Showing posts with label supply. Show all posts
Showing posts with label supply. Show all posts

Law of Supply and Its Exceptions

Law of Supply


The quantity supplied, other things remaining equal, varies directly with price. The supply of a commodity increases with increase in price and decreases with decrease in price. This tendency is called the law of supply. When the price of a commodity increases, there is an increase in profit. This induces firms to produce and sell more quantity.

The law that supply varies directly with the price is based on several assumptions:
  1. There is no change in the price of substitutes.
  2. There is no change in the cost of factors of production.
  3. There is no expectation of any change in prices in future.
The law of supply can be explained by the help of supply schedule presented below:
Supply Schedule
Price ($ per kg)
Quantity Supplied (kg. per month)
2
4
6
8
10
12
1
10
20
30
35
37

As shown in table, when price is $2 per kg, the quantity supplied is 1kg. When price increases to $4, quantity supplied increases to 10kg. Likewise when price increases to $6, quantity supplied increases to 20kg and so on.

The law of supply can be explained by the help of figure below:

Law of Supply

In the figure, OX axis represents quantity supplied and OY axis represents price of the commodity. SS is supply curve, which has been derived by joining different price-quantity combinations of above table. The supply curve is upward sloping which means that more is supplied in higher prices. The quantity supplied increases from 1kg to 10kg, 20kg, 30kg, when price increases from $2, $4, $6 and $8 respectively.

Exception to the Law of Supply

Some of the exceptions to the law of supply are as follows:
  1. Auction sale: The law of supply does not hold goods in auction sale. Auction sale may be made when a seller is badly in need of money. Hence, he will be prepared to sell all his goods at whatever the price offered. But even in auction sale, goods are sold to the highest bidder, which may be called the operation of law of supply.
  2. Clearance sale: The shopkeepers offer the clearance sale at heavily discounted price so as to get rid of the old stock. Hence, the law of supply does not hold good, since the shopkeepers attempt to sale more at lower price.
  3. Expectation of sellers: If the sellers expect that there will further fall in price in future, they will try to sell more even if price falls. Likewise, if they expect the further rise in price, they will not sell more even if the price is high. The sellers attempting to hoard food grain before the cultivating season and sell before harvesting season proves this.
  4. Fear of being out of fashion: The taste and fashion change from time to time. The advanced technology has brought rapid change in taste and fashion. This makes some of the goods out of fashion. Hence, if the change in fashion is expected, the sellers try to sell more at lower prices.
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Derivation of Market Supply Curve and Shift in the Supply Curve

Derivation of Market Supply Curve


The sum of quantity supplied by all firms in the market at given price is called market supply. When this process is repeated at all prices, we find the total supply of all firms. The derivation of total supply is shown in the table below.

Individual and Market Supply Schedule
Price ($ per kg)
Supply of A (kg per month)
Supply of B (kg per month)
Supply of C (kg per month)
Market Supply (kg per month)
2
4
6
8
10
12
1
10
20
30
35
37
1
20
30
35
40
42
3
15
25
35
40
41
5
45
75
100
115
120

The supply schedule shows the quantity supplied by the producers at different prices. When price per kg is $2, the market supply is 5kg, when price is $4, the market supply is 45kg, when price is $6, market supply is 75kg and so on. This implies that the quantity supplied increase with increase in price.

The market supply curve SS is derived on the basis of the above supply schedule. The market supply curve SS is derived by joining each price-quantity points.

Market Supply Curve

The market supply curve SS also shows that quantity supplied is 5kg at $2, 45kg at $4, 75kg at $6 and so on.

According to R. G. Lipsey, “The supply curve of a commodity shows the price of the commodity and the quantity that the supplier is willing to supply at each time period.” This curve is drawn on the assumption that all the factors affecting supply are assumed to be constant. The market supply curve is also upward sloping or slopes upwards to the right. It implies that the producers are willing to supply more at high prices.

Shift in the Supply Curve


The shift in the supply curve means that at each price more is supplied than before. The increase in supply at each price has been shown in table below. Likewise, the shift in supply curve has been shown in table and figure below:

Two Alternative Supply Schedule
Price ($ per kg)
Original quantity supplied (units per month)
New quantity supplied (units per month)
2
4
6
8
10
12
5
45
75
100
115
120
28
76
102
120
132
140

It is seen in the table that more is supplied than before at the same price. As for instance, when price of sugar is $2 per kg, supply is 28kg, at $4, supply is 76kg, at $6, and supply is 102kg and so on.

When supply increases at each price, the supply curve shifts to the right from S1 to S2 as shown in figure. The supply may increase due to improvement in technology, fall in the price of other commodities, fall in the prices of factors of production, and change in the objective of producers.

Likewise, when the supply decreases at each price, the supply curve shifts to the left from S1 to S2 as shown in figure. The supply may decrease due to the end of technical knowledge, rise in the price of other goods, increase in the prices of factors of production, change in the objective of producers. As in demand curve, the change in the price of the commodity alone leads to movement along the same supply curve. This supply curve shifts due to the change in factors other than price of the commodity.

Factors Causing the Shift in Supply Curve


The quantity supplied depends on different factors. The change in price of a commodity alone leads to the movement along the same supply curve. But the change in the factors other than price leads to the shift in the supply curve. The factors causing shift in the supply curve can be explained as follows:

1. Price of factors of production

The production cost depends on the prices of factors of production. When the price of a factor of production increases, the cost of production of the commodities using more of that factor increases more. On the other hand, the cost of production of the commodities using less of that factor increases less. As for example, when the price of land increases, the cost of producing wheat increases more. But it has less effect on the cost of producing motorcar.

When the price of a factor changes, the relative profitability of different types of products also changes. Due to this the producers stop one type of production and start another type of production. On account of this, the quantity supplied of different commodities also change. In brief, the supply of a commodity decreases with increase in the process of production. A reduction in input prices induces firms to supply more output at each price, shifting the supply curve to the right. On the contrary, higher input prices makes production less attractive and shift the supply curve to the left.

2. Price of other commodities

The supply of a commodity is also affected by the prices of other commodities. If the price of a commodity increases and that of other commodities do not increase, in general, the production of that commodity relative to other commodities becomes less attractive. Hence, other things remaining the same, the supply of a commodity decreases when the price of other commodities rise. On the contrary, the supply of a commodity increases when the price of other commodities fall.

3. Goals of firms

Every firm has definite objectives. The objectives of a firm also affect the supply of a commodity. In general, if the objective of the firm is profit maximization, less quantity is supplied at higher price. On the contrary, if the objective is sales maximization, the firm supplies more at lower price. In traditional economics, it is generally assumed that the firms aim to maximize profit. At present some economists are of opinion that the firms have other objectives such as sales maximization objective has not declined.

4. State of technology

The state of technology is also an important determinant of supply. The improved technique of production has significantly increased the production in recent days. The improvement in the technique of production has been facilitated by the progress of science. The development of technology has affected the production and brought change in the supply of commodities. Hence, whenever there are changes in state of technology, the existing commodities are supplied more. Besides, the new commodities are also supplied. This will shift the supply curve to the right. In the long run, the change in technology causes change in cost and affects the supply of a commodity.

5. Effects of taxation

The taxation raises the prices of commodities. The imposition of tax on commodities leads to an increase in cost of production. This will generally result in a decrease in supply. A reduction of taxation will have the opposite effect.

6. Government Regulation

The government regulation also affects the quantity supplied of a commodity at each price. The most stringent safety regulations may prevent producers using the most productive process. Because, it is quite dangerous to workers. The anti-pollution devise raise the cost of production. The environmental regulation may make it unprofitable for firms to extract surface mineral deposits. “Whenever government regulations prevent producers from selecting the production method, they would otherwise have chosen, the effect of these regulations is to shift the supply curve to the left.” It has the effect of reducing quantity supplied at each price.

In addition to these factors, bad weather, strike, cost of transport and communication, time needed for the product also effect the supply of a commodity. In the short run, the price expectation of sellers may also affect the supply of a commodity.

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Theory of Supply and Derivation of Single Producer's Supply Curve

Meaning of Supply


Supply like demand is also the function of price. It is expressed as, s = f(p). When the price of a commodity changes, the supply of the commodity also changes. But unlike demand, supply varies directly with price. The supply has positive relationship with price. It implies that supply increases with increase in price and supply decreases with decrease in price. The supply is the quantity that a seller is willing to sell at particular price and particular time. According to Watson and Getz, “In economics, the word supply always means a schedule – a schedule of possible prices and of amounts that would be sold at each price.”
According to R. G. Lipsey, “The amount of commodity that firm are willing to offer for sale is called the quantity supplied of the commodity.”
The concept of supply curve is relevant only in perfect competitive market. The nation of supply curve is not applicable in other forms of market like monopoly, monopolistic competition. Because, the main task of a supply curve is to show how much a firm can supply at given price. In perfect competition, a firm is only a price-taker and quantity adjuster. It cannot influence price. In the imperfectly competitive markets, a firm determines the price of its product. It is not necessary to adjust supply at given price.

Derivation of Single Producer’s Supply Curve


The quantity supplied by a firm, other things remaining equal, changes directly with change in price of commodity. The supply increases with increase in price and the supply decreases with decrease in price. This tendency is expressed as s = f(p). It shows that the supply of a commodity depends on its price. This tendency is called the Law of Supply. When price of commodity is high, more profit can be earned. This induces firms to produce and sell more quantity. The supply of a firm is called individual supply.

The individual supply schedule is a schedule of prices of commodity and the supply of the commodity made by an individual firm. Similarly, an individual supply curve is a schedule of different quantity of goods supplied by an individual firm at different prices. The supply schedule, therefore, shows the relationship between the prices of a commodity and the quantity supplied. The individual producer’s supply schedule has been presented in table below.

Individual Supply Schedule
Price ($ per kg)
Quantity Supplied (kg. per month)
2
4
6
8
10
12
1
10
20
30
35
37

As shown in the table, the quantity supplied at price $2 per kg is 1kg, at $4 is 10kg, at $6 is 20kg, at $8 is 30kg and so on. It shows that quantity supplied increases with increase in price.

A market supply curve is derived by the horizontal summation of the supply curves of all individual sellers in the market. The individual firm’s supply curve SS has been derived in the following figure on the basis of above table.

Individual Supply Curve

In the figure, OX axis represents quantity supplied and OY axis represents price of sugar. SS is the supply curve. It shows that the quantity supplied increases with increase in price. The quantity supplied is 1kg at price $2, 10kg at $4, 20kg at $6, 30kg at $8, 35kg at $10 and so on. In this way, the supply curve shows the relationship between price of the commodity and the quantity supplied.

In general, the supply curve has positive slope or it slopes upwards to the right. This implies that a firm supplies more at higher price. Because, at low price only the efficient producers can produce hand make profit. But at high price, even the firms previously unable to compete begin to supply and earn profit. Moreover, previously existing firms may be able to expand output at high price. In general, higher prices are needed to provide an incentive for firms to produce more.
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Inflation, Cost Push Inflation | Supply Shock Inflation

Supply Shock Inflation / Cost Push Inflation


Inflation is also caused by increase in the cost of production. As a result of increase in the cost of production, the aggregate supply schedule shifts downwards to the left, indicating that a lesser quantity is supplied at the existing prices. Aggregates demand schedule remaining unchanged, any leftward shift in the aggregate supply schedule will push the prices upwards as could be seen in figure.

Cost Push Inflation

In the figure, DD is the aggregate demand schedule which remains unchanged; S1S1 is the original aggregate supply schedule which intersects DD at point K. At the full employment equilibrium point K, the level of full employment output is OY0 and the price level is OP1. With increase in the costs (may be due to rise in wage rates, higher prices or inputs, etc.), the aggregate supply schedule shifts to S2S2 intersecting the aggregate demand schedule DD at point K1. At new equilibrium point K1, the level of real output OY1 is less than the full employment output, therefore, the price level rises to OP2. A further shift in the aggregate supply schedule to S3S3 pushes the price level of OP3.

Causes of Cost Push Inflation


Cost-push inflation is generally caused by three factors.
  1. Increase in money wages: In the modern business world, trade unions have become very well-organized and have been also to secure higher wages for their members. Whenever the products are compelled to accept the demand for higher wages by the trade unions, they try to shift the burden of increasing costs on to the consumers by charging higher prices for the final goods and services. This leads to ‘wage-price-spiral’. Increase in the wage rates leads to rise in prices, the real wages of the workers decline. To neutralize this fall, still higher wages are demanded and granted, and thus inflationary spiral continues.
  2. Higher profit margins: As discussed earlier aspiration for higher profit margin sets in motion ‘profit-push inflation’. This situation is typical to a sellers’ market in which demand exceeds the supply. Pressure on demand leads to increase in prices. Taking advantages of this situation, the producers set higher profit margins, which again would push the prices upwards.
  3. Rise in the prices of basic inputs: Scarcity of strategic and basic raw materials results in an increase in their prices, and in turn, the prices of final goods and services are increased. A fall in the supply of cement, iron and steel, sugarcane, cotton, etc., would raise their costs, and finally, the prices of the finished goods will also go up. The cost-push inflation may also be caused by the scarce supply of imported raw materials and intermediate goods.
  4. Administered higher prices of inputs: The prices of inputs do not always increase due to their scarcity but may increase due to some administrative action on the part of the government. Higher administered prices of basic inputs would affect the prices of final goods and services of the concerned business units. Thus, rises in administered prices sets in motion, the cost push inflationary forces in the economy.
  5. High rate of taxes: Taxes imposed on goods and services (i.e., indirect taxes) also generate inflationary pressure in the economy. As a result of increase in indirect taxes, the prices of raw material in international market. It is also known as supply shock inflation.
  6. International reasons: Another case of supply inflation on cost-push inflation is prices of the raw material in international market. It is also known as supply shock inflation.

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Inflation and Demand Pull Inflation | Causes of Demand Pull Inflation

Inflation is a fall in the market value or purchasing power of money. It is the opposite of deflation. It refers to a continuous increase in the aggregate price level of goods and services rather than just a one-time increase in it. In other words, inflation means rise in price level or fall in the value of money. Inflation is simply the increase in the general price level in sufficiently a long period. In
some context, the term inflation is used to refer to an increase in the money supply, although this concept is also often referred to as monetary expansion. Due to the causes of inverse relationship between general price level and value of money, inflation is continuous decrease in value or the purchasing power of money.

Inflation results from an increase in the amount of circulating currency beyond the needs of trade; an oversupply of currency is created. In the past, inflation was often due to a large influx of bullion, such as took place in Europe after the discovery of America and at the end of 19th century. In modern times, wars are the most common cause of inflation, as government borrowing, the increase in money supply, and a diminished supply of consumer goods, increase demand relative to supply and thereby cause rising price. The economists have defined inflation in many ways. Some of the definitions have been presented here.

According to Edward Shapiro, “Inflation is a persistent and appreciable rise in the general level of prices.”

 

In the words of Gardner Ackley, “Inflation is defined as a persistent and appreciable rise in the general level of prices. This clearly makes inflation a process rising prices not higher prices.”

 

In the words of Coulbourn, “Inflation is too much money charging too few goods”.

 

According to Sir RG Hawtrey, “Inflation is the issue of too much currency.”


According to Prof. Samuelson, “Inflation occurs when the general level of prices and costs is rising.”


Demand Pull Inflation


Demand pull inflation occurs when there is an excess demand over the available supplies at existing prices. Excess demand means aggregate real demand for output in excess of maximum feasible, or potential, or full employment output. Excess demand is generated by forces operating on the demand side of the commodity market.

As a result of increase in demand, the aggregate demand function shifts upwards to the right (supply function remaining constant). In this case, rise in price is caused exclusively by the increase in demand as could be seen in the figure.


In the figure, OU shows the full-employment level of real output. Beyond OU, rise in prices does not, result in increase in the real output. As the demand for real output increases from D1 to D2 and D3 to D4, the prices level also rises from P1 to P2, P3 and P4 respectively.

Causes of Demand Pull Inflation


Demand-pull inflation is caused by the following factors.

i) Excess demand

Prof. Keynes has explained the effect of excess demand on prices through his notion of ‘inflationary gap’. Inflationary gap may be defined as an excess of aggregate demand for goods over their aggregate supply measured at constant prices.

ii) Increase in money supply

Monetarists held excess increase in the quantity of money responsible for inflation. According to the quantity theory of money, at a given level of national income (potential as well as actual) the general price level (P) rises in the same proportion as increase in the quantity of money (M), the velocity of money being held constant. In a static economy, M is policy-determined; therefore, the rate of inflation also becomes policy-determined.

In a dynamic economy, the real demand for money grows over time and the national income also grows over time. Apparently, the rate of growth of real demand for money will be equal to the rate of growth of the national income. However, excess increase in the stock of money will lead to increase in prices. Excess supply of money is nothing but the excess demand for output that causes inflation.

iii) Disposable income

It refers to the income payments to factors after personal taxes have been paid. An increase in disposable income results in increased purchased power with the people. There is increasing pressure on the demand for goods and services, as a result, prices tend to rise.

iv) Increase in business outlays

During the prosperity phase of business activities, increase in business outlays or capital expansion take on a speculative character. New equipment and plans are often financed by speculative borrowings. Most of business outlay finds their way into the income stream via dividends, wages and other factor of payments. These business outlays are inflationary in character.

v) Increase in foreign demand

Increase in the export demand for domestic goods and services also lead to inflation. This is particularly true for the economies which maintain considerable inflationary pressure on domestic areas of shortages which may be a focal point of spreading inflation.

vi) Increase in government expenditure

There may be an increase in the government expenditure of government revenue. This might have been made possible through government borrowings from banks or through deficit financing, which implies an increase in the money supply.

vii) Reduction of taxation

If government reduces taxes, households are left with more disposable income in their pockets. This leads to increase consumer spending, thus increasing aggregate demand and eventually causing demand pull inflation.

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Value of Maximization Theory of Firm | Superiority of Maximization Theory

In managerial economics, the primary objective of management is assumed to be maximization of the firm’s value. The value can be defined as the present value of the firm’s expected future cash flows. Cash flows may be for now, be equated to profits, therefore the value of the firm today, its present value, is the value of its expected future profits, discounted back to the present at an appropriate interest rate.

The essence of the model with which are concerned expressed as follows:
 
Value of the firm = PV of expected future profits


Where,
PV is the abbreviation for the present value, and so forth represent the expected profits in each year ‘t’, ‘i’ is the appropriate interest rate.
 
Since profits are equal to total revenue (TR) minus total cost (TC), equation (i) may be written as


Maximizing equation (ii) involves the determinants of revenues, costs and the discount rates in each future year of some unspecified time. Revenues, costs and the discount rates are interrelated, complicating the problem even more.

A firm’s total revenues are directly determined by the quantity of its products sold and the process received, for managerial decision making, the important considerations relate to factors that affect prices and quantities, and to the interrelationships between them. These factors include the choice of products of the firm designs, manufactures and sells the advertising-strategies, it employs, the pricing it established, the general state of the economy it encounters and the nature of the competition it faces in the market place. In short, revenue relationship encompasses both demand and supply considerations.

The cost relationships involved in producing a firm’s products are similarly complex. Costs require examination of alternative production systems, technological options, input possibilities, and so on. The prices of the factors of production play an important role in cost determination, and thus factors supply considerations are important.

Finally, there is the relationship between the discount rate and the company’s production mix, physical assets and financial structure. These factors affect the cost of availability of financial resources for the firm and ultimately determine the discount rate used by investors to establish a value of the firm.

To determine the optional course of action requires that marketing, production and financial decisions as well as decisions related to personnel, product distribution and so on be combined into a single integrated system, one which shows how any action affects all parts of the firm. The economic model of the firm provides a basis for this integration and the principles of economic analysis enable to analyze the important interrelations.

Superiority of Maximization Theory


Shareholder wealth maximization is the basic goal of any business firm because of the following reasons:
  1. Efficient allocation of resources: It provides guideline for making decision of firm and also promotes an efficient allocation of resources. Resources are generally allocated by taking into consideration the expected return and risk associated to course of action. The market value of stock itself reflects the risk return trade off associated to any investor in the capital market. 
  2. Separation between ownership and management: The goal of shareholder wealth maximization is also justifiable from the view point of separation of ownership and management in a business firm. Stockholders provides funds to operate a business firm and they appoint a team of management to run the firm. 
  3. Residual owners: Shareholders are the last to share in earnings and assists of the company. Therefore, shareholders wealth is maximized, and then all other with prior claim that shareholder could be satisfied. 
  4. Emphasis on cash flow: Wealth maximization goal uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flow is clearer because it uniformly means profit after tax plus non-cash outlays to all. 
  5. Recognizes time value of money: It also recognizes the time value of money. All the cash flow generated over the life of the business firms are discounted back to present value using required rate of return and decision is based on the present value of future returns.
  6. Consideration risk: Wealth maximization objective also considers the risks associated to the streams of future cash flows. Depending on the degree of risk, a proper required rate of return is determined to discount back the future streams of cash flows. Greater the risk larger will be the required rate of return and vice-versa.

The complexities involved in the fully integrated decision making analysis limit its use to major planning decisions. The decision process involved in both fully integrated and partial optimization problems takes place in two steps, one must apply various techniques to determine the optimal decision.

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