SVKM’s NMIMS ASMSOC (NAVI MUMBAI CAMPUS)

Microeconomics for B.Sc (Finance) | Course Code : 42EC0C005

Students Handout / Notes

Session 4 – 04/08/23

Concept of Supply: Supply refers to the quantity of a good or service that producers are
willing and able to offer for sale in the market at a given price and time. It represents the
relationship between the price of a product and the quantity that producers are willing to
provide. The law of supply states that as the price of a product increases, the quantity supplied
also increases, assuming all other factors remain constant.

Factors Affecting Supply (Supply Function): Several factors influence the supply of a
product in the market. These factors include:
1. Price of the Product: As the price of a product increases, producers are motivated to
supply more of it to take advantage of higher profits.
2. Cost of Production: If the cost of producing a good or service rises, producers may
reduce the quantity supplied to maintain their profit margins.
3. Technology: Advancements in technology can lead to increased production efficiency,
which may boost the overall supply.
4. Number of Producers: An increase in the number of producers in the market can lead
to a higher total supply.
5. Expectations of Future Prices: If producers anticipate higher prices in the future, they
might hold back some supply from the market to sell later at a higher price.
6. Input Prices: The prices of resources and raw materials required for production can
significantly impact supply. If input prices rise, supply may decrease.
7. Government Policies and Taxes: Government regulations, subsidies, and taxes can
influence production costs and, in turn, affect supply.
8. Natural Disasters and Weather Conditions: Events like natural disasters or adverse
weather can disrupt production and reduce supply.
9. Changes in the Number of Sellers: If new sellers enter the market or existing ones
exit, it can affect the overall supply.

Law of Supply: The law of supply states that there is a direct relationship between the price
of a product and the quantity supplied. When the price of a good or service increases, the
quantity supplied increases, and vice versa. This positive correlation occurs assuming all other
factors that affect supply remain constant.

Supply Curve: The supply curve is a graphical representation of the relationship between the
price of a product and the quantity supplied by producers. It is typically upward-sloping,
indicating the positive relationship between price and quantity supplied. The supply curve
shows that as the price increases, the quantity supplied also increases, ceteris paribus (all else
being equal).
Movement vs. Shift of Supply Curve:
• Movement: A movement along the supply curve occurs when there is a change in the
quantity supplied in response to a change in price. This happens when the only factor
affecting supply is the price of the product itself. If the price increases, the quantity
supplied increases (a movement up the curve); if the price decreases, the quantity
supplied decreases (a movement down the curve).
• Shift: A shift of the supply curve occurs when one of the factors affecting supply, other
than price, changes. This means that at each price level, producers are willing to
supply a different quantity than before. Factors like production costs, technology,
input prices, and government policies can cause the supply curve to shift either to the
right (increase in supply) or to the left (decrease in supply). An increase in supply
shifts the curve to the right, meaning more is supplied at every price level, and a
decrease in supply shifts the curve to the left, indicating less is supplied at every price
level.

Elasticity

The price elasticity of supply (PES) measures the responsiveness of quantity supplied to
changes in price, as the percentage change in quantity supplied induced by a one percent
change in price. It is calculated for discrete changes as Since supply is usually increasing in
price, the price elasticity of supply is usually positive.

The price elasticity of supply (PES) is measured by % change in Q.S divided by % change in
price.
• If the price of a cappuccino increases by 10%, and the supply increases by 20%. We say
the PES is 2.0.
• If the price of bananas falls 12% and the quantity supplied falls 2%. We say the PES =
2/12 = 0.16

a. Elastic Supply: PES > 1

• Quantity supplied is highly responsive to changes in price.
• Suppliers can increase or decrease production significantly in response to price
changes.
b. Inelastic Supply: 0 < PES < 1
• Quantity supplied is not very responsive to changes in price.
• Suppliers find it difficult to adjust production in response to price changes.
c. Unitary Elastic Supply: PES = 1
• Percentage change in quantity supplied is equal to the percentage change in price.

Significant determinants include:

Complexity of production: Much depends on the complexity of the production process.
Textile production is relatively simple. The labor is largely unskilled and production facilities
are little more than buildings—no special structures are needed. Thus, the PES for textiles is
elastic. On the other hand, the PES for specific types of motor vehicles is relatively inelastic.

Auto manufacture is a multi-stage process that requires specialized equipment, skilled labor,
a large suppliers network and large R&D costs.

Time to respond: The more time a producer has to respond to price changes the more elastic
the supply. For example, a cotton farmer cannot immediately respond to an increase in the
price of soybeans.

Excess capacity: A producer who has unused capacity can quickly respond to price changes
in his market assuming that variable factors are readily available.

Inventories: A producer who has a supply of goods or available storage capacity can quickly
respond to price changes.

Other elasticities can be calculated for non-price determinants of supply. For example, the
percentage change the amount of the good supplied caused by a one percent increase in the
price of a related good is an input elasticity of supply if the related good is an input in the
production process. An example would be the change in the supply of Pav (Bun) caused by a
one percent increase in the price of maida (refined flour).

Importance:
• Understanding PES helps businesses and policymakers predict how changes
in prices will affect the quantity of goods available in the market.
• It helps in price planning and revenue optimization for firms.
• Governments use PES to anticipate the impact of taxation or subsidies on the
supply of specific goods.

Cross Elasticity of Supply: This is another related concept that measures the responsiveness
of the quantity supplied of one good to a change in the price of another related good. It helps
to understand the interaction between goods in the market.

Remember that price elasticity of supply is essential for businesses, policymakers, and
economists to understand how suppliers will react to price changes and how market
equilibrium may be affected.

Market Equilibrium: Market equilibrium is a fundamental concept in economics that occurs

when the quantity demanded by consumers equals the quantity supplied by producers at a
specific price level. In other words, it is the point where the demand and supply curves
intersect. At this equilibrium price and quantity, there is no tendency for the market price to
change. Both buyers and sellers are satisfied with the prevailing conditions, and there is no
excess demand (shortage) or excess supply (surplus).
How Market Equilibrium is Achieved:
1. Surplus and Shortage: When the market price is above the equilibrium price, there is
a surplus of the product as the quantity supplied exceeds the quantity demanded.
Producers may lower the price to clear the excess supply. On the other hand, when the
market price is below the equilibrium price, there is a shortage, and producers may
raise the price to meet the excess demand.
2. Price Adjustments: Through the process of trial and error, the market price moves
towards the equilibrium price as producers and consumers adjust their behavior based
on prevailing market conditions.
3. Market Forces: The forces of demand and supply play a crucial role in bringing the
market to equilibrium. If there is a surplus, the decreasing prices stimulate more
demand and reduce supply until equilibrium is achieved. Conversely, if there is a
shortage, the increasing prices reduce demand and increase supply until equilibrium
is reached.
Changes in Market Equilibrium: Market equilibrium can change due to shifts in demand or
supply. Several factors can lead to such shifts:
1. Changes in Demand: If there is an increase in demand, the demand curve shifts to the
right, leading to a new equilibrium with a higher price and quantity. Conversely, a
decrease in demand shifts the demand curve to the left, resulting in a new equilibrium
with a lower price and quantity.
2. Changes in Supply: If there is an increase in supply, the supply curve shifts to the
right, leading to a new equilibrium with a lower price and a higher quantity.
Conversely, a decrease in supply shifts the supply curve to the left, resulting in a new
equilibrium with a higher price and a lower quantity.
3. Simultaneous Shifts: It is also possible for both the demand and supply curves to shift
simultaneously, leading to more complex changes in price and quantity at
equilibrium.
Role of Price as an Invisible Hand: The concept of the "invisible hand" was introduced by the
economist Adam Smith in his famous work, "The Wealth of Nations." The invisible hand refers
to the self-regulating nature of the market economy, where individuals pursuing their self-
interest unintentionally contribute to the overall economic well-being of society.
1. Allocation of Resources: In a market economy, prices act as signals that guide
producers and consumers. When the price of a good or service increases due to
increased demand or decreased supply, it sends a signal to producers to increase
production and consumers to reduce their consumption. Conversely, when the price
falls, it signals producers to decrease production and encourages consumers to buy
more. This dynamic process ensures that resources are allocated efficiently to meet the
needs and wants of consumers.
2. Balancing Supply and Demand: Prices adjust in response to changes in demand and
supply, helping to bring the market to equilibrium. If there is excess demand, prices
rise, reducing demand and encouraging producers to increase supply. If there is excess
supply, prices fall, reducing supply and stimulating demand. This constant interplay
of prices helps balance supply and demand in the market.
3. Encouraging Innovation and Efficiency: In a competitive market, higher prices often
indicate higher profits, which attracts new producers and encourages existing ones to
improve their efficiency and offer better products at competitive prices. This
competition fosters innovation and efficiency, leading to overall economic growth.
 4. Signals and Information: Prices convey valuable information about the state of the
market. They provide insights into relative scarcity, consumer preferences, and
changing economic conditions. Entrepreneurs and businesses can use price signals to
make informed decisions about their production, investment, and expansion plans.

5. Resource Reallocation: Price changes facilitate the reallocation of resources from one
sector to another. When prices rise in a particular industry, it signals that resources are
in high demand in that sector, leading to the movement of labor and capital toward
that industry. On the other hand, declining prices indicate reduced demand,
prompting resources to flow away from less competitive sectors.

6. Equilibrium Point: The invisible hand mechanism helps the market reach an
equilibrium point where the quantity demanded equals the quantity supplied at a
specific price level. This equilibrium price reflects the market's optimal allocation of
resources, ensuring that the right quantity of goods and services is produced and
consumed.

The role of price as an invisible hand highlights how decentralized decision-making in a

market economy can lead to optimal outcomes without the need for central planning. The
pursuit of self-interest by individuals collectively guides the economy towards equilibrium
and efficient resource allocation.

Invisible hand

The "invisible hand" is a concept introduced by the Scottish economist and philosopher Adam
Smith. Adam Smith was an eighteenth-century Scottish economist who lived from 1723 until
1790. The idea of the invisible hand is one of the most influential concepts in economics and
plays a fundamental role in understanding market mechanisms and the efficiency of free
markets. Smith’s original text from “An Inquiry Into the Nature and Causes of the Wealth of
Nations”, Book 4, Chapter 2 read:

“(Each individual) generally, indeed, neither intends to promote the public interest, nor knows how
much he is promoting it...He intends only his own security; and by directing that industry in such a
manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as
in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

Smith’s concept of the Invisible Hand was likely influenced by earlier economist Richard
Cantillon, who broke up a single farming estate into multiple competing leased farms, and
observed that the farming techniques became more efficient, products more desired by
consumers, and overall yields greater than when the estate was managed by a single farmer.

Adam Smith argued that individuals, while pursuing their self-interest and trying to
maximize their own well-being, unintentionally contribute to the overall economic well-being
of society. This unintended social benefit arises from the self-regulating nature of competitive
markets.
Here's how the invisible hand works:
1. Self-Interest: In a market economy, individuals, including consumers and producers,
act in their self-interest. Consumers seek to maximize their utility by purchasing goods
and services that satisfy their needs and wants. Producers aim to maximize their
profits by producing and selling goods and services that consumers demand.
2. Competition and Prices: The market operates under conditions of competition, where
multiple buyers and sellers interact freely. In a competitive market, prices are
determined by the forces of supply and demand.
3. Resource Allocation: As individuals pursue their self-interest, they make choices
about what goods to buy and produce. The prices of goods and services reflect the
interaction between supply and demand. When the demand for a particular good or
service increases, its price rises, providing an incentive for producers to increase
production to meet the higher demand.
4. Efficient Outcomes: The invisible hand refers to the process by which the pursuit of
self-interest, guided by market prices, leads to the most efficient allocation of resources
in society. In a free and competitive market, resources tend to flow towards the
production of goods and services that are in high demand and away from those that
are less desired by consumers. This reallocation of resources happens automatically,
without the need for central planning or coordination.
5. Wealth and Prosperity: According to Adam Smith, the invisible hand fosters economic
growth, prosperity, and the overall well-being of society. As resources are efficiently
allocated, production increases, leading to higher economic output and a higher
standard of living for the population.

It's important to note that while the concept of the invisible hand highlights the benefits of
free markets and individual self-interest, it does not imply that markets are perfect or that
there is no need for government intervention. Adam Smith acknowledged the role of the
government in providing public goods, ensuring the rule of law, and regulating certain
aspects of the economy to prevent market failures and protect consumers and workers.

In summary, the invisible hand is a metaphorical representation of how individual self-

interest and competition, guided by market prices, work together to achieve efficient
outcomes and contribute to the overall prosperity of society in a free-market economy.