#### Theory of Supply - Concepts of Supply Curve

Theory of Supply:

Chapter Summary:

A small seller, that can’t affect the market price, maximizes gain by producing at a rate where its marginal cost equivalents the price. (For a small seller, the price equivalents marginal revenue.) In short run, at least one input is fixed and thus can’t be adjusted. The business breaks even whenever total revenue covers variable cost. In long run, the business can adjust all inputs and depart or enter the industry. It breaks even whenever total revenue covers total cost.

The supply curve exhibits the quantity supplied as a function of price, other things equivalent.  The consequence of a change in price is symbolized by a movement all along the supply curve to a new quantity. Modifications in other factors like wages and the prices of other inputs are symbolized by shifts of the whole supply curve.

Seller surplus is the difference among revenue from certain production rate and the minimum amount needed to induce the seller to generate that quantity. Elasticity of supply, measure the responsiveness of supply to modifications in underlying factors which affect supply.

The Math Supplement to this illustrates two things mathematically. First, it exhibits that the profit-maximizing (or loss minimizing) production rate exists where marginal revenue equivalents marginal cost. Second, it exhibits that a change in any factor of supply other than the price of item is symbolized by a shift of the whole market supply curve.

Key Concepts:

General Chapter Objectives:

A) Elucidate why short run costs differ with the production rate and what could cause a shift in the short run cost curves.

B) Find out the profit-maximizing (or loss-minimizing) production level in short run.

C) Elucidate beneath what short-run conditions a business will remain in operation and whenever it is best to shut down.

D) Describe why individual seller’s supply curve is that part of its marginal cost curve above minimum average variable cost.

E) Describe why demand for inputs is derived from level of production.

F) Describe why costs differ with the production rate and what could cause a shift in the cost curves.

G) Find out the profit-maximizing (or loss-minimizing) production level in the long run and elucidate the breakeven situation in the long run.

H) Explain how the market supply curve is derived in short and long run and their properties.

I) Explain seller surplus in words and find out it graphically.

J) Elucidate why labor supply curves usually slope upward in terms of work-leisure tradeoff and the income consequence.

K) Explain the elasticity of supply concept, compute price elasticity of supply coefficients and deduce them.

Notes:

1) Individual supply: long run and short run.

a) Whether to carry on in production and how much to generate based on costs and revenues.

b) Time horizon:

i) Short run: time horizon in which a seller can’t adjust at least one input.  In short run, the business should work in the constraints of past commitments like employment contracts and investment in equipment and facilities.
ii) Long run: time horizon long adequate for a seller to adjust all inputs (comprising the size of its facility) and production.

2) Costs and production rate: short run.

A) Costs:

i) Based on estimates of expenditures on wages, rent and other supplies required at different production rates.

ii) Fixed cost = cost of inputs which do not change with the production rate. The whole fixed cost is a sunk cost, that is, a cost which has been committed and can’t be avoided.

iii) Variable cost = cost of inputs which change with the production rate. Therefore, variable cost differs with the scale of operations. This is an avoidable cost.

iv) Total cost = sum of fixed cost and variable cost (that is, C = F + V).

(Note: Various expenses might have both a fixed and variable component.)

v) Average fixed cost = fixed cost divided by output level.

vi) Average variable cost = variable cost divided by output level.

vii) Average (total) cost/unit cost = the total sum of average variable and average fixed cost; as well equivalents total cost divided by production rate;

viii) Marginal cost = the change in total cost (that is, variable cost) related with each additional unit generated; symbolized graphically as the slope of total cost curve.

B) Marginal product:

i) Definition: The increase in output occurring from an extra unit of the input.

ii) Reducing marginal product from the variable inputs: the marginal product becomes smaller with each and every raise in the quantity of variable input.

C) Average total cost (or average cost) usually first drops with raise in the production rate and then increases.

i) Whenever the production rate is greater, the fixed costs will be spread over more units, the average fixed cost will be diminishing.

ii) Whenever the production rate is higher:

• At first, the average variable cost drops (since the variable inputs match the fixed input comparatively better);
• Then, the average variable cost increases (as more of the variable inputs are added up in the combination with fixed input, there will be a mismatch, leading to a reducing marginal product from the variable inputs).
• Accordingly, the average variable, average (or total), and marginal cost curves are U-shaped. The curves will modify with the technology being employed.

3) Revenue and production rate: short run.

a) Total revenue = price x sales.

b) Marginal revenue = the modification in total revenue occurring from selling an additional unit; symbolized graphically as the slope of total revenue line.

4) Individual supply: short run.

a) Suppositions:

i) Business goals to maximize gain.

ii) The business is too small relative to the market which it can sell as much as it would like at going market price.

b) Profit-maximizing (or loss-minimizing) quantity to generate.

i) If continuing in production, profit = total revenue – total cost; that is, Profit = R – F – V.

ii) Profit-maximizing production rate is where marginal revenue equivalents marginal cost (where the total revenue line and total cost curve climb at exactly similar rate).

• If the marginal revenue surpasses the marginal cost, profit will be increased by increasing the production.
• Whenever marginal revenue is less than the marginal cost, profit will be increased by decreasing production.

iii) Whenever a business can sell as much as it would like at the market price, marginal revenue equivalents price (that is, it does not have to decrease price to sell more units); and thus, the profit-maximizing rule for such a business becomes the production rate at which price equivalents marginal cost.

c) To decide whether to carry on production at all.

i) If the business shuts down, it should pay the fixed cost, although not the variable cost; profit = -F.

ii) A business must continue in production:

• If the maximum gain from continuing in production is at least as big as the gain from shutting down; that is, if the business breaks even.
• Break even condition: too long as total revenue covers variable cost; or equivalently, too long as average revenue (or price) covers the average variable cost.
• Sunk costs must be ignored in making a present decision.

d) Individual supply curve – short run.

i) The graph exhibiting the quantity which one seller will supply at every possible price. It exhibits the minimum price which the seller will accept for each and every unit of production.

ii) It is similar to that part of marginal cost curve above the minimum point of the average variable cost curve.

iii) For each and every possible price of its output, a business must generate at the rate which balances its marginal cost with the price, given that the price covers the average variable cost.

iv) Since marginal cost increases when production is expanded, a seller must expand production only when it receives a higher price.

v) A change in the price of output usually causes movement all along a supply curve.

e) Demand for inputs:

i) Since the costs of inputs modifications, the marginal cost curve shifts up or down, the profit-maximizing scale of production modifications, the demand of input as well changes.

ii) By varying the cost of a specific input, we can find out the quantity demanded of that input at each and every possible cost and build the seller’s demand for that input.

iii) Since the quantity demanded of the input will be greater at a lower input price, the demand curve will slope downward.

5) Individual supply: long run.

a) Costs:

i) Based on estimates of expenditures on wages, rent and other supplies required at different production rates whenever all inputs are avoidable.

ii) The business might incur certain costs even at production level of zero, example: maintenance of minimum size facility.

iii) Long run average cost curve is lower and consists of a gentler slope than that of short run.  In long run, the seller has more flexibility in adjusting inputs to modifications in the production rate, and can therefore produce at a lower cost. In short run, it might not be able to modify one or more inputs.

b) Profit-maximizing quantity to generate. The profit-maximizing rule is to generate where price equivalents long run marginal cost (essentially similar in the long run as for short run).

c) To decide whether to carry on production at all.

i) If business shuts down, it will acquire no costs (that is, as all costs are avoidable in the long run); then profit = 0.
ii) A business must continue in production:

• When the maximum profit from continuing in production is at least as big as the gain from shutting down; that is, when the business breaks even.
• Break even condition: too long as its total revenue covers total cost; or equivalently, too long as average revenue (or price) covers average total cost.

d) Individual supply curve: long run.

i) The long run individual supply curve is similar to that portion of the long run marginal cost curve above the minimum point of the long run average total cost.

6) Market supply: short run.

a) The market supply curve:

i) This is a graph exhibiting the quantity which the market will supply at every possible price of the output.
ii) The consequence of a change in the price of an output is symbolized by a movement all along the supply curve.

b) The market supply curve is a horizontal summation of different individual seller’s supply curves. The market supply curve starts with the seller which has the lowest average variable cost, then blends in sellers with the higher average variable cost.

c) Market supply curve slopes upward. The higher the price of output, each individual seller will wish to generate more, the market as an entire will too produce more.

d) A change in the price of an input will influence an individual seller’s marginal cost at all production levels and shift the whole marginal cost curve. These changes will too shift the market supply curve.

7) Market supply: long run.

a) The market supply curve.

i) This is a graph exhibiting the quantity which the market will supply at every possible price of output.
ii) The consequence of a change in the price of an output is symbolized by a movement all along the supply curve.

b) The long-run market supply curve might be flat. Quantity supplied can expand via replication of existing businesses. The cost of production supplied by new entrants must be similar as that of the existing businesses.

c) The long-run market supply curve might slope upward. The resources accessible to different suppliers might vary in quality. New entrants might not be capable to replicate the resources (particularly in resource-based industries and where place is important) of existing suppliers and will acquire higher costs.

d) The long-run market supply curve slopes more tenderly upward (that is, more elastic) than the short-run market supply curve.

i) The freedom of entry and exit is a key difference among the short and long run: In the long run, every business consists of complete flexibility in deciding on inputs and production.

ii) In long run, when there is a modification in market price, the quantity supplied will adjust in two manners:

• All existing sellers will adjust their quantities supplied all along their individual supply curves; and
• Some sellers might leave or enter the market.

iii) Sellers whose total revenue can’t cover total costs will leave the industry till all remaining sellers break even.

iv) The industry where businesses are gainful (that is, total revenue surpasses total costs) will attract new entrants. This will raise market supply, decrease market price (that is, push down the gain of all sellers):

• Existing sellers will adjust the quantities supplied all along their individual supply curves;
• Some sellers might enter or leave the market till all sellers just break even.

e) A change in price of an input and other factors, than the price of output will cause a shift in the whole market supply curve.

8) Individual seller surplus:

a) A seller’s profit differs with the price of its output.

b) Seller’s surplus = difference between a seller’s revenue from certain production rate and the minimum amount essential to persuade the seller to generate that quantity.

i) It is equivalent to the difference between price and marginal cost, for each and every quantity from zero up to the production level.

ii) In short run, it is equivalent to the difference between total revenue from various production rate and the variable cost, or R – V.

iii) In long run, it is equivalent to the difference among total revenue from certain production rate and total cost.

c) A buyer can remove the seller’s surplus. The buyer must design a bulk order and pay the seller the minimum amount to persuade production at the desired level, that is, the buyer must purchase up the seller’s marginal cost curve.

d) A seller’s profit differs relatively more than the price of its output.

i) A change in price influences the revenue at the initial production rate; and
ii) Induces the seller to amend its production level.

9) Market seller surplus:

a) Market seller surplus = difference between seller’s revenue from certain production rate and the minimum amount essential to induce the seller to generate that quantity.

i) It is equivalent to the sum of individual seller surpluses; and
ii) It is symbolized graphically by the region between the price line and the market supply curve (that is, in both short run and long run).

b) In the long run:

i) If the market supply curve is flat, then there will be no market seller excess;
ii) If the market supply curves slopes upward, then there will be some market seller surplus.  Seller surplus ensue to those who own the superior resources.

10) Supply of labor (that is, as an output, as opposed to being an input).

A) The sellers are individual persons.

B) Individual labor supply curve.

i) It exhibits the quantity of labor which the person will supply at each and every possible wage.

ii) Slope of an individual labor supply curve: work-leisure tradeoff.

a) Leisure is a consumer good.

• A person’s time is restricted to 168 hrs per day.
• Increasing marginal cost of labor: the marginal cost of labor starts from a low level for 0 hrs to labor and increases with raising hrs of labor.
• Reducing marginal profit of leisure time: owing to reducing marginal profit, the marginal profit of leisure begins high and declines with rising leisure time.

b) Rising marginal cost of labor: causes the labor supply curve to slope upward.  To maximize total benefit, a person selects the quantity of labor where the marginal cost of labor equivalents the wage. Since the marginal cost of labor rises with the quantity labor, when the wage is higher, a bigger quantity of labor will be supplied.

c) The income effect: it causes the labor supply curve to slope downward.  For any specified quantity of labor, income will be higher with a greater wage. The higher income will increase the marginal profit from leisure and the marginal cost of work, decreasing the quantity of labor supplied.

d) The total effect on the supply curve based on the balance of the two consequences.

C) Market supply curve of labor: this is the horizontal summary of all individual supply curves of labor.

11) Price elasticity of supply:

a) Elasticity of supply: the responsiveness of supply to modification in an underlying factor (like the price of the item and inputs). There is an elasticity equivalent to every factor which affects supply.

b) Price elasticity of supply:

i) This is the percentage by which, the quantity supplied will modify if the price of the item increases by 1percent; other things equivalent.

ii) Computed by employing the arc or point approach and interpreting the resultant number.

iii) A pure number which does not based on any units of measure.

• Usually the supply curves of businesses selling goods and services slope upward, therefore the price elasticity of supply is a positive number varying from 0 to infinity.
• When the price elasticity is less than 1, then supply is inelastic.
• When the price elasticity is greater than 1, then supply is elastic.

iv) It might vary all along a supply curve.

v) A change in any of the factors, influence supply might also affect the price elasticity.

c) Intuitive factors:

i) Capacity utilization influences individual and market supply elasticity, example: if capacity is tight, the seller might not raise production much even if the price increases substantially, and supply will be comparatively inelastic.

ii) Time beneath consideration. In short run, some inputs might be costly or not possible to modify, the marginal cost of production will be steep and supply inelastic.  In long run, the marginal cost of production will slope more tenderly, and an individual and market supply curve will be much elastic.

12) Forecasting quantity supplied. A change in price will influence revenue:

a) Directly; and

b) Via changing the sales or quantity supplied (that is, employing the price elasticity).

Question-Answer:

Mercury Ltd was finalizing plans for a brick factory. Variable and fixed costs would have been similar to those of Jol Inc.'s existing brick factory. The only main difference between the two companies was that Jol had already sunk the fixed cost of its plant, whereas Mercury had not. Then, an industry analyst predicts that, due to expansion of supply, the long-run price of bricks would drop by 20 percent.

Mercury suspended all investment plans. By disparity, Jol announced that it would carry on production. Mercury and Jol are too small relative to the market that each can sell as much as it would like at market price

a) Describe the short run break-even condition.

b) Elucidate the long run break-even condition.

c) Assume that the new long-run price is less than Mercury’s average cost however higher than Jol's average variable cost. Describe why the two companies came to distinct decisions.

Answer:

a) In short run, the business must continue production too long as its revenue covers variable costs. Or, alternatively, too long as price covers the average variable cost.

b) In long run, the business must continue in production so long as its net revenue covers total cost. Or, alternatively, too long as price covers average cost.

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