Supply and elasticity of supply
Supply
Supply works in a similar way to demand. It is assumed that suppliers seek to maximise profits.
The higher the price of a good, the easier it is to make a profit. Consequently, suppliers will offer more and more of a good to the market as the price goes up. Thus, under normal conditions, the supply of a good will increase as the price increases. Supply is also strictly speaking supply per unit of time; although it is customary to omit this when referring to supply.
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Figure 1. The supply curve.
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The supply curve is a relationship between price and quantity. That is, the graph shows how changes in price affect changes in the quantity supplied. Thus, a movement along the supply curve reflects the result of a change in price. Shifts in the supply curve from one position to another reflect changes in the conditions of supply.
It is customary to draw a straight-line for a supply curve; but this is a matter of convenience when dealing with diagrams of supply (and demand). There is no necessary reason why a supply curve should result in a straight-line (that is, linear) relationship between quantity supplied and price. In practice most supply curves will not be represented by straight lines. |
Figure 2. An improvement in the conditions of demand leads to an outward shift of the demand curve. This causes the price of the good to increase from P1 to P2 and the quantity demanded to increase from Q1 to Q2. The result of this shift in the demand curve is a movement along the supply curve. The conditions of supply have not been altered.
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Individual supply and market supply
Just as the demand in a market results from adding together the demand curves of individuals, a market is supplied by individual firms. Each firm has a different supply curve – that is a relationship between the quantity the firm would seek to supply to a market at a given price. When these individual supply curves are added together, the result is the supply curve for the market (or industry, which here means the same thing as market).
Figure 3. Industry supply curve as the summation of individual supply curves.
Individual and market supply curves. For simplicity we imagine an industry supplied by just three firms, X, Y and Z. When their individual supply curves are added horizontally, the result is the industry (market) supply curve.
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Factors influencing the conditions of supply
Some of the factors that could affect the conditions of supply are as follows.
There may be other factors that affect the supply of a good. For example, government legislation to reduce pollution and the weather may play a particular role. In addition, the influence of interest rates, and the expectations and plans of producers may play a role. The conditions of supply cannot be studied separately from those conditions that affect investment and supply in general, and should be examined in connection with supply side macroeconomics. |
Figure 4. Rising unit costs cause the supply curve to shift inwards. Less is supplied at any given price than before.
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Elasticity of Supply
Just as we can define the
elasticity of demand, so we can define the elasticity of supply. This is given by:
This is basically the same equation as the equation for price elasticity of demand.
It is a curious outcome of the way in which the
elasticity of supply is defined that for straight-line supply curves any supply
curve (line) passing through the origin has elasticity equal to 1 (ε = 1). A line cutting the price axis above the origin
has elasticity greater than 1 (ε > 1) and is elastic. A line cutting the quantity axis to the right
of the origin has elasticity less than 1 (ε < 1) and is inelastic.
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Figure 7. Unitary elasticity of supply. All these supply curves have unitary
elasticity (ε = 1).
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Figure 8. Elastic and inelastic
supply. For straight-line supply curves,
any curve cutting the price axis above the origin is elastic; any supply curve
cutting the quantity axis to the right of the origin is inelastic.
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Factors affecting elasticity of supply
The longer the period over which
the quantity supplied is taken the more elastic supply is. This is a consequence of how the time period
is defined.
Supply is elastic if it is easy to transfer resources in production from other goods to the good in question. For example, companies that produce dinner plates also tend to produce coffee mugs. It is a relatively easy thing to produce more mugs and fewer dinner plates.
A related question would be that of how easy it is for a company that does not produce dinner plates or coffee mugs to enter the market for either. This is concerned with entry barriers to the industry and can be studied separately under market conditions. In other words, the market conditions affect the elasticity of supply, and the easier it is for companies to enter a market and produce a good or service, the more elastic the supply will be.
Supply is elastic if it is easy to transfer resources in production from other goods to the good in question. For example, companies that produce dinner plates also tend to produce coffee mugs. It is a relatively easy thing to produce more mugs and fewer dinner plates.
A related question would be that of how easy it is for a company that does not produce dinner plates or coffee mugs to enter the market for either. This is concerned with entry barriers to the industry and can be studied separately under market conditions. In other words, the market conditions affect the elasticity of supply, and the easier it is for companies to enter a market and produce a good or service, the more elastic the supply will be.
Profits and supply
The housing market is an example
of a market where supply at any given time will be inelastic. From start to finish, and including time
required to obtain planning consent, it takes at least 2 years to build a new
house. At any given time, the number of
houses available for sale will be a small proportion of the total stock of
houses in the country as a whole.
Consequently, in the short run prices in the housing market are likely
to be strongly influenced by changes in demand.
During a boom, the demand for housing may increase in excess of the new
supply, since decisions to build those new houses coming onto the market will
have been taken at least two years before the boom began.
Supply and price fluctuations
The above example concerning
housing also illustrates how elasticity (or inelasticity) of supply can
influence changes in prices. It is
because the supply of houses in the short-run is inelastic that small changes
in demand can cause large changes in prices.
Consequently, the housing market is an example of a market where prices
are more volatile – subject to changes.
Where supply is elastic, prices are more stable.