Lesson 3 THEORY OF SUPPLY

#1. What is supply?

It refers to the quantity of a commodity which producers or sellers are willing to produce
and offer for sale at a particular price during a particular period of time.

#2. Differences between Stock (intended supply) and Supply (actual supply)

Stock/Potential Supply/Intended Supply THS ECO Supply /Actual Supply

1. It refers to the volume of a 1. Supply refers to the quantity of a
commodity which can be brought commodity which is actually brought
into the market for sale at a short into the market for sale.
notice. 2. Market sale of the commodity is only
2. Stock = (unsold commodity of the part of the total stocks.
previous period) + (production of the
commodity in the present period) –
(sales of the commodity in the 3. Concept of supply has a time
present period) dimension.
3. Concept of stock has no time
dimension.

[Refer to ABS for other differences]

#3. What are the determinants of supply?

 Price of the commodity (Px) - Given other things, a larger quantity of a commodity
will be supplied at a higher price and vice versa. However, the price of the product
should be more than the marginal cost of production as the firm can earn excess profit
by selling its product at that higher price. Thus, the supply of the product will also
increase.
 Prices of inputs (Pf) - If prices of inputs like raw materials, workers, machines
increase, then profitability of the firm will fall because of an increase in the cost of
production. Hence, the firm will supply less than before at the prevailing price level.
In case of a fall in input prices, the firm will be willing to supply more at the
prevailing price level.
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  State of technology(t)- If there is an improvement in production technology, then the
firm will produce more with the given resources. Thus, average cost of production
falls and the firm will be willing to supply more at a given price. If there is
deterioration in production technology, then supply falls at the given price level.
 Goals of the firm(G)- The goal of every firm is to maximise its profit. However,
some firms may opt for sales maximization and will supply more than before at each
price level. However, if the firm is a risk avertor, he will follow a safer line of
activity and will produce less than before at a given price level.
 Government Policy (T) – If the Govt. imposes indirect taxes on the commodity, then
the seller has to pay this tax to the Govt. In order to keep the profit margin same as
before, the seller may either sell the same quantity at a higher price than before or
supply a lower quantity at the old price level.
If the Govt. gives a subsidy to the seller, then the seller can either sell the same
quantity at a lower price than before or he can supply more at the same price level.
 Future price expectation (PE) – If the THS
producer
ECO expects an increase in the future price
of the commodity, then he will supply less than the present amount and hoard so as to
offer a larger quantity of the commodity in future at higher prices. If he expects the
prices to fall in future, he will tend to increase his supply at present.

In addition to the above-mentioned determinants

 Natural Factors -Natural factors like drought, flood etc. will lead to a decrease in the
supply of particularly agricultural goods. However, favourable climatic conditions help
to increase the supply of agricultural goods.
 Agreement among producers – Sometimes producers may form a pool and enter into
some agreement to restrict the supply of a commodity so as to earn larger profits. This
creates artificial scarcity of goods as a result of which supply decreases.
 Prices of related goods – Producers have the possibility of shifting from the production
of one commodity to another. Thus, if prices of substitute goods are rising while price
of the given commodity remains constant, then the producers will it more profitable to
produce and sell the substitute commodity. As a consequence, supply of the given
commodity will fall.
If prices of substitutes fall, then supply of the given commodity will rise.
 Number of producers (N)– If number of firms selling the same type of product in the
market increases, then at a given price, the supply of the product would increase in the
market and vice versa.
 Availability of transport and communication facilities - Supply of a commodity will be
more if there is an improvement in the transport and communication facilities.
However, if there is no such improvement in transport and communication facilities,
then it will lead to a decrease in the supply of a commodity.

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 Nature of the industry - In case of a monopoly market, one firm supplies a particular
product. Hence, a monopolist can restrict its output so as to raise the market price of
the commodity.
However, if there is competition amongst firms, the firms are likely to produce and sell
more as compared to a monopolized industry.

#4. What do you mean by Supply function?

The functional relationship between the supply of a commodity and its determinants. It is
expressed as:
Sx = f (Px, Pf, t, G, T, PE, N, …) where Sx denotes the supply of a commodity ‘X’ and the
remaining as mentioned above.

Ceteris Paribus Supply Function

THS ECO
The functional relationship between the supply of a commodity and its own price, keeping
other factors affecting supply unchanged.
Sx = f (Px) where Sx denotes the supply of a commodity ‘X’ and Px indicates the price of
the commodity

#5. What is individual supply schedule and market supply schedule?

An individual supply schedule is a tabular representation of the various quantities of a

commodity that are supplied at different prices in a given period of time.

Hypothetical individual supply schedule

Price (Rs) Quantity (units)

10 1
20 2
30 3
40 4

A market supply schedule is a tabular representation of the various quantities of a

commodity that all firms are willing to supply at different prices in a given period of time.

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 Hypothetical Market supply schedule
Price (Rs) Qty A (kg) Qty B (kg) Qty M (kg)
10 1 2 3
20 2 3 5
30 3 4 7
40 4 5 9

#6. Individual supply curve

The graphical representation of the various quantities of a commodity that are supplied at
different prices in a given period of time.

THS ECO

Market supply curve

It is the graphical representation of the various quantities of a commodity that all firms are
willing to supply at different prices in a given period of time.

#8. Explain the law of supply.

Statement: The law of supply states that, other factors affecting supply remaining constant,
the quantity supplied of a commodity increases when its price rises and decreases when its
price falls.

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Assumption: It is assumed that the following factors affecting supply remain constant.
Prices of inputs
State of technology
Goals of the firm
Government policy
Future price expectations
Number of firms
Etc.
Hypothetical individual supply schedule
Price (Rs) Quantity (units)
10 1
20 2
30 3
THS ECO
40 4
Individual supply curve:

The graphical representation of the individual supply schedule.

In the above figure, price is measured along the ‘Y’ axis and quantity supplied is measured
along the ‘X’ axis. Points a, b, c and d are different price-quantity combinations joining
which we get the supply curve SS. The supply curve slopes upward establishing the direct
(positive) relation between the price of a commodity and the quantity supplied of it.
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