Chapter 3: Understanding Supply
Chapter 3: Understanding the Five Factors of Supply
Supply Curve Shift: Definition and Direction
Supply Curve Shift: A movement of the entire supply curve. This occurs when factors other than the product's own price change, leading to altered selling plans.
Example: For a bakery, if wheat becomes more expensive or an oven breaks down, the quantity of bread supplied at any given price will change, causing the supply curve to shift.
Increase in Supply: A shift of the supply curve to the right.
At every price, a greater quantity is supplied.
Decrease in Supply: A shift of the supply curve to the left.
At every price, a lesser quantity is supplied.
The Interdependence Principle and Market Supply Curve Shifters
Your best choice as a seller depends on many factors beyond just the price of the good itself.
What shifts a supply curve? Any factor that affects a firm's marginal cost other than the price of the product.
There are five key factors that shift the market supply curve (mnemonic: I, POET):
Input prices
Productivity and technology
Output prices of related goods
Expectations
Type and number of Sellers
Crucial Note: A change in the product's own price does not shift the supply curve; it causes a movement along the curve.
1. Input Prices
These are the costs of raw materials, labor, and other resources used to produce a good or service.
Impact: If the price of an input rises, the marginal cost (MC) of production increases.
Scenario (iPhone Example): If the wage paid to workers increases (an input price rises),
Firms' marginal costs increase.
This leads to a decrease in supply (supply curve shifts left), as firms are less willing to supply the same quantity at the previous price or need a higher price to supply the same quantity.
2. Productivity and Technology
Productivity Growth: Producing more output with fewer inputs. This is often driven by technological change, such as the invention and adoption of new machinery.
Impact: Improvements in productivity and technology typically reduce the marginal cost (MC) of production.
Scenario (Bakery Oven Example): If a bakery acquires a new oven with three times more baking racks,
The firm's marginal costs decrease (more output per unit input).
This leads to an increase in supply (supply curve shifts right), as firms are able to supply more at any given price.
3. Output Prices of Related Goods
The effect depends on whether the related products are complements-in-production or substitutes-in-production.
Complements-in-Production: Goods that are made together; one is often a main product and the other a byproduct.
Examples: Asphalt (byproduct) and Oil (main product) from a petroleum refinery; Leather (byproduct) and Beef (main product).
Impact: If the price of a main product rises, its production increases, leading to an increased supply of its complement-in-production.
Scenario (Peanut Example): If peanut oil and peanut butter are complements-in-production, and the price of peanut oil rises:
The factory will produce more peanut oil (because it's now worth more).
Since peanut butter is made together with peanut oil, the factory will also produce more peanut butter.
This results in an increase in the supply of peanut butter (supply curve shifts right).
Substitutes-in-Production: Alternative uses of your resources. Producing more of one good means producing less of another.
Example: A farmer can use land and machinery to grow either corn or wheat.
Impact: If the price of one substitute-in-production rises, resources are shifted towards producing that good, leading to a decrease in the supply of the other substitute.
Scenario (Farmer Example): If the price of corn rises dramatically:
Corn becomes a more attractive product to sell.
The farmer will devote more resources to growing corn.
The quantity of corn supplied will increase, but the supply of wheat will decrease (supply curve for wheat shifts left), as fewer resources are available for wheat production.
4. Expectations
A seller's beliefs about future prices can influence current supply decisions.
Impact: If a seller expects the price of their product to rise in the future, they might withhold some current supply to sell it later at a higher price.
Scenario: If you expect the price of your product to rise next year:
You might store your product to sell next year.
This will cause a decrease in current supply (supply curve shifts left).
5. Type and Number of Sellers
The aggregate market supply is the sum of all individual sellers' supplies.
Impact:
If new sellers enter the market, the total quantity supplied at each price increases -> supply curve shifts to the right.
If sellers exit the market, the total quantity supplied at each price decreases -> supply curve shifts to the left.
Shifts versus Movements Along Supply Curves
Movement Along the Supply Curve: Occurs only when the price of the good itself changes.
This represents a change in the quantity supplied.
Higher prices lead to an increase in quantity supplied; lower prices lead to a decrease in quantity supplied (following the law of supply).
Shift in the Supply Curve: Occurs when any of the five other factors (I, POET) change.
This represents a change in supply itself.
An increase in supply (right shift) means more is supplied at every price; a decrease in supply (left shift) means less is supplied at every price.
Key Take-aways on Supply Curve Shifts
Increase in Supply: A shift of the supply curve to the right, meaning an increased quantity is supplied at each and every price.
Decrease in Supply: A shift of the supply curve to the left, meaning a decreased quantity is supplied at each and every price.
Five factors shift the supply curve (I, POET). Be careful: A change in the price of the good itself does NOT shift supply.
The effect of changing the price of a related output depends on whether the two products are complements- or substitutes-in-production.
Parallels Between Demand and Supply
Feature | Demand | Supply |
|---|---|---|
Your Objective | Maximize economic surplus | Maximize profit |
Quantity Decision | Rational Rule for Buyers | Rational Rule for Sellers |
Quantity Decision Implies | Demand curve is marginal benefit curve | Supply curve is marginal cost curve |
Curve Slopes… | Down (diminishing marginal benefits) | Up (increasing marginal costs) |
The Market Curve | Sum of quantity each individual consumer demands, at each price | Sum of quantity each individual business supplies, at each price |
A Rise in Price Causes… | A movement along the demand curve, reducing the quantity demanded | A movement along the supply curve, raising the quantity supplied |
A Fall in Price Causes… | A movement along the demand curve, raising the quantity demanded | A movement along the supply curve, reducing the quantity supplied |
Curves are Shifted by… | A change in one of the six factors (but not price) | A change in one of the five factors (but not price) |
Practice Examples and Concept Checks
Concept Check Examples (Review of Demand Concepts):
Normal vs. Inferior Good: When income increases, demand for a normal good increases, while demand for an inferior good falls. (Option A)
Substitutes vs. Complements: Substitute goods are used for the same purposes, while complementary goods are used together. (Option D)
Law of Demand Explanation: The demand curve slopes downward because when the price of a good increases, consumers' purchasing power falls, and they cannot buy as much of the good as they did prior to the price change. (Option C, which combines A and C from choices, meaning A: consumers purchase relatively less expensive complementary goods, which is part of the substitution effect, and C: purchasing power falls, which is the income effect. So A and C are jointly correct.)
Practice Examples (Supply Concepts):
Rational Seller Decision: If the price of gasoline is 3.99 per gallon, a rational seller (Rexhall Fuel Supplies) should be willing to sell up to the quantity where marginal cost equals or is less than the price. According to the table provided,
At 20 million gallons, the marginal cost is 3.99.
Thus, Rexhall Fuel Supplies should sell 20 million gallons per week.
Complements-in-Production: If a farmer produces more pumpkins and also has more decorative pumpkins to sell, pumpkins and decorative pumpkins are complements-in-production.
Supply Shift Scenario (Lumber Mill): Henderson Lumber produces boards and sawdust (a byproduct). When the housing market collapses, causing prices of boards to fall:
Henderson Lumber will likely produce fewer boards (due to lower demand/price for boards).
Since sawdust is a byproduct, the supply of sawdust will decrease (shift left).
Supply Curve Shift due to Input Price Change: If the price of organic wheat (an input) used in bread production rises:
The marginal cost of producing bread increases.
This will cause the supply curve for bread to shift to the left (a decrease in supply), as seen in Graph D of the example (where the new supply curve is to the left of the old supply curve).