Supply theory. This article will explain what the supply theory is and how the supply of a good is related to the price of the good. Furthermore, the article will explore movements along a supply curve and shifts in the supply curve.
Welcome to Simply Economics. This article is the sixth in a series to explain economics to those who want to broaden their scope of the subject. Click here to find out more about the series.
WHAT IS SUPPLY?
Producers supply goods in the market. Supply is the amount of good producers are willing to sell at a given price over a given period of time.
SUPPLY THEORY AND THE SUPPLY CURVE
Supply theory is the relationship between the supply of a good and its price. The relationship is as follows: as the price of a good increases so does the supply of the good. This relationship can be shown through a diagram shown below:
As shown above the supply curve is modelled as a straight line sloping upward. This upward slope shows that the price and supply of a good move in the same direction (i.e. as price goes up so does supply). The supply curve shows the amount of a good a producer is willing to sell at different price levels in a given period of time.
The reason why the supply curve slopes upward (has a positive gradient) is because as prices rise, it encourages producers to supply more of the good because they will make more profit. Furthermore, higher profits encourage new producers to enter the market which will also increase the supply.
MOVEMENT ALONG A SUPPLY CURVE
As shown in the diagram above, the supply of a good can move along the supply curve. This only happens when there is a change in the price of the good.
If the price of the good falls, then supply moves from point A to point B. This is known as a contraction of supply.
If the price of the good rises, the supply moves from point A to point C. This is known as an extension of supply.
SHIFTS IN THE SUPPLY CURVE
An increase in supply means the whole supply curve shifts outwards, from S to S1
A decrease in supply means the whole supply curve shifts inwards, from S to S2
There are may reasons why the supply curve may shift for a good. For example, supply for oil may increase because of:
· An increase in the number of companies in the oil industry – if there are more firms then it is more likely that there will be more oil extracted as more oil rigs will be in operation.
· A reduction in labour costs – if the cost of labour is lower, then firms will make more profit per barrel. Therefore, they will increase the supply so they can sell more barrels hence, gaining more profits.
· A reduction in capital costs – capital costs include the cost of pipelines and refineries. If the cost of these goes down, then the firms will make more profit per barrel. Therefore, they would increase output to maximise profits.
· A fall in tax on oil – again, if there is less tax on oil then profit per barrel will increase. Therefore, in order to maximise profits, firms will increase output so they can sell more barrels.
· A rise in government subsidies – if oil producers receive subsidies, the output of oil will increase as they are given a grant which makes the costs of production to fall. This increases the profit per barrel and therefore causes an increase in supply.
In conclusion, supply is the amount of good a producer is willing to sell at a given price over a given time period. Supply will contract if the price of the good falls and will extend if the price of the good increases. An increase of decrease in supply refers to the entire supply curve shifting outwards or onwards.
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