Economics (9640) | The supply of goods and services

Study Notes: The Supply of Goods and Services (3.1.2.3 & 3.1.2.4)

Welcome to the supply side of Economics! If demand tells us what consumers want, supply tells us what producers are willing and able to offer. Understanding supply is crucial because it’s the engine that responds to price signals and ultimately determines how much stuff gets made in the economy. Don't worry if this seems tricky at first; we will break down the rules of production one step at a time!

1. Defining Supply and the Law of Supply (3.1.2.3)

What is Supply?

Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at various prices in a given period of time.

• Willing: The producer must see an opportunity for profit.
• Able: The producer must have the resources (factors of production) to physically produce the good.

The Law of Supply

The relationship between the price of a good and the quantity supplied is generally direct (or positive).

When the price of a good rises, the quantity supplied rises.
When the price of a good falls, the quantity supplied falls.

Why? This is driven by the profit incentive.
Higher prices imply higher revenues for the firm. Holding costs constant (this is the ceteris paribus assumption—all else equal), higher revenue means higher profits. This higher profit provides a strong incentive to expand production.

Analogy: Imagine you run a bakery. If the price of croissants suddenly doubles, you’ll be motivated to work longer hours, hire extra staff, or switch production away from less profitable items (like muffins) just to make more croissants!

2. The Supply Curve and Movements (3.1.2.3)

The Supply Curve (S)

The supply curve graphically illustrates the relationship between price (P, usually on the vertical axis) and quantity supplied (Qs, usually on the horizontal axis).

• It is upward sloping (it slopes upwards from left to right) reflecting the Law of Supply.

Movement Along the Supply Curve

A change in the price of the good itself causes a movement along the existing supply curve. This results in a change in the quantity supplied (Qs).

• Contraction of Supply: A movement up and to the left, caused by a fall in price. Producers supply less.
• Extension of Supply: A movement down and to the right, caused by a rise in price. Producers supply more.

Key Distinction: Only the good's own price causes a movement. If we talk about anything else changing—like the cost of wages—that causes a shift.

3. Causes of Shifts in the Supply Curve (3.1.2.3)

A shift in the supply curve occurs when a factor other than the product's own price changes. This changes the quantity producers are willing and able to supply at every price level.

• Shift Right (S to S1): Represents an increase in supply. Producers are willing to supply more at the same price.
• Shift Left (S to S2): Represents a decrease in supply. Producers are willing to supply less at the same price.

To remember the key factors that shift the supply curve, think of the mnemonic N.I.C.E P.A.N.T.S (or use any simple mnemonic that works for you!):

Nature/Weather, Indirect Taxes/Subsidies, Costs of Production, Expectations, Price of other goods, Advances in technology, Number of firms, Time (or related factors), Shocks.

Detailed Factors Determining Supply (Non-Price Factors)

1. Changes in the Cost of Production (C)

• If the cost of inputs (raw materials, wages, rent, capital) falls, production becomes cheaper, increasing profit margins.
• Effect: Supply Increases (Shift Right).
• Example: If the price of coffee beans (a raw material) falls, coffee shops can afford to supply more lattes at the same price, shifting the supply curve right.

2. Changes in Technology (T)

• New technology (like better machinery or efficient software) typically allows firms to produce more output with the same level of input, lowering average costs.
• Effect: Supply Increases (Shift Right).

3. Government Policy (Taxes and Subsidies) (I)

• Indirect Taxes (e.g., VAT, excise duty) increase the firm’s costs of production. Effect: Supply Decreases (Shift Left).
• Subsidies (payments made by the government to producers) reduce the firm's cost of production. Effect: Supply Increases (Shift Right).

4. Price of Related Goods (P)

• Firms often have the flexibility to switch between producing different goods (substitute goods in production).
• Example: A farmer can grow wheat or barley. If the price of wheat rises, the farmer will switch resources to growing more wheat, reducing the supply of barley. Effect on barley supply: Supply Decreases (Shift Left).

5. Number of Firms in the Market (N)

• If more firms enter the industry (attracted by high profits), the total market supply increases. If firms exit, supply decreases.
• Effect: Entry shifts Supply Right; Exit shifts Supply Left.

Did you know? A sharp, unexpected event, often called a Supply Shock, can dramatically shift the curve. For instance, a natural disaster (like a hurricane destroying crops) would be a massive decrease in supply (shift left).

4. Price Elasticity of Supply (PES) (3.1.2.4)

Meaning of Price Elasticity of Supply (PES)

PES measures the responsiveness of the quantity supplied of a good or service to a change in its price.

If a firm can increase its output easily and quickly following a price rise, supply is elastic. If it struggles to increase output, supply is inelastic.

The Formula and Interpretation

The PES is calculated using this formula:
\[ \text{PES} = \frac{\%\text{Change in Quantity Supplied}}{\%\text{Change in Price}} \]

The value of PES is always positive because of the Law of Supply (price and quantity supplied move in the same direction).

• PES > 1 (Elastic): Quantity supplied changes by a proportionally larger percentage than the change in price. (Highly responsive).
• PES < 1 (Inelastic): Quantity supplied changes by a proportionally smaller percentage than the change in price. (Not very responsive).
• PES = 1 (Unitary Elasticity): Quantity supplied changes by the exact same percentage as the change in price.
• PES = 0 (Perfectly Inelastic): Supply cannot change, no matter the price (e.g., antique paintings, capacity limits in the short run).

Example: If the price of avocados increases by 10% and the quantity supplied increases by 20%, the PES is \( 20\% / 10\% = 2 \). Since \( 2 > 1 \), supply is elastic.

Factors Influencing Price Elasticity of Supply

The ability of a firm to respond to a price change depends on several factors:

1. Time Period of Production (The Most Important Factor)

• Short Run: Firms usually find it difficult to adjust inputs (e.g., building a new factory takes time). Supply is often inelastic.
• Long Run: Firms can vary all factors of production (buy new machines, build factories, hire more skilled labour). Supply tends to become more elastic.
• Memory Aid: In the short run, you are stuck (inelastic). In the long run, you have flexibility (elastic).

2. Spare Capacity

• If a firm has lots of unused capacity (e.g., machinery sitting idle, factories running only half the day), it can easily increase output without raising costs much if the price rises.
• Lots of spare capacity: Elastic PES.

3. Ease of Switching / Factor Mobility

• If the factors of production (labour, land, capital) can be easily moved or switched from one type of production to another, supply is more elastic.
• Example: A producer of soft drinks can quickly switch their bottling lines from making Cola to making Lemonade if Lemonade prices rise. This means their supply of lemonade is elastic.

4. Levels of Stocks / Inventories

• If a firm holds large stocks of finished goods, they can respond instantly to a price rise by selling off their inventory, even if production itself is slow.
• High stock levels: Elastic PES.

5. Barriers to Entry (Difficulty and Cost of Production)

• If starting a new firm or expanding production is very complex (requires high startup capital, long government approvals, highly specialized labour), the overall market supply will be inelastic because new firms cannot quickly enter when prices rise.