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Unit 2.2: Supply theory
In this chapter, we examine the way supply affects the allocation of resources in the economy. Supply is the resource element of the central economic problem of scarcity and the allocation of the factors of production is based on the supply decisions made by businesses. The central theme of this section is to analyse the price and non-price factors that affect supply decisions made by the different producers on the supply side of the economy.
- Law of supply
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- Assumptions underlying the law of supply
- Supply curve
- Relationship between an individual producer’s supply and market supply
- Movements along and shifts of the supply curve
- Non-price determinants of supply
Revision material
The link to the attached pdf is revision material from Unit 2.2: Supply theory. The revision material can be downloaded as a student handout.
Revision notesDefining supply
Supply is the willingness and ability of producers to offer a given quantity of a good for sale at a point in time and at a given price. Supply refers to the resource element of the central economic problem of scarcity. The factors of production (land, labour, capital and enterprise) are used to produce goods and services on the supply side of a market.
For example, supply in the sportswear market is made up of the workers who work for businesses like Nike and Adidas, the capital used to manufacture their sportswear products, the raw materials used in production, and the entrepreneurs who organise and manage the companies in the sportswear market.
The law of supply – how price affects quantity supplied
The law of supply states that an increase in price leads to an increase in the quantity supplied of a good or service, and a decrease in price leads to a fall in quantity supplied. There is a positive relationship between price and quantity supplied.
The supply curve
The positive relationship between price and quantity supplied is illustrated by the supply curve. Diagram 2.6 shows that a rise in the price of soft drinks from 60c to 80c leads to a rise in quantity supplied from 2 million to 3 million units. As the price changes, there is a movement along the supply curve.
Profits and supply
The law of supply can be explained by how a rise in price can lead to an increase in producer profits. The increase in profit from a higher price gives producers a greater incentive to increase supply. The higher price also means a higher unit cost of production can be covered by the price. For example, if the unit cost of producing an extra unit of a soft drink increases as a firm produces more, the higher price can cover this extra cost and make the increase in production profitable.
*The law of supply can be explained using the law of diminishing returns and how this affects a firm's costs of production. This explanation is covered in detail in Unit 2.11(1).
Unit 2.11(1) Market power - Theory of production and costs (HL)
The price of pomegranates is on the rise globally driven by rising demand from consumers who are looking to buy exotic fruits beyond everyday choices. Pomegranates are used in salads, cooking and as a drink and the fruit is considered to have health benefits. The last 5 years have seen prices rise at an average rate of 3.2%. The growers who produce pomegranates in countries like India, Iran and Turkey are certainly benefiting from rising prices that increase their profits and enable them to expand production.
Worksheet questionsQuestions
a. Define the term supply. [2]
Supply is the willingness and ability of producers to offer a given quantity of a good for sale at a point in time and at a given price.
b. Outline how capital and labour are used to supply pomegranates. [4]
To produce pomegranates growers will use capital such as harvesting machinery and vehicles such as tractors. The labour used in the production of pomegranates is the workers who plant, manage and pick the fruit.
c. Using a diagram explain why a rise in the price of pomegranates leads to an increase in quantity supplied. [4]
As the price of pomegranates increases producers can earn more profit and cover higher costs of production which increases the quantity supplied of pomegranates.
Investigation
Research into another exotic fruit that is experiencing a price rise and how this is affecting supply.
Non-price determinants of supply
Cost of factors of production
Changes in the costs of the factors of production used to produce a good or service will affect supply and cause the supply curve to shift. If, for example, the cost of coffee beans used by coffee shops increases, then the supply of coffee from coffee shops will fall and the supply curve will shift to the left. This is shown in diagram 2.7 where the supply curve for coffee sold in coffee shops shifts from S1 to S2 and the price of coffee and the quantity of coffee traded falls.
A decrease in the cost of factors of production would lead to an increase in supply, and the supply curve would shift to the right. For example, a reduction in the minimum wage would reduce the cost of labour for businesses like coffee shops and would increase supply.
An €8.50 per hour minimum wage was introduced in Germany two years ago. In an attempt to improve the living standards of the lowest-paid workers the German government has increased the earnings of people who work in industries such as hospitality, retail and social care. Increasing the minimum wage raises the lowest wage individuals can earn per hour but it has increased labour costs for certain businesses. Many firms are now bracing themselves for a further increase in costs as the German government looks to increase the minimum wage to €12 per hour.
Questions
a. Outline two types of costs that could affect the supply of coffee shops. [4]
- The cost of materials to make coffee such as coffee beans, milk and sugar could affect the supply of coffee and other drinks by coffee shops.
- Property charges such as rent and property tax could affect the supply of food and drink sold by coffee shops.
- The wages paid to coffee shop employees could affect the supply of food and drink sold by coffee shops.
b. Using a diagram, illustrate the effect of a rise in the minimum wage in Germany on the supply curve of German coffee shops. [4]
As the minimum wage in Germany rises, the cost of producing coffee and other food and drink in coffee shops increases and this cause the supply curve of coffee shops to shift to the left from S to S1. This causes the prices charged by coffee shops to increase from $2.30 to $2.70 and the quantity of output sold to fall from 800,000 units to 600,000 units.
Investigation
Investigate other service sector firms in the place where you live that might be affected by changes in minimum wages.
Competitive supply
Many firms produce a range of goods, and a change in the price of one good a firms sells may affect the quantity supplied of other products they sell. An agricultural producer of soft fruit, for example, might sell strawberries and raspberries. If the price of strawberries rises, the farm may allocate more land to strawberries, which means less land is allocated to raspberries. As a result of this, the supply of raspberries will fall, and the supply curve for raspberries will shift to the left. If the price of strawberries falls the producers might reduce their supply of strawberries and allocate more land to raspberries which increases the supply of raspberries.
Joint supply
When a production process yields two or more goods at the same time this is called joint supply. This means increasing the supply of one good directly leads to an increase in the supply of a good it is in joint supply with. Joint supply often occurs in the agricultural industry with examples such as beef and leather, wheat and straw, and mutton and wool. Another example of joint supply occurs in the production of oil. The refinery process for oil also produces the chemical bases for plastics. This means an increase in the supply of oil will lead to an increase in the supply of plastic.
The UK has been suffering from a shortage of CO₂ over the last three years. CF Industries supplies 60% of the UK’s C02 as a by-product of producing fertilizers. CF announced it would be closing two of its fertilizer production plants in because of a surge in energy prices which had made their operation unprofitable. Closing down the production of fertilizer means less C02 is produced because they are in joint supply. The supply of C02 is critical for things such as hospital operations, keeping food fresh during transport, and even the production of fizzy drinks.
Questions
a. Outline joint supply in the market for C02. [2]
Joint supply is where the production process yields two or more goods at the same time. In this case, the supply of fertilizer and C02 is produced at the same time. When the supply of fertilizer falls the supply of C02 falls.
b. Explain why CF industries are reducing their supply of C02. [4]
CF Industries is reducing its supply of C02 because an increase in energy costs is reducing the profits it is making from the production of fertilizer. As CF industries’ profits fall it may lead to losses and cause it to shut down the two production plants.
c. Using a diagram, explain how a fall in the supply of C02 might affect the supply of fizzy drinks. [4]
As the supply of C02 falls this will lead to an increase in its cost in the market for fizzy drinks. As the cost of C02 rises this causes the supply of fizzy drinks to fall and the supply curve for fizzy drinks shifts from S to S1 leading to a rise in price from P to P1 and a fall in output from Q to Q1.
Investigation
Research into another market where two goods are in joint supply.
Technology
As technology in the production process advances the production capacity of firms increases. As a result, businesses supply more to the market. This has been the case with manufactured goods like computers, mobile phones, televisions and cars. You can also see the impact of advances in technology on supply in service industries such as online music, games and film streaming services.
Diagram 2.8 shows an increase in the supply of mobile phones as a result of improvements in technology in the mobile phone market. As the supply of mobile phones increases it leads to a fall in their price and a rise in the quantity traded.
Supply-side shocks
A country or region may experience supply-side shocks which lead to a decrease in supply. This is particularly true in agricultural markets where the weather can impact on growing conditions. Cold conditions in coffee-growing areas can dramatically reduce the output of coffee producers and the supply of coffee. The Tsunami in Japan in 2011 led to a significant fall in the production of cars as many manufacturers were forced to reduce output for a period of time.
Price expectations
Producer supply decisions can be affected by their expectations of what may happen to the price of a good or service in the future. If, for example, a construction company believes that the price of a building will be worth 20 per cent more in two years, they may wait for two years before they put the building onto the market which reduces supply. If producers expect prices to fall, they may increase supply in the present. For example, housebuilders might increase the supply of housing in the present if they expect house prices to fall next year.
Number of producers in the market
As more firms enter a market, the supply in the market increases and as firms leave a market, the supply falls. The growth of online shopping has led to a rise in the number of delivery businesses. As more delivery firms enter the market, the supply of this service increases.
Taxes
When indirect taxes are levied on goods and services supply decreases as a tax adds to a firm's costs of production. For example, taxes on cigarettes, alcohol and petrol cause the supply curve of these goods to shift upwards leading to an increase in price and a decrease in market output. *The impact of taxation on supply is covered in more detail in Unit 2.7(1).
Subsidies
A subsidy on a good or service leads to an increase in supply as the cost of production decreases. For example, subsidies on agricultural goods and renewable energy cause the supply curve to shift downwards leading to a decrease in price and an increase in market output. *The impact of subsidies on supply is covered in more detail in Unit 2.7(1).
The impact of tax and subsidies on supply are covered in Unit 2.7(1)
In Europe and North America, car makers are gearing up to make 2022 the year of the electric car. The automotive market is going to see a wave of new models launched by leading manufacturers such as BMW, General Motors, Honda and Fiat. The number of electric vehicle (EV) models available to buyers will jump from fewer than 100 to 330 by 2025.
Electric vehicles have also become cheaper. Industry data shows that the prices of EVs have fallen from an average price of $64,300 to $55,600 in 2021. A lot of this is down to Tesla’s success in selling their Model 3, which has a starting retail price of $39,000. Tesla now dominates the US EV market with nearly 80% of EV sales.
Changes on the supply side of the electric vehicle market are crucial to its growth. The cost of batteries, a key component in EVs, are becoming cheaper and the number of EV producers in the market has increased significantly. Many countries are also offering subsidies to encourage people to buy them. These factors have increased the supply of electric vehicles and are a key factor behind the growth of the market.
Question
Explain the effect the falling costs of batteries and improvement in technology in the production of electric cars will have on the supply, market price and output of electric vehicles. [10]
Answers might include:
Definitions of supply, market price and market output.
A diagram to show the effect of the falling costs of batteries and improvement in technology on supply, market price and output of electric vehicles (EVs).
An explanation that as the cost of batteries used in the production of EVs to falls, this causes the cost of producing electric vehicles to decrease. Improvement in technology used in the production of EVs also causes their costs to fall.
An explanation that the decrease in the production costs for lower costs batteries and improvements in production line technology of EVs leads to an increase in supply from S to S1 which causes the market price to fall from $40,000 to $30,000 and output to increase from 10 million to 16 million units.
Investigation
Research into another market where technology is having a significant impact on supply.
Which of the following is the most accurate definition of supply?
When the price of a good increases, which of the following is the most likely explanation of why quantity supplied increases?
A higher profit is an incentive for producers to increase output.
Which of the following factors is the most likely to cause S1 to shift to S2 in an agricultural market?
4. If a housebuilder expects prices to fall next year, what is the most likely supply decision the housebuilder will make?
A house building firm will reduce supply in the present and wait until next year to supply the market at a higher price.
5. The law of supply states that:
6. Which of the following is least likely to lead to an increase in the supply of computer games?
As wages increase the cost of producing computer games increases and supply decreases.
Which of the following is true about the supply of oranges?
As price increases quantity supplied increases because of the law of supply.
An improvement in technology in the electric car market is most likely to lead to which of the following?
As technology advances the supply curve of electric cars increases and this cause the market price to fall and output to increase.
Which of the following is least likely to cause the supply of gold to increase?
A rise in price causes the quantity supplied to increase.
Two products are in joint supply when:
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