Theory of supply, law of supply, graphical explanation

2. CONTENTS
•What is supply
•Determinants of supply
•Key terms
•Law of supply,assumptions,schedule and graph
•Important points
•Reasons for law of supply
•Exceptions of the law of supply
•Price elasticity of supply
•Measurement of price elasticity of supply
•Factors influencing elasticity of supply

3. Meaning of supply
Supply refers to quantity of a commodity that a
firm is willing and able to offer for sale at a
given price during a given period of time.
The definition of supply highlights 4 essential
elements:
•Quantity of a commodity
•Willingness to sell
•Price o the commodity
•Period of time

4. Determinants of Supply
1) Goals of the firm: The goals of a firm
influence the amount of a good that
producers are willing to supply. The goals
may be profit maximisation or sales
maximisation.
2) Good’s own price: As the price of a good
rises, with costs and the prices of all other
goods unchanged, production of that good
becomes profitable.

5. 3) Prices of inputs: The prices of inputs such as
labour, machines, raw materials, determine
the cost of production. If the input price
rises, cost of production increases and
profits are reduced. This will cause supply to
fall at the given price and vice-versa.
4) Technology: Technology refers to ways in
which inputs can be combined to produce a
given output. Technological improvements
will reduce costs and increase the profits.

6. 5) Price of related goods: The related goods
may be;
a) Substitutes: If the price one production
substitute rises, the supply of another
substitute will decrease. For e.g. Wheat and
corn.
b) Complementary: When goods are
complements or joint products like petrol
and paraffin or like car and petrol, an
increase in the price of one complement or
joint product yields an increase in the
supply of the other.

7. Key Terms

9. Law Of supply
Definition: Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price paid by
buyers for a good rises, then suppliers increase the supply of that good in the market.
Description: Law of supply depicts the producer behaviour at the time of changes in the prices
of goods and services. When the price of a good rises, the supplier increases the supply in order
to earn a profit because of higher prices.
The above diagram shows the supply curve that is upward sloping (positive relation between the
price and the quantity supplied). When the price of the good was at P3, suppliers were
supplying Q3 quantity. As the price starts rising, the quantity supplied also starts rising.

10. Assumptions of law of supply
While stating law of supply the phrase ‘keeping other
factors constant or ceteris paribus’ are used. This
phrase is used to cover the following assumptions on
which the law is based:
1. Price of other goods are constant;
2. There is no change in the state of technology;
3. Prices of factors of production remain the same;
4. There is no change in the taxation policy;
5. Goals of the producer remain the same.

11. Supply schedule and graph
Price (in Rs.) Quantity (in units)
1
2
3
4
5
10
20
30
40
50
Table: clearly shows that more and more units of the commodity are being offered for sale as
the price of the commodity is increased. As seen in Fig. 9.3, supply curve SS slope upwards from
left to right, indicating direct relationship between price and quantity supplied.

12. Important points about law of supply:
1. It states the positive relationship between price and
quantity supplied, assuming no changes in other factors.
2. It is a qualitative statement, as it indicates the direction of
change in the quantity supplied, but it does not indicate the
magnitude of change.
3. It does not establish any proportional relationship between
change in price and the resultant change in quantity supplied.
4. Law is one sided as it explains only the effect of change in
price on the supply, and not the effect of change in supply on
the price.

13. Reasons for supply of supply
1. Profit Motive:
The basic aim of producers, while supplying a commodity, is to secure maximum
profits. When price of a commodity increases, without any change in costs, it raises
their profits. So, producers increase the supply of the commodity by increasing the
production. On the other hand, with fall in prices, supply also decreases as profit
margin decreases at low prices.
2. Change in Number of Firms:
A rise in price induces the prospective producers to enter into the market to produce
the given commodity so as to earn higher profits. Increase in number of firms raises
the market supply. However, as the price starts falling, some firms which do not expect
to earn any profits at a low price either stop the production or reduce it. It reduces the
supply of the given commodity as the number of firms in the market decreases.
3. Change in Stock:
When the price of a good increases, the sellers are ready to supply more goods from
their stocks. However, at a relatively lower price, the producers do not release big
quantities from their stocks. They start increasing their inventories with a view that
price may rise in near future.

14. Exceptions to law of supply
1. Future Expectations:
If sellers expect a fall in price in the future, then the law of supply may not hold true. In this
situation, the sellers will be willing to sell more even at a lower price. However, if they expect
the price to rise in the future, they would reduce the supply of the commodity, in order to
supply the commodity later at a high price.
2. Agricultural Goods:
The law of supply does not apply to agricultural goods as their production depends on climatic
conditions. If, due to unforeseen changes in weather, the production of agricultural products is
low, then their supply cannot be increased even at higher prices.
3. Perishable Goods:
In case of perishable goods, like vegetables, fruits, etc., sellers will be ready to sell more even if
the prices are falling. It happens because sellers cannot hold such goods for long.
4. Rare Articles:
Rare, artistic and precious articles are also outside the scope of law of supply. For example,
supply of rare articles like painting of Mona Lisa cannot be increased, even if their prices are
increased.
5. Backward Countries:
In economically backward countries, production and supply cannot be increased with rise in
price due to shortage of resources.

15. Price Elasticity of supply
Price elasticity of supply (PES or Es) is a measure used in economics to
show the responsiveness, or elasticity, of the quantity supplied of a
good or service to a change in its price or cost.
The elasticity is represented in numerical form, and is defined as the
percentage change in the quantity supplied divided by the percentage
change in price.
When the coefficient is less than one, the said good can be described as
inelastic; when the coefficient is greater than one, the supply can be
described as elastic. An elasticity of zero indicates that quantity supplied
does not respond to a price change: it is "fixed" in supply. Such goods
often have no labour component or are not produced, limiting the short
run prospects of expansion. If the coefficient is exactly one, the good is
said to be unitary elastic.

16. Price elasticity of supply (Pes) measures the relationship between
change in quantity supplied and a change in price.
• If supply is elastic, producers can increase output without a rise in cost
or a time delay
• If supply is inelastic, firms find it hard to change production in a given
time period.
The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage
change in price
• When Pes > 1, then supply is price elastic
• When Pes < 1, then supply is price inelastic
•When Pes = 0, supply is perfectly inelastic
•When Pes = infinity, supply is perfectly elastic following a change in
demand

17. Measurement of price elasticity of supply
Price Elasticity of Supply measures the responsiveness
of quantity supplied to change in price, as percentage
change in Quantity Supplied induced by percentage
change in Price.
There are two methods of measuring Price Elasticity
of Supply:‐
1. Percentage – Change Method
2. Geometric method

18. 1. Percentage – change Method
According to this method Price Elasticity of supply (Es) is measured as under:‐
Price Elasticity of Supply (Es) = % Change in Quantity Supplied
% Change in price

19. Where
Q – Change in Quantity supplied
Q – initial Quantity Supplied
P – Change in Price
P - Initial Price

20. 2. Geometric Method
Under this method five different situations of Price Elasticity can be
described as follows:-
a)Unitary Elasticity or Es=1
In this situation the supply curve slopes upward in a straight line which
starts from point of origin. This shows the percentage change in
Quantity supply is exactly equals to percentage change in price.

21. b) Greater than Unitary Elasticity or Es ≥ 1
When a straight line upward sloping curve starts from Y-axis, then this is
a case of Unitary Elasticity. This depicts that percentage change in
quantity supplied is greater than percentage change in price.

22. c) Less than Unitary Elasticity or Es ≤ 1
When a straight line upward sloping curve starts from X-axis then this is
a case of less than Unitary Elasticity. This represents that percentage
change in quantity supplied is less than percentage change in price.

23. d) Perfectly Inelastic Supply or Es = 0
It is a situation where there is no change in supply regardless of change
in price. It shows that supply remain unchanged with the change in
price. In such situation supply curve is vertical straight line curve.

24. e) Perfectly Elastic Supply or Es = 0
In this situation supply is infinite corresponding to a particular price of
the commodity. Accordingly a slightest fall in price caused an infinite
change in supply, reducing it to zero. In this case supply curve is
horizontal straight line.
Es=0

25. Factors influencingElasticity of supply
•Time: In the short run firms will only be able to increase input of labour to increase
supply of commodities may not be able to increase the supply in response to the price
change but the supply change will be little because other factors of production may
not be increased in the same proportion and may limit the supply. However, in the
long run a firm will increase the input of all factors of production and thus the supply
becomes more price elastic.
•Availability of resources: If the economy already using most of its scarce resources
then firms will find it difficult to employ more and so output will not be able to rise.
The supply of most of goods and services will therefore be price inelastic.
•Number of producers: More producers mean that the output can be increased more
easily. Thus supply is more elastic.

26. •Ease of storing stocks: If goods can be stocked with ease and have a long shelf life,
the supply will be elastic, otherwise inelastic. For example perishable goods such as
fresh flowers, vegetables have comparatively inelastic supply because it is difficult to
store them for longer periods.
•Increase in cost of production as compared to output: In cases where there is a
significant increase in cost of production when output is increased, supply is inelastic.
This is because suppliers will have to have to do a significant investment in order to
increase the output. It will take time and some suppliers may be hesitant in doing so.
•Improvement in Technology: In industries where there is a rapid improvement in
technology, the PES of such goods will be more elastic as compared to industries
where there is not much improvement in technology.
•Stock of finished goods: In industries where there are high inventories/stocks of
finished goods, the suppliers can easily supply more as the price rises. Thus, the PES
for these goods will be elastic.

27. By:
CHHAVI GUPTA
BBA-1A(gen.)