERNMENT POLICIES :It comprises of two aspects :

(a) Taxation: The government imposes taxes such as excise duty, sales tax and import duties. These taxes
raises the cost of production and thus reduces the supply.

(b) Subsidies: They are the incentives and funding done by the government and thus reduces the cost of
production and thus provide an incentive to the firm to increase supply.

6. NATURE OF COMPETITION AND SIZE OF INDUSTRY: Under competitive conditions, supply will be more
that of monopolised conditions.

7. EXPECTATIONS: Expectations of future prices is of great consideration as sellers compare current prices
with future prices. An increase in anticipated future price of goods or service reduces its supply today and
if sellers expect a fall in price in future, more will be supplied now.

8. NUMBER OF SELLERS: If there are large number of firms in market supply will be more and vice versa.
THE LAW OF SUPPLY:

It states that as ‘Other things remain constant, the quantity of goods produced and offered for sale will
increase as price of good rises and decrease as price falls’.

SUPPLY SCHEDULE:
It is a tabular presentation of the law of supply. It shows the different prices of a commodity and the
corresponding quantities that suppliers are willing to offer for sale, with all other variables to be held
constant.

Example:
Supply Schedule of Good X:

Price(Rs.) Quantity
(Per Kg.) Supplied(Kg.)
1 5
2 35
3 45
4 55
5 65

SUPPLY CURVE:
The graphical presentation of the supply schedule showing quantity of a good producer are willing to sell
at a given price is called as Supply Curve.

MOVEMENT ON SUPPLY CURVE –INCREASE OR DECREASE IN THE QUANTITY SUPPLIED

It is bifurcated into two parts:
 (a) Extension of Supply :
• When the supply of good increase as a result of an increase in its price it is said to be increase
in quantity supplied.
• It leads to upward movement along the same supply curve.

(b) Contraction of Supply:

• When the supply of good decrease as a result of a decrease in its price it is said h
• It leads to downward movement along the same supply curve.

SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY

(a) Increase in Supply :
• When the supply increases due to factor other than price, keeping prices as constant is known as Increase
in Supply.
• It leads to rightward shift to a new supply curve.
• It can be caused because of advanced technology, more subsidies, less taxes, etc.
 (b) Decrease in Supply :
• When the supply decreases due to factor other than price, keeping prices as constant is known as
Decrease in Supply.
• It leads to leftward shift to a new supply curve.
• It can be caused because of obsolete technology, less subsidies, more taxes, etc.

ELASTICITY OF SUPPLY:

The elasticity of supply is defined as responsiveness of the quantity supplied of a good to a change in its price.
It is measured by dividing the percentage change in quantity supplied of a good by percentage change in its
price, i.e.,

Es = Percentage Change in quantity supplied

Percentage Change in Price

Or

△𝑄𝑄 𝑃𝑃
Es = △𝑃𝑃 𝑥𝑥 𝑄𝑄

DEGREES OF PRICE ELASTICITY OF SUPPLY:

1. Perfectly Elastic Supply
2. Perfectly Inelastic Supply
3. Unitary Elastic Supply
4. More than unitary elastic Supply
5. Less than unitary elastic Supply
1. Perfectly Elastic Supply:
(a) When the supply curve becomes zero with the slight rise in the price of commodity or when the supply is
infinite at the given price, it is called as perfectly elastic supply.
(b) This curve is horizontal curve parallel to the x-axis.
(c) Hence the coefficient of elasticity of supply would be equal to infinity.
(d) It is an imaginary situation.

2. Relatively or Highly Elastic Supply:

(a) When the proportionate or percentage change in the quantity supplied is greater than the
proportionate or percentage change in price, it is called as elastic or relatively elastic supply.
(b) Hence elasticity of supply is greater than one, i.e. Es>1.
(c) Example: If the percentage change in quantity supplied is 30% while percentage change in price is
25% then it is case of elastic supply.

3. Unitary Elasticity of Supply

(a) When the proportionate change in quantity supplied and the proportionate change in price are equal
it is termed as unitary elastic supply.
(b) It is denoted by Es=1.
(c) Example: Percentage change in price =20% and Percentage change in quantity = 20%.
4. Perfectly Inelastic Supply
(a) When there is no change in the quantity supplied with the change in the price.
(b) Its supply curve is vertical curve parallel to Y- Axis.
(c) Example: When price is Rs. 2, supply is 4 units and when price rises to Rs. 4 still the supply remains
constant at 4 units.

5. Less Than Unitary Elastic Supply (Es<1)

(a) When the proportionate percentage change in quantity supplied is less than proportionate
percentage change in price.
(b) For example: Due to decrease in price by 40% the supply increases by 10%.
 DETERMINANTS OF ELASTICITY OF SUPPLY:

1. If increase in production causes substantial increase in cost, producers will have less incentive to
increase quantity supplied in response to increase in price and therefore price elasticity of supply will
be less.
2. Production that involve more complex production process or require relatively longer time to produce
have low elasticity of supply.
3. The longer the time period the more responsive the quantity supplied to change in price and greater
the supply elasticity.
4. Supply is more elastic when there is large number of producers and there is high degree of competition
among them.
5. The greater the spare capacity with the firm the elasticity of supply will be greater as firms can increase
output without rise in cost.
6. If raw materials and inputs are easily available then supply will be elastic. If it is difficult to procure
resources economically the cost of production increases and supply will become less elastic.
7. If firms have adequate stock of raw material, components and finished products they will be able to
respond with higher supply as price rises.
8. If the factor of production are easily mobile then the elasticity of product is higher than that in the case
where factors of production are not mobile.

EQUILIBRIUM PRICE

• The equilibrium price in market is determined by the intersection between demand and supply.
• It is also called Market Equilibrium.
• At this price, the amount that buyer wants to buy is equal to amount that sellers want to sell.
• Equilibrium price is also called market clearing price.
• The determination of market price is central theme of micro economic analysis.
• Hence micro economic theory is called as Price Theory.
• Following table shows the concept of equilibrium as under :

Price(Rs.) Quantity Demanded Quantity Supplied Impact on Price

5 6 31 Downward
4 12 25 Downward
3 19 19 Equilibrium
2 25 12 Upward
1 31 6 Upward

• The equilibrium between demand and supply is depicted in the diagram below. The equilibrium
is reached at Price = Rs.3 where demand and supply is equal to 19 units. If the price is more than
the equilibrium level, excess supply will push the price downwards as there are few takers in the
market at this price. There will be excess supply in the market which will force the sellers to reduce
price if they want to sell off their product .Hence the price will fall and continue falling till it
reaches the level where quantity demanded becomes equal to quantity supplied. Opposite will
happen when quantity demanded is more than quantity supplied at a particular price.
MARKET EQUILIBRIUM AND SOCIAL EFFICIENCY:

• Social efficiency represents the net gains to society from all exchanges that are made in particular market.
• It consist of two components: Consumer Surplus and Producer Surplus.
• Producer Surplus is the benefit derived by producers from the sale of a unit above and beyond their cost of
producing that unit. This occurs when the price they receive in the market is more than the minimum price
at which they would be prepared to supply. It is represented by the area above the supply curve and below
the price line.
• Consumer Surplus is a measure of Consumer welfare.
• For all quantities below OQ, we find there is a difference between the price that producers are willing to
accept the supplying the goods and price that prevails in the market (P).
• Producer Surplus disappears when market price is at equilibrium i.e. price at which sellers are willing to
offer for sale is equal to price that they receive.
• At Price P when the market is in equilibrium social efficiency is achieved with both producers and consumers
enjoying maximum possible surplus.