First
and foremost, we study about the microeconomic. Economics may appear to be the
study of complicated tables and charts, statistics and numbers, but, more
specifically, it is the study of what constitutes rational human behavior in
the endeavor to fulfill needs and wants.
Our group’s topic is concentrated on the law of demand
and supply. Demand and supply is perhaps one of the most fundamental concepts
of economics and it is the backbone of a market economy. Demand refers to how
much (quantity) of a product or service is desired by buyers. The quantity
demanded is the amount of a product people are willing to buy at a certain
price; the relationship between price and quantity demanded is known as the
demand relationship. On the other hand, supply represents how much the market
can offer. The quantity supplied refers to the amount of a certain good
producers are willing to supply when receiving a certain price. The correlation
between price and how much of a good or service is supplied to the market is known
as the supply relationship. Therefore, price is a reflection of supply and
demand. The relationship between demand and supply underline the forces behind
the allocation of resources. In market economy theories, demand and supply
theory will allocate resources in the most efficient way possible. In this
report, we can take a closer look at the law of demand and the law of supply.
3.1 Definition
& Law of Supply
Supply plays a fundamental role in
Economics. It can be defined as the ability and willingness to sell or produce
a particular product and service in a given period of time at a particular
price, ceteris paribus. It simply means "all things being
equal". The phrase is often used in economic theory and modeling in order
to indicate that a particular relationship between two quantities holds
providing that nothing else changes.
The ''law of supply'' states that
the higher the price of a good or service, all other variables remaining the
same, the greater the quantity is supplied. For example, if the price of
chicken increases, the quantity of chicken supplied will increase since the
seller will sell more to earn more profit. There are some assumptions for the
law of supply. The other variables must be constant such as cost of production,
the number of sellers, the price of related goods either complements or
substitutes and the availability of other inputs remain unchanged.
Next, supply schedules is a table or
listing showing the exact quantities of a single type of good (or service) that
potential sellers would offer to sell at each of a number of varying prices
during some particular time period. Supply schedules may be drawn up to reflect
the behavioral propensities of a single unique individual, household, or firm
-- or, more frequently encountered in microeconomic analysis, composite supply
schedules for the particular good may be derived by adding up all the supply
schedules of the large number of individuals, households or firms that are
active or potentially active as sellers in the market under consideration. Supply schedules represent a functional
relationship between price and quantity supplied. It assumes that other supply
determinants such as the state of technology, government policies and the price
of related goods.
With the supply schedule, we can
construct a supply curve. A supply curve shows the relationship between the
quantities supplied of a product and its price provided everything else is
constant. Such a table is called a supply schedule, as shown in the following
example:
Supply Schedule
By graphing this data, one obtains
the supply curve as shown below:
Supply Curve
As with the demand curve, the
convention of the supply curve is to display quantity supplied on the x-axis as
the independent variable and price on the y-axis as the dependent variable. The
law of supply states that the higher the price, the larger the quantity
supplied, all other things constant. The law of supply is demonstrated by the
upward slope of the supply curve. As with the demand curve, the supply curve
often is approximated as a straight line to simplify analysis.
3.2 Shifts in Supply Curve
While changes in price result in
movement along the supply curve, changes in other relevant factors cause a
shift in supply, that is, a shift of the supply curve to the left or right.
Such a shift results in a change in quantity supplied for a given price level.
If the change causes an increase in the quantity supplied at each price, the
supply curve will shift to the right:
Supply Curve Shift
There are several factors that may
cause a shift in a good’s supply curve. Some supply shifting factors include
the price of other goods that is the supply of one good may decrease if the
price of another good increases, causing producers to reallocate resources to
produce larger quantities of the more profitable good, number of sellers that
means more sellers result in more supply, shifting the supply curve to the
right, prices of relevant inputs which is state that if the cost of resources
used to produce a good increase, sellers will be less inclined to supply the
same quantity at a given price, and the supply curve will shift the left,
technology which is state that technological advances can increase the
production efficiency shift the supply curve to the right, expectation by
giving a situation with if sellers expect prices to increase, they may decrease
the quantity currently supplied at a given price in order to be able to supply
more when the price increases, resulting in a supply curve shift to the left.
Market consists of many individuals. Like market
demand, market supply will also obtained by
summing up the quantity supplied by all sellers at various price levels.
Assuming there are only two sellers in the market, at the price of RM1 per
unit, seller 1 is supplying 10 units and seller 2 supplying 5 units. Hence,
market quantity supplied at RM1 per unit is 15 units and so on. Table 2.4 and
Figure 2.12 illustrate how market supply curve is derived.
Table 2.4 Derivation of Market Supply
Price (RM)
|
Quantity Supplied (Unit)
|
Market Supply (Unit)
|
Seller 1
|
Seller 2
|
1
|
10
|
5
|
15
|
2
|
20
|
10
|
30
|
3
|
30
|
15
|
45
|
4
|
40
|
20
|
60
|
5
|
50
|
25
|
75
|
(a) Supply Curve for Seller 1
(b) Supply Curve for Seller 2
(c) Market Supply Curve
3.3 Determinants
of Supply
Now
we will discuss on supply determinants in more detail. First, the determinant
of supply is the price of other goods. Correlation of goods in production
process influences the supply of a particular good when a price change for
related good occurs. Correlation of goods in production process can be divided
into two which is substitutes in supply and complements in supply. Substitutes
in supply refer to goods that can be produced to substitute the production of
other goods without having to make significant changes in the production
process. For example, the production of rice flour and glutinous rice flour can
be done using the same machine. If the profit or price of a substitute good in
the production increases, producer will shift production to that particular
good and decrease the production of other goods. From the example of flour
mentioned above, if the price of rice flour increases, producer will suspend
the production of glutinous rice flour to be substituted with the production of
rice flour, in order to gain current profit. Complements in supply refer to
goods jointly produced in a production process. For example, in the process of
producing petrol from crude oil, a few other products such as gas and diesel
will also be yielded. If the price of petrol increases, increase in supply of
petrol also causes the increase in supply of other products, and vice-versa.
Then, the other determinant is the change in
production cost. Production cost
can change
due to a few reasons including the change in price of production factors,
change in technology, tax collection and subsidies provided by the government.
Producers use a combination of production factors in the production process.
The price of production factors is determined in the factors market. Change in
the price of factors will influence production cost. Therefore, if the price of
factors decreases, production cost will also decrease. This situation provides
incentive to producers to increase production, even if there is no price
increase for that particular good in the market. Hence, decrease in the price
of factors will shift the supply curve to the right due to increase in supply.
Changes
in the government policy related to tax and subsidies will also influence the
supply curve. When producers have to pay tax, production cost will increase,
resulting in the left shift of the curve. On the other hand, subsidies given to
producers will reduce the production cost and hence, shift the curve to the
right. The discovery of new technologies that can reduce production cost will
also shift the supply curve to the right.
Next,
the prediction of price can determine the supply. If producers are able to
predict an increase in price of the goods produced, production will be
increased and the supply curve will shift to the right. If price is predicted
to decrease, production will also be decreased and the supply curve will shift
to the left.
In addition, the number of producers will also
influence the supply market.
Supply curve
will shift to the right when there is an increase in the number of producers
and vice-versa.
3.4 Changes in Quantity Supplied versus Change in
Supply
Like
demand, the concept of supply and quantity supplied also differ. Change in
quantity supplied occurs when there is a change in the price of the goods
itself. Price of goods positively influences quantity supplied. Increase in
price will increase the quantity supplied, and vice-versa. Change in goods
supplied triggered by change in price will show movement along the same supply
curve. Change in supply on the other hand, refers to shifts of the supply curve
caused by changes in supply determinants. The determinants include production
cost, predictions and price of other goods. Change in good supplied means
movement along one supply curve, whereas change in supply is illustrated by the
right or left shift of the curve.
Figure
2.10(a) illustrates the change in quantity supplied caused by the price
variation of the goods itself. Increase in price will cause an increase in
quantity supplied from point A to point B. Whereas decrease in quantity
supplied caused by price decrease of the product itself is shown by the
movement from point A to point C. Look at how movement takes place along the
same curve. This is known as change in quantity supplied.
Figure
2.10(b) on the other hand, shows the change in supply due to factors of supply determinants
such as price of other goods, production cost, price prediction and number of
producers. For example, increase in production cost will bring about decrease
in supply and further causes the supply curve to shift to the left from point A
in curve S0 to point C in curve S2. On the other hand,
decrease in production cost will increase supply in the market and will shift
the supply curve to the right (S0®S1). Observe that price is not a factor
that changes supply, but changes are caused by other factors of supply
determinants. This is illustrated by shifts in supply curve known as supply
change.
3.5 Exceptional Supply
The
law of supply is a general statement. The exception occurs when the price of a
products increases and the supply decrease. The exceptional supply curve is
negatively slope. Normally, this happen in the supply of labour and this is
known as the ‘Backward Bending Labour Supply Curve’. Supply of labour is
defined as the number of hours or days a particular type of labour is offered
for hire a different wage rates. The higher the wage rate, the longer the
supply of labour hours will be. However, there may be exceptions to this rule
(which is known as exceptional supply). The supply of labour can be affected by
the work-leisure ratio as illustrated in the following diagram:
A
labour will spend 24 hours of his day either on work or on leisure. His
non-working hours (earning income) will be considered his leisure time. The
opportunity cost of working is to forgo the hours of leisure. An increase in
wage rate may encourage substitution of leisure for work and encourages the
workers to put in additional hours as his wages are higher now. This is called
the substitution effect of an increase in wage rate. Supply of labour will
shift upward to the right as shown in the diagram. Workers will increase their
hours of work if wage rates are high. After a certain number of hours, workers
are unwilling to substitute their leisure for work. Although higher wage rates
may be offered, workers view their leisure as important. This is called the
income effect of an increase in wage rate. The supply of labour curve does not
upward throughout its entire length but begins to bend back on itself at one
point. This is what we call as the ‘Backward Bending Supply Curve’.
Based
on the substitution effect, the higher the wage rate, the more people will
economize on their non-market activities and increases their work hours. For
example, if David is given additional pay on the extra hours he works, he will
reduce his leisure and substitution them with work.
According to the income effect, a higher
income increases in demand for leisure. So, less time is spent on work and
there is a decrease in the quantity of labour supplied. For example, if David
has enough money, additional pay will not encourage him to increases his work
hours above the normal 8 hours. He will wish to spend his money on leisure
activities. Therefore, an increase in income will reduce the labour supplied.
3.6 Elasticity
of Supply
Price
elasticity of supply 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.
Based on supply, elasticity can take three forms
that is elastic when the
quantity supplied is very sensitive to price,
inelastic when the quantity supplied is not very sensitive to price and unitary
elastic when the quantity supplied moves in lock-step with price change.
If the result of the elasticity calculation is
greater than 1, the relationship is
said to be elastic. If the result of the elasticity
calculation is less than 1, the relationship is said to be Inelastic. If the
result of the Elasticity calculation is exactly 1, the relationship is said to
be Unitary Elastic. When Supply is Elastic, price has a large impact on the supply
for a good. Elastic Supply often reflects a longer period of time as Supply is
often difficult to change in the short term as many production factors must be
considered. Put simply, if a Producer can collect a large price for an item,
they will supply more of it – as soon as they can. When Supply is Inelastic,
price does not have a large impact on the supply for a good. Inelastic Supply
generally reflects a short period of time as Supply is often difficult to
change quickly as many production factors must be considered. Essentials, such
as food, are generally inelastic. When Supply is Unitary Elastic, price and
quantity demanded move in lock step. This indicates that the percentage change
in the price of the good will equal the percentage change in the demand for the
good. This is a special case scenario.
3.7 Determinants
of Price Elasticity of Supply
There
are some factors that affect price elasticity of supply. First, the spare
production capacity is used to determine the price elasticity of supply. If
there is plenty of spare capacity then a business should be able to increase
its output without a rise in costs and therefore supply will be elastic in
response to a change in demand. The supply of goods and services is often most
elastic in a recession, when there is plenty of spare labour and capital
resources available to step up output as the economy recovers.
Besides that, the stocks of finished products and components are another
important determinant. If stocks of raw materials and finished products are at
a high level then a firm is able to respond to a change in demand quickly by
supplying these stocks onto the market - supply will be elastic. Conversely
when stocks are low, dwindling supplies force prices higher and unless stocks
can be replenished, supply will be inelastic in response to a change in demand.
The ease and cost of factor substitution also can be used to determine the
price elasticity of supply. If both capital and labour resources are
occupationally mobile then the elasticity of supply for a product is higher
than if capital and labour cannot easily and quickly be switched.
On the other hand, time period involved in the
production process is one of
the
determinant of price elasticity of supply. Supply is more price elastic the
longer the time period that a firm is allowed to adjust its production levels.
In some agricultural markets for example, the momentary supply is fixed and is
determined mainly by planting decisions made months before, and also climatic
conditions, which affect the overall production yield.
In
this report, we learned about the supply and demand is an economic model of
price determination in a market.
The market price of a good is determined by
both the supply and demand for it. In the world today supply and demand is
perhaps one of the most fundamental principles that exists for economics and
the backbone of a market economy. Demand refers to how much of a product or
service is desired by buyers. The quantity demanded is the amount of a product
people are willing to buy at a certain price. The relationship between price
and quantity demanded is known as the demand relationship. Supply represents
how much the market can offer. The quantity supplied refers to the amount of a
certain good producers are willing to supply when receiving a certain price.
The correlation between price and how much of a good or service is supplied to
the market is known as the supply relationship.
It is important to understand
the basics of the law of demand and supply, in order to understand the basics
of economics. .Supply or demand model helps to explain how the market works and
gives a greater understanding of actual market behaviour. Therefore, analysis of this concept can be
used to develop economic and business decisions and policies. The purpose of
this assignment is to outline the basic elements of the model and discuss its
usefulness in understanding actual behaviour in the market place.
David
N. Hyman, Modern Microeconomics: Analysis and Application. 3rd ed.
Irwin. 1993.
Karl
E. Case and Ray C. Fair, Principles of Economics. 6th ed. Pearson,
Addison-Wesley, 2004.
Robert
S. Pindyck and Daniel L. Rubinfeld, Microeconomics. 6th ed. Eastern
Economy edition, Prentice-Hall India. 2006.
