Supply

Supply Curve a function that shows the quantity supplied at

different prices.

Quantity Supplied the amount of a good that sellers are will-

ing and able to sell at a particular price.

Producer Surplus the producers gain from exchange, or the

difference between the market price and the minimum price

at which a producer would be willing to sell a particular

quantity.

Producer Surplus the area above the supply curve and below

the price.

Why produce more when prices rise?

You spent a few weeks analyzing this in microeconomics. Basi-

cally when resources have competitive uses, it tends to be more

costly to produce extra output in the short-run. Hence, higher

prices are required to cover costs that increase at the margin.

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Two ways to read a supply curve

It can be read horizontally or vertically.

Horizontally given the price of a good, how much will be pro-

duced? Start with the price. ⇒ then ⇓ to get Q.

Vertically given the amount people want to sell, what is the

lowest price they willing to charge? Start at Q. Read ⇑then ⇐ to get price.

Figure 4 illustrates this.

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Figure 4: A graph from (Cowen and Tabarrok, 2011, ch. 3): Two ways to

read a supply curve.

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Figure 5: A graph from (Cowen and Tabarrok, 2011, ch. 3). Given the price

of oil is $40, the producer surplus will be the area below $20 and above the

supply curve, which is shaded in green.

Producer Surplus

What benefits do producer get from trade? It depends on the

difference between how much they are willing to accept to pro-

duce and what they actually get paid for producing that amount.

It’s the difference between price and the supply curve. See Fig-

ure 5.

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Changes in Supply

When something alters how much you are willing to produce of

a good at each possible market price, we say that supply has

changed. Graphically, this appears as a shift in the location of

the supply curve. There is a new set of prices for each quantity

(or new quantities for each set of prices).

Increase in Supply Producers are willing to produce more of

the good at existing prices. Supply shifts to the right.

Decrease in Supply Producers aren’t willing to produce as

much of the good at existing prices. Supply shifts to the

left.

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What changes or shifts supply?

1. Technological innovations – technology improves, supply in-

creases, shifting to the right.

2. Changes in input (resource) prices – resource prices rise,

costs rise and supply decreases, shifting supply curves to

the left.

3. Taxes and subsidies – taxes increase costs and decrease sup-

ply (shift left), subsidies reduce costs and increase supply

(shift right).

4. Entry or exit of producers into industry – more firms usu-

ally means more competition which tends to increase sup-

ply.

5. Changes in opportunity costs – in general, higher opportu-

nity costs reduce supply.

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Equilibrium

The demand curve is a simple model of how consumers behave in

a market. The supply curve is a model of the provision of those

goods or services. Together, they form a market and, provided

that institutions that govern ownership, buying, and selling are

goods ones, prices will adjust to bring about a balance between

the wishes of both sides of the market. This balance is referred

to as equilibrium.

Equilibrium Price the price at which quantity supplied is equal

to quantity demanded.

Surplus when quantity supplied exceeds quantity demanded.

Cause: price is above equilibrium.

Shortage when quantity demanded exceed quantity supplied.

Cause: price is below equilibrium

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The adjustment process

If buyers compete with one another for scarce goods, then rivalry

tends to drive prices up. So, when there are shortages, prices

rise as potential buyers outbid each other. Suppliers are willing

to provide more in response to the rising prices. Eventually, the

shortages are eliminated as equilibrium is approached.

If sellers compete with each other for customers, then there

is an incentive for prices to fall towards the cost of production–

eliminating all excess profits. Surpluses are eliminated by com-

petition among sellers which result in falling prices. Falling

prices discourage production and the surplus is eliminated as

equilibrium is appoached.

So, as long as we have sufficient competition markets are

self-equilibrating. Furthermore, as long as all of the benefits of

consuming go to the buyer and the costs to the seller, the equi-

librium quantity and price maximize the net benefits of trade in

that good to society. This is shown if Figure 6.

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Figure 6: A graph from (Cowen and Tabarrok, 2011, ch. 4): Surplus drives

price down, shortage drive prices up. Markets tend to be self-equilibrating

provided there is sufficient competition.

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Who competes with whom?

Common Fallacy “Sellers want higher prices and buyers want

lower prices so buyers and sellers compete against one an-

other.” This is False!

Fact Sellers compete against each other, which causes prices to

fall.

Fact Consumers compete against each other for access to goods;

this causes prices to rise.

“If the price of a good that you want is high, should you

blame the seller? Not if the market is competitive. Instead, you

should blame other buyers for outbidding you.” (Cowen and

Tabarrok, 2011, p.49)

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Gains from trade are maximized at equilib-

rium prices and quantities

This statement requires a little qualification. There are some

things that have to go right for markets to maximize gains

from trade. These conditions suggest goods that carry signif-

icant spillover costs or benefits may not be optimal. Or, goods

for which you are unable to prevent non buyers (referred to as

free riders) from consuming once the good is provided (pub-

lic goods). Still, most goods don’t carry large spillovers and

technology and property rights are making it easier to charge

free-riders for consumption.

• Provided there is sufficient competition among buyers and

among sellers

• Buyers get all of the benefits that are associated with the

good.

• Sellers bear all of the costs associated with producing the

good.

The conclusion is based on the supply and demand model that

shows the market price maximizes the total surplus from trade.

This is illustrated in Figure 7.

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Figure 7: A graph from (Cowen and Tabarrok, 2011, ch. 4): Maximizing

gains from trade in free markets. This demonstrates one dimension of what

Adam Smith was talking about when he referred to an “Invisible Hand.”

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Shifting Curves

A picture is worth a thousand words? Probably. See Figure 8.

Be sure you know how to describe the difference between

changes in demand and changes in quantity demanded. Likewise

for supply.

Describing changes

Change in Quantity Demanded Move along a given demand

curve. This is caused by a change in price.

Change in Demand This shifts the demand curve. This is

caused by changes in income, population, prices of other

goods, expectations, or tastes and preferences.

Change in Quantity Supplied Move along a given supply curve.

This is caused by a change in price.

Change in Supply This is a shift in the supply curve. This is

caused by changes in technology, input prices, taxes, subsi-

dies, entry or exit from the industry, or changes in oppor-

tunity costs.

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Figure 8: A graph from (Cowen and Tabarrok, 2011, ch. 4): Shifting supply

and demand and determining the effects on equilibrium prices and quantities.

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Bibliography

Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of

Economics, 2nd edn, Worth, New York.

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