Supply Theory and Analysis

Chapter-3: Supply Theory and Analysis
Lecture - 7
- Supply
- shift in supply
- market equilibrium
- consumer surplus
- producer surplus
- changes in market equilibrium
1
Supply and some basic concepts:
Supply: Supply is the quantity of a good
or service that offered for sale in a
market during a given period of time
which is called quantity supplied and
denoted as Qs.
The time frame might be an hour, a day,
a month, or a year or so…
2
The amount of good or service offered
for sale depends on an extremely large
number of variables.
As in the case of demand, economists
ignore all the relatively unimportant
variables in order to concentrate on
those variables that have the greatest
effect on quantity supplied.
The major variables are… 3
Supply depends on…
- the price of the good it self
- price of input used to produced it
- prices of goods related in production
- level of available technology
- producer expectations of future price
- number of firms / productive capacity
4
The general supply function:
The general supply function show how
all six of the variables jointly determine
the quantity supplied an expresses as…
Qs = f(P, Pi, Pr, T, Pe, F)
Quantity of supply depends not only on
the price of the product but also some
other factors…
5
i. Higher the price of a product greater
the supply of the product, there is a
positive relation between price and
supply quantity.
ii. An increase in price of one or more of
the inputs increases the production cost,
as cost rises, goods become less profitable
and producers will want to supply less
quantity at each price. 6
iii. Changes is the price of goods that are
related in production may affect either
ways depending on whether the good is
substitutes (wheat/corn) or complements
(Oil field crude oil and by product gas).
iv. Better the technology, increasing the
productivity, reducing cost, increasing
profits allowing the producers to supply
more remaining all other things same. 7
v. If the suppliers expects that price of
goods they produce will rise in future,
they will withheld and reduce current
supply hoping to catch higher revenue in
the future.
vi. As more number of firms in the
industry, the productive capacity of the
industry increases thereby supplying
more at the same price. 8
As in the case of demand, economists
often find it useful to express the general
supply function in linear form
Qs = h + kP + lPi + mPr + nT + rPe +sF
Where, Qs, P, Pi, Pr, T, Pe, F defined
earlier and h is an intercept parameter, k,
l, m, n, r, and s are the slope parameters.
The summary of the discussion shown…
9
Variable Relation to Qty Slope parameters
Supplied
P (Price) Direct k = ∆Qs / ∆P is positive
Pi (Input price) Inverse l = ∆Qs / ∆Pi is negative
Pr (Price related Inverse for m = ∆Qs / ∆Pr is negative

goods) substitute
Pr (Price related Direct for m = ∆Qs / ∆Pr is positive
goods) complements
T (technology) Direct n = ∆Qs / ∆T is positive
Pe (Expected price) Inverse r = ∆Qs / ∆Pe is negative
F (Number of Direct s = ∆Qs / ∆F is positive

firms) 10
Direct Supply Function:
Just as demand functions are derived
from the general demand function, direct
supply functions are derived from the
general supply function.
Holding other determinants of supply
(Pi, Pr, T, Pe, F) constant, quantity of
supply is a direct function price
Qs = f(P) 11
Supply schedule:
Price Supply
140 2400
120 2000
100 1600
80 1200
60 800
40 400
20 0
12
Price
Price
160
140 2400, 140
Price of goods
120 2000, 120

100 1600, 100
80 1200, 80
60 800, 60
40 400, 40
20 0, 20
0
0 500 1000 1500 2000 2500 3000
Quanity supplied
13
Qs = 100 + 20P – 10Pi + 20F
Suppose price of important input is 100,
and 25 firms producing the good
Therefore,
Qs = 100 + 20P – 10x100 + 20x25
= - 400 + 20P
For example, price is 40, Qs = 400
but if price is 100, Qs = 1600 14
Relation:
For a supply function Qs = f(P), a change
in price causes a change in quantity
supplied. The other variables that affect
supply in the general supply function (Pi,
Pr, T, Pe, F) are fixed in value for any
particular supply function.
On the graph a change in price causes a
movement along a supply curve from one
price to another price. 15
Shifts in Supply:
A shift in supply occurs only when one of
the six determinants other than price (eg.
Pi, Pr, T, Pe, F) is allowed to change.
1. Increase in supply: A change in the
supply function that causes on the
increase in quantity supplied at every
price and is reflected by a rightward
shift in the supply curve. 16
2. Decrease in Supply: A change in the
supply function that causes a decrease in
quantity supplied in every price and is
reflected by a leftward shift in the supply
curve.
An increase in supply means that at each
price, more of the goods is supplied; a
decrease in supply means that at each
price less of the goods is supplied. 17
Different Supply at same price:
Price Supply 1 Supply 2 Supply 3

140 2400 2800 2100
120 2000 2400 1700
100 1600 2000 1300
80 1200 1600 900
60 800 1200 500
40 400 800 100
20 0 400 0 18
Shifts in Supply
S’ S
s S’
Price Price
Price Price
Q Q
Q’ Q Q’ 0’ Q 0’ Q
Increase in Supply Decrease in Supply
19
Determinants of Supply Supply Supply Sign of
increases decreases slop
Price if input (Pi) Pi falls Pi rises i<0

Price of goods related in Pr falls Pr rises m<0
production (Pr) substitute
Price of goods related in Pr rises Pr falls m>0

production (Pr) complement
State of technology (T) T rises T falls n>0

Expected price (Pe) Pe falls Pe rises r<0
Number of firms in the industry F rises F falls s>0
(F) 20
Supply changes or shifts when one of the
determinants of supply changes.
These determinants of supply are the
price of inputs, the price of goods related
in production, the state of technology, the
expected prices in the future, and the
number of firms or amount of productive
capacity in the industry.
21
Market Equilibrium:
Demand & supply provide an analytical
framework for the analysis of the
behavior of buyers & sellers in markets.
Demand shows how buyers respond to
changes in prices and other variables
that determines quantities buyers will be
willing and able to purchase.
22
Supply shows how sellers respond to
changes in price and other variables that
determine quantities offered for sale.
The interaction of buyers & sellers in the
marketplace leads to market equilibrium.
Market equilibrium is a situation in
which at prevailing price, consumer can
buy of a good they wish and producers
can sell all of the goods they wish. 23
In other words, equilibrium occurs when
prices is a the level for which quantity
demanded equals quantity supplied.
In equilibrium, the price is called
equilibrium price, and the quantity sold
is called equilibrium quantity.
When Qd = Qs
Qd = - 400 + 20P and Qs =1400 - 10P
24
Market Equilibrium
Qs – Qd
– excess supply
Price Qs = -400+20P Qd = 1400-10P + excess demand
140 2400 0 2400

120 2000 200 1800
100 1600 400 1200
80 1200 600 600
60 800 800 0
40 400 1000 -600
20 0 1200 -1200
25
Excess Supply:
Surplus exists when quantity supplied
exceeds quantity demanded because more
sellers are interested to sell as there is higher
price.
Excess Demand:
Shortage exists when quantity demanded
exceeds quantity supplied because more
buyers are interested to buy as there is lower
price. 26
Market Clearing price:
The price of a good at when buyers can
purchase all they want and sellers can
sell all they want at the equilibrium price
Because of this clearing of the market,
equilibrium price is sometimes called the
market clearing price. Qd = Qs
1400 – 10P = - 400 + 20P
Therefore, P = 60, Qd = 800, Qs = 800.
27
Equilibrium Price and Quantity
Price
140
Surplus
600 unit
100
Supply
E
60 Shortage
600 unit
Demand
20
400 800 1200

28
Quantity (Qd and Qs)
When the current price is above the
equilibrium price, quantity supplied
exceeds quantity demanded.
The resulting excess supply induces
sellers to reduce price in order to sell.
If the current price is below the
equilibrium price, quantity demanded
exceeds quantity supplied.
29
The resulting excess demand causes the
unsatisfied consumers to bid up price.
Since prices below equilibrium are bid
up by consumers and prices above
equilibrium are lowered by producers,
the market will converge to the
equilibrium price-quantity combination.
Both excess demand and excess supply
are zero in equilibrium. 30
Consumer Surplus:
The difference between the economic
value of a good (its demand price) and
the market price the consumer must pay.
The economic value of a unit is simply the
maximum amount some buyer is willing to
pay for the unit.
Economic value = demand price =
maximum amount buyers willing to pay 31
Price
140 u
Consume
r surplus
r
100
Supply
v s a
60
Demand
20
400 800 1200

32
At quantity 400, the area for consumer
surplus is uvsr (below the demand curve
and above the equilibrium price)
uvsr is trapezoid & one way to compute
multiply the length from base (vs) by
average distance of two sides (uv and rs).
Area uvsr = 400 x (($80 + $40)/2) = $2400
The total consumer surplus when 400
units are purchased is $2400 33
At quantity 800, the area for consumer
surplus is uva (below the demand curve
and above the equilibrium price).
Area of the triangle is (0.5 x 800 x $80) =
$ 32,000.
Net gain of all consumer who voluntarily
buy 800 units from producers at $60 per
unit is $ 32,000. (below the demand line
above the equilibrium price) 34
Producer Surplus:
For each unit supplied, the difference
between market price and the minimum
price producers would accept to supply
the unit (its supply price).
Using the same unit as 400 and 800 the
producer surplus are area vwts and avw.
For 400 units the producer surplus vwts
= 400 x ($40 +$20)/2 = $12,000
35
Price
140 u
r Producers
100
Surplus
Supply
v s a
60
t
Demand
20
w
400 800 1200

36
Let us measure the producer surplus in
market equilibrium. At point a, total
producers surplus wva = 0.5 x 800 x $40
= $16,000.
By doing business in this market,
producers experience net gain of $
16,000. (above the supply line and below
the equilibrium price)
37
Changes in Market Equilibrium:
If demand and supply never changed,
equilibrium price and quantity would
remain the same forever or for a very
long time, and market analysis would be
extremely uninteresting and totally useless
for mangers.
However, demand and supply may
change in either directions, lets see… 38
Changes in demand (supply constant)
Price S
E’
P’
E
P E’ D’
P’
D
D’
Q’ Q Q’ Quantity
39
Changes in supply (demand constant)
Price S’
S
S’
E’
P’ E
P E’
P’
D
40
Changes both in supply and demand
Price S’
S
S’
E
P
D’
D’
Q Quantity
41
Both demand and supply increases
Price S
S’
S’’
E’
P’ E E’’
P
D’
Q Q’ Quantity
Price may rise or fall but quantity rises 42
Demand decreases and supply increases
Price S
S’
S’’
E
P
P’ D
P’’ D’
Price falls but quantity may rise or fall 43
Demand increases supply decreases
S’’
Price S’
S
P’
E
P
D’
Price rises quantity may rise or fall 44
Demand decreases supply decreases
S’’ S’
Price S
P’ E
P
P’
D
D’
Q’ Q’ Q Quantity
Price may rise or fall, quantity falls 45
Thank you!
46

Supply Theory and Analysis

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Supply Theory and Analysis

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Chapter-3: Supply Theory and Analysis

Pi (Input price) Inverse l = ∆Qs / ∆Pi is negative

Pr (Price related Inverse for m = ∆Qs / ∆Pr is negative

Pe (Expected price) Inverse r = ∆Qs / ∆Pe is negative

F (Number of Direct s = ∆Qs / ∆F is positive

120 2000, 120

Price Supply 1 Supply 2 Supply 3

Price if input (Pi) Pi falls Pi rises i<0

Price of goods related in Pr rises Pr falls m>0

State of technology (T) T rises T falls n>0

140 2400 0 2400

400 800 1200

400 800 1200

Quantity (Qd and Qs)

400 800 1200

Quantity (Qd and Qs)

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