Supply - EdTechnology

AA family buys a half-gallon of orange juice at the supermarket.An author hires a graduate student to translate a book. A

store sells a bicycle to a woman over the Internet. Each of these exchanges involves a buyer and a seller. In this

chapter you’ll read about the “supply side” of the marketplace,where sellers decide how much to produce or supply. Afterreading the chapter, you’ll better understand the factors thatinfluence sellers’ decisions on how much orange juice to produce,how many hours a week to work as a translator, or how manybicycles to export.

Supply

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Write down a list of three goods: onethat is usually available and “on sale,”another that is popular but difficult tofind, and a third that falls somewherein between. What prices do storescharge for these goods?

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II f you were running a business, whatwould you do if you discovered that

customers were suddenly willing to paytwice as much for your product? If youwere like most entrepreneurs, you wouldtry to produce more in order to take advan-tage of the higher prices. Even if you usedthe higher prices as a way to work fewerhours while earning the same income, youcould be sure that someone else wouldjump into the market and start selling thesame good.

The Law of SupplySupply is the amount of goods available.How do producers decide how much tosupply? According to the law of supply, thehigher the price, the larger the quantityproduced. Economists use the term quantitysupplied to describe how much of a good isoffered for sale at a specific price.

The law of supply develops from thechoices of both current and newproducers of a good. As the price of agood rises, existing firms will producemore in order to earn additional revenue.At the same time, new firms will have anincentive to enter the market to earn aprofit for themselves. If the price of a goodfalls, some firms will produce less, andothers might drop out of the market.

These two movements—individual firmschanging their level of production andfirms entering or exiting the market—combine to create the law of supply.

Higher Production If a firm is already earning a profit byselling a good, then an increase in theprice—ceteris paribus—will increase the

Understanding Supply

Chapter 5 ■ Section 1 101

Section FocusThe law of supply predicts thatproducers will offer more of a goodas its price goes up. How stronglyproducers react to a change in pricedepends on their ability to raise orlower output.

Key TermsObjectivesAfter studying this section you will be able to:1. Explain the law of supply.2. Interpret a supply graph using a supply

schedule.3. Explain the relationship between elasticity

of supply and time.

Figure 5.1 Law of SupplyFigure 5.1 Law of Supply

Quantitysupplied

increases

SupplyAs price

increases . . .

Price

As pricefalls . . .

PriceQuantitysupplied

falls

Supply

The law of supply predicts that higher prices lead to moreproduction. Incentives How is the law of supply different from the lawof demand?

Preview

supply law of supplyquantity suppliedsupply schedulevariablemarket supply schedulesupply curvemarket supply curveelasticity of supply

supply the amount ofgoods available

law of supplytendency of suppliersto offer more of a goodat a higher price

quantity supplied theamount a supplier iswilling and able tosupply at a certainprice

ECON_07NA_se_CH05_S1 8/3/05 10:53 AM Page 101

firm’s profits. The promise ofhigher revenues for each salealso encourages the firm toproduce more. Consider thepizzeria you read about inChapter 4. The pizzeria isprobably making a reason-able profit by selling a certainnumber of slices a day at themarket price. If the pizzeriaweren’t making a profit, theowner would soon try toraise the price or switch frompizzas to something moreprofitable.

If the price of pizza rises,but the firm’s cost of making

pizza stays the same, then the pizzeria willearn a higher profit on each slice of pizza.A sensible entrepreneur would try toproduce and sell more pizza to take advan-tage of the higher prices.

Similarly, if the price of pizza goes down,the pizzeria will earn less profit per slice oreven lose money. The owner will choose tosell less pizza and produce something else,

such as calzones or sandwiches, that willyield more profit.

In both cases, the search for profit drivesthe supplier’s decision. When the price goesup, the supplier recognizes the chance tomake more money and works harder toproduce more pizza. When the price falls,the same entrepreneur is discouraged fromproducing as much as before.

Market Entry Profits appeal both to producers already inthe market and people who may decide tojoin the market. As you have seen, whenthe price of pizza rises, a pizzeria stands outas a good opportunity to make money. Ifyou were considering opening a restaurantof your own, a pizzeria would look like asafe bet. In this way, rising prices draw newfirms into a market and add to the quantitysupplied of the good.

Consider the market for music. In thelate 1970s, disco music became popularamong young people. The music industryquickly recognized the popularity of disco,and more and more groups began releasingdisco recordings. Even some groups thatonce performed soul music and rhythmand blues chose to record disco albums.New entrants crowded the market to takeadvantage of the potential for profit. Disco,however, proved to be a short-lived fad. Bythe early 1980s, disco music was gone fromthe radio, and stores couldn’t sell thealbums on their shelves.

102 Supply

� The music industryillustrates how profit drivessuppliers’ decisions. Asdifferent musical stylesbecome popular, new groupsmake recordings to profit fromthe current fad.

In the News Read more about supply in“Blockbuster Stresses Buying OverRenting,”an article in The Wall Street Journal Classroom Edition.

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This pattern of sharp increases anddecreases in supply occurs again and againin the music industry. In the early 1990s,“grunge” music emerged from Seattle tobecome widely popular among high schooland college students across the country.How did the market react? Record labelssoon hired many grunge groups. Musicstores devoted more and more space to thisstyle of music. Within a few years,however, grunge lost its appeal, and manygroups disbanded or moved on to newstyles. Other styles of music, such as salsa,achieved new popularity.

In each of the examples above, manymusicians joined the market for a partic-ular style of music to profit from a trend.Their actions reflected the law of supply,which says that the output or quantitysupplied of a good increases as the price ofthe good increases.

The Supply ScheduleSimilar to a demand schedule, a supplyschedule shows the relationship betweenprice and quantity supplied for a specificgood. The pizzeria discussed earlier mighthave a supply schedule that looks like theone in Figure 5.2. This table compares twovariables, or factors that can change. Thesevariables are the price of a slice and thenumber of slices supplied by a pizzeria. Wecould collect this information by asking thepizzeria owner how many slices she iswilling and able to make at different prices,or we could look at records to see how thequantity supplied has varied as the pricehas changed. We will almost certainly findthat at higher prices, the pizzeria owner iswilling to make more pizza. At a lowerprice she prefers to make less pizza and todevote her limited resources to other, moreprofitable, items.

Like a demand schedule, a supplyschedule lists supply for a very specific setof conditions. The schedule shows how theprice of pizza, and only the price of pizza,affects the pizzeria’s output. All of the otherfactors that could change the restaurant’soutput decisions, such as the costs of

tomato sauce, labor, and rent, are assumedto remain constant.

A Change in the Quantity Supplied Economists use the word supply to refer tothe relationship between price and quantitysupplied, as shown in the supply schedule.The pizzeria’s supply of pizza includes allpossible combinations of price and output.According to this supply schedule, thepizzeria’s supply is 100 slices at $ .50 aslice, 150 slices at $1.00 a slice, 200 slicesat $1.50 a slice, and so on. The number ofslices that the pizzeria offers at a specificprice is called the quantity supplied at thatprice. At $2.50 per slice, the pizzeria’squantity supplied is 300 slices per day.

A rise or fall in the price of pizza willcause the quantity supplied to change, butnot the supply schedule. In other words, achange in a good’s price moves the sellerfrom one row to another in the samesupply schedule, but does not change thesupply schedule itself. When a factor otherthan the price of pizza affects output, wehave to build a whole new supply schedulefor the new market conditions.

Market Supply ScheduleAll of the supply schedules of individualfirms in a market can be added up to createa market supply schedule. A market supplyschedule shows the relationship betweenprices and the total quantity supplied by all

supply schedule achart that lists howmuch of a good asupplier will offer at different prices

variable a factor thatcan change

market supply schedulea chart that lists howmuch of a good allsuppliers will offer atdifferent prices

Slices supplied per day

100150200250300350

Price per slice of pizza

$ .50$1.00$1.50$2.00$2.50$3.00

Figure 5.2 Supply ScheduleFigure 5.2 Supply Schedule

This supply schedule lists howmany slices of pizza one pizzeriawill offer at different prices.Incentives What does this charttell you about the pizzeriaowner’s decisions?


104 Supply

firms in a particular market. The informa-tion in a market supply schedule becomesimportant when we want to determine thetotal supply of pizza at a certain price in alarge area, like a city.

The market supply schedule for pizzaresembles the supply schedule at a singlepizzeria, but the quantities are much larger.Figure 5.3 shows the supply of pizza for ahypothetical city.

This market supply schedule lists thesame prices as those in the supply schedulefor the single pizzeria, since all restaurantswill charge prices within the same range.The quantities supplied are much largerbecause there are many pizzerias in thecommunity. Like the individual supplyschedule, this market supply schedulereflects the law of supply. Pizzerias supplymore pizza at higher prices.

The Supply GraphWhen the data points in the supplyschedule are graphed, they create a supplycurve. A supply curve is very similar to ademand curve, except that the horizontalaxis now measures the quantity of the goodsupplied, not the quantity demanded.Figure 5.4 shows a supply curve for onepizzeria and a market supply curve for all thepizzerias in the city. The data used to drawthe two curves are from the supply sched-ules in Figures 5.2 and 5.3. The prices

shown along the vertical axes are the samein both graphs. However, the quantities ofpizza supplied at each price are much largerin the market supply curve.

The key feature of the supply curve isthat it always rises from left to right. Asyour finger traces the curve from left toright, it moves toward higher and higheroutput levels (on the horizontal axis) andhigher and higher prices (on the verticalaxis). This illustrates the law of supply,which says that a higher price leads tohigher output.

Supply and ElasticityIn Chapter 4, you learned that elasticity ofdemand measures how consumers willreact to a change in price. Elasticity of supplyis based on the same concept. Elasticity ofsupply is a measure of the way suppliersrespond to a change in price.

Elasticity of supply tells how firms willrespond to changes in the price of a good.The labels elastic, inelastic, and unitaryelastic represent the same values of elasticityof supply as those of elasticity of demand.When elasticity is greater than one, supplyis very sensitive to changes in price and isconsidered elastic. If supply is not veryresponsive to changes in price, and elas-ticity is less than one, supply is consideredinelastic. When a percentage change in priceis perfectly matched by an equal percentagechange in quantity supplied, elasticity isexactly one, and supply is unitary elastic.

Elasticity of Supply and TimeWhat determines whether the supply of agood will be elastic or inelastic? The keyfactor is time. In the short run, a firmcannot easily change its output level, sosupply is inelastic. In the long run, firms aremore flexible, so supply is more elastic.

Elasticity of Supply in the Short RunAn orange grove is one example of abusiness that has difficulty adjusting to achange in price in the short term. Orangetrees take several years to mature and grow

supply curve a graph ofthe quantity supplied ofa good at differentprices

market supply curve agraph of the quantitysupplied of a good byall suppliers at differentprices

elasticity of supply ameasure of the wayquantity supplied reactsto a change in price

Slices supplied per day

1,0001,5002,0002,5003,0003,500

Price per slice of pizza

$ .50$1.00$1.50$2.00$2.50$3.00

Figure 5.3 Market Supply ScheduleFigure 5.3 Market Supply Schedule

A market supply schedule repre-sents all suppliers in a market.Supply and Demand How does thismarket supply schedule compareto the individual supply schedule?



fruit. If the price of oranges goes up, anorange grower can buy and plant moretrees, but he will have to wait several yearsfor his investment to pay off. In the shortterm, the grower could take smaller stepsto increase output. For example, he coulduse a more effective pesticide. While thisstep might increase his output somewhat, itwould probably not increase the number oforanges by very much. Economists wouldsay that his supply is inelastic, because hecannot easily change his output. The samefactors that prevent the owner of theorange grove from expanding his supplywill also prevent new growers fromentering the market and supplying orangesin the short term.

In the short run, supply is inelasticwhether the price increases or decreases. Ifthe price of a crate of oranges falls, thegrove owner has few ways to cut his supply.He invested years ago in land and trees, andhis grove will provide oranges no matterwhat the price is. Even if the price dropsdrastically, the grove owner will probablypick and sell nearly as many oranges asbefore. The grove owner’s competitors havealso invested heavily in land and trees andwon’t drop out of the market if they cansurvive. In this case, supply is inelasticwhether prices rise or fall.

While orange groves illustrate a businessin which supply is inelastic, other busi-nesses benefit from more elastic supply.For example, a business that provides aservice, such as a haircut, is highly elastic.Unlike oranges, the supply of haircuts iseasily expanded or reduced. If the pricerises, barber shops and salons can hireworkers quickly.

O 400

$3.00

$2.50

$2.00

$1.50

$1.00

$.50

50 100 150 200 250 300 350 O 4,000500 1,000 1,500 2,000 2,500 3,000 3,500

SupplySupply

Output (slices per day)

Pri

ce

$3.00

$2.50

$2.00

$1.50

$1.00

$.50

Pri

ceOutput (slices per day)

Figure 5.4 Supply CurvesFigure 5.4 Supply Curves

Individual Supply Curve Market Supply Curve

Figure 5.5 Elastic SupplyFigure 5.5 Elastic Supply

When supply is elastic, a small increase in price hasa big effect on supply.

Price Supply

Supply curvesalways rise from leftto right, as predictedby the law of supply.As price increases,so does the quantitysupplied.Supply and DemandHow many sliceswill one pizzeriaproduce at $2.00 aslice?

When supply is elastic, it reactsstrongly to changes in price. Supply and Demand If supply isinelastic, how will supply reactto a small increase in price?


106 Supply

In addition, new barber shops andsalons will open, and existing businessesmight stay open later in the evening. Thismeans that a small increase in price will

cause a large increase in quantity supplied,even in the short term.

If the price of a haircut drops, somebarbers will close their shops earlier in theday, and others will leave the market forjobs elsewhere. Quantity supplied will fallquickly. Because haircut suppliers canquickly change their operations, the supplyof haircuts is elastic.

Elasticity in the Long RunLike demand, supply can become moreelastic over time. Consider the example ofthe orange grower who could not increasehis output much when the price of orangesrose. Over time, he could plant more treesto increase his supply of oranges. Thesechanges will become more effective overtime as trees grow and bear fruit. Afterseveral years, he will be able to sell manymore oranges at the high market price.

If the price drops and stays low forseveral years, orange growers who survivedthe first two or three years of losses mightdecide to give up and grow something else.Given five years to respond instead of sixweeks, the supply of oranges will be farmore elastic. Just like demand, supplybecomes more elastic if the supplier has along time to respond to a price change.

Section 1 Assessment

Key Terms and Main Ideas1. Explain the law of supply in your own words.2. What is the difference between supply and quantity

supplied?3. How does the quantity supplied of a good with a large

elasticity of supply react to a price change?

Applying Economic Concepts4. Problem Solving If the price of oil rises around the

world, what will happen to oil production in Texas?Explain your answer.

5. Decision Making Explain whether you think the supplyof the following goods is elastic or inelastic, and why. (a) hotel rooms (b) taxi rides (c) photographs

6. Critical Thinking When the price of a good rises, totalsupply in the market will rise, but some entrepreneursmight actually choose to work less. Why might theymake this choice?

� While the supplyof oranges isinelastic, the supplyof goods made fromoranges is elastic.For example,producers canchoose whether toproduce more or lessorange juice from theoranges.

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LIFESkills for

107

1. Identify the people and places in thereport. Environmental policy dealswith both the natural world and theway people use it. In this policyreport, the author has described aparticular kind of natural landscapeand also a particular kind of humanactivity. (a) What is the natural land-scape discussed in the report? (b)What are the human actions dis-cussed in the report?

2. Describe the impact of human action onthe environment. When there are dif-ferent courses of action open to peo-ple, it's not always easy to choosebetween them. (a) The reportdescribes two different ways peoplecan act in this situation. What arethey? (b) List the advantages and dis-advantages of each course of action.

3. Identify the different needs of differentgroups. Most environmental policystatements have to deal with the differ-ent needs of all of the groups involvedin the decision. (a) Do you think theneeds of people who live closer to thefire risk areas are different than theneeds of people who don't live asclose? (b) Does this report discuss anyways that people who live near fire riskareas can act to protect themselvesfrom the regular small fires?

Environmental Policy

Environmental policy deals with the way humans interact with the naturalworld. Environmental policy should help set guidelines for how people can

best use natural resources without having a long-term negative effect on theworld around us. This sample environmental policy report discusses a situa-tion where the actions of people have had an effect on the landscape.

For decades, we have worked to managefire danger in the national forests and park-lands by putting out all fires as soon as possi-ble. Fire suppression was believed to be in thebest interests of the forest, and served to pro-tect the houses built in or near forests. Morethan thirty-four million people live in areas at ahigh risk of fire, and for many years wethought that fire suppression was the best wayto protect those people.

Experts on forest and forests fires nowsay that fire suppression may not be the bestthing for the forests, or for the people livingnear the forests. The normal life cycle for aforest probably involves regular small firesand the occasional large fire. Under thoseconditions, the underbrush plants betweenthe large trees will be cleared out on a regu-lar basis. If we suppress fires in the forestareas, then the underbrush becomes too talland crowded, which eventually puts thewhole forest area at a higher risk for the typeof large and difficult to control fires thatswept through Southern California in 2004.We are recommending that the forestry ser-vice adopt a new policy of not suppressingsmaller fires.

Find a natural landscape near yourhome that has been affected byhuman use, and write a sampleenvironmental policy report. Do youthink that the human use of thatarea should continue the way it hasbeen going so far? Do you think thatpeople should change their use ofthat area? Why or why not?

Additional Practice

ECON_05_se_SK_CH05 7/20/05 7:13 AM Page 107

II n Section 1, we identified how producersrespond to a change in price. The law of

supply states that producers will offermore goods as the price goes up and feweras the price falls. In this section, we willexplain how a supplier decides how muchto produce.

Consider a firm that produces beanbags.The firm’s factory has one sewing machineand one pair of scissors. The firm’s inputsare workers and materials, including cloth,thread, and beans. Assume that eachbeanbag requires the same amount ofmaterials. As the number of workersincreases, what happens to the quantity ofbeanbags produced?

Labor and OutputOne of the basic questions any businessowner has to answer is how many workersto hire. To answer this question, ownershave to consider how the number ofworkers they hire will affect their totalproduction. For example, at the beanbagfactory, one worker can produce fourbeanbags per hour. Two workers can makea total of ten bags per hour, and three canmake a total of seventeen beanbags anhour. As new workers join the company,total output increases. After the seventhworker is hired, production peaks at 32beanbags per hour. When the firm hires theeighth worker, however, total output dropsto 31 bags per hour.

Figure 5.6 shows the relationshipbetween labor, measured by the number ofworkers in the factory, and the number ofbeanbags produced.

Marginal Product of LaborThe third column of Figure 5.6 shows themarginal product of labor, or the change inoutput from hiring one more worker. Thisis called the marginal product because itmeasures the change in output at themargin, where the last worker has beenhired or fired.

marginal product oflabor the change inoutput from hiring oneadditional unit of labor

Costs of Production

108 Supply

Section FocusEntrepreneurs consider marginalbenefits and costs when decidinghow much output to produce.Ordinarily, firms earn their highestprofits when the cost of makingone more unit is the same as themarket price of the good.

ObjectivesAfter studying this section you will be able to:1. Explain how firms decide how much labor

to hire to produce a certain level of output.2. Analyze the production costs of a firm.3. Understand how a firm chooses to set

output.4. Explain how a firm decides to shut down

an unprofitable business.

Key Termsmarginal product of laborincreasing marginal returnsdiminishing marginal returnsfixed costvariable costtotal costmarginal costmarginal revenueoperating cost

Preview

The supply ofbeanbag chairs inthe market dependson several factors,including the cost oflabor and capital. �



The first worker to be hired producesfour bags an hour, so her marginal productis four bags. The second worker raises totaloutput from four bags an hour to ten, so hermarginal product of labor is six. Lookingat this column, we see that the marginalproduct of labor increases for the first threeworkers, rising from four to seven.

Increasing Marginal ReturnsThe marginal product of labor increases forthe first three workers because there arethree tasks involved in making a beanbag.Workers cut and sew cloth into the correctshape, stuff it with beans, and sew the bagclosed. In our example, a single workerperforming all these tasks would onlyproduce four bags per hour. Adding asecond worker would allow each worker tospecialize in one or two tasks. If eachworker focuses on only one part of theprocess, she will waste less time switchingbetween tasks and will become moreskillful at her assigned tasks. In otherwords, specialization increases output perworker, so the second worker adds more tooutput than the first. The firm enjoysincreasing marginal returns.

In our example, there are benefits fromspecialization for the first three workers.The firm enjoys a rising marginal productof labor for the first three workers.

Diminishing Marginal ReturnsWhen the fourth through the seventhworkers are hired, the marginal product oflabor is still positive. Each new worker stilladds to total output. However, themarginal product of labor shrinks as eachworker joins the company. The fourthworker increases output by six bags, whilethe seventh increases output by only onebag. Why?

After the beanbag firm hires its first threeworkers, one for each task, the benefits ofspecialization end. At that point, addingmore workers increases total output, but ata decreasing rate. This situation is knownas diminishing marginal returns. A firm withdiminishing marginal returns of labor will

produce less and less output from eachadditional unit of labor added to the mix.

The firm suffers from diminishingmarginal returns from labor because itsworkers must work with a limited amountof capital. Remember that capital is anyhuman-made resource that is used toproduce other goods. In this example,capital is represented by the factory’ssingle sewing machine and pair of scissors.When there are three workers, but onlyone needs to use the sewing machine, thisworker will never have to wait to get to

increasing marginalreturns a level ofproduction in which the marginal product oflabor increases as thenumber of workersincreases

diminishing marginalreturns a level ofproduction in whichthe marginal product oflabor decreases as thenumber of workersincreases

Output(beanbagsper hour)

Marginalproductof labor

—467653

0410172328313231

012345678

Labor(number ofworkers)

Figure 5.6 Marginal Product of LaborFigure 5.6 Marginal Product of Labor

1-1

Figure 5.7 Increasing, Diminishing, and Negative Marginal Returns

8

7

6

5

4

3

2

1

0

–1

–2

–3

Mar

gina

l pro

duct

of l

abor

(bea

nbag

s pe

r ho

ur)

1 2

Increasingmarginalreturns

Diminishingmarginalreturns

Negativemarginalreturns

3 4 5 6 7 8 9

Labor(number of workers)

Figure 5.7 Increasing, Diminishing, and Negative Marginal Returns

The marginal productof labor is the increasein output added by thelast unit of labor. Specialization Why does themarginal product oflabor decrease withmore than fourworkers in thisexample?

Labor has increasingand then diminishingmarginal returns.Opportunity CostWhat is the marginalproduct of labor whenthe factory currentlyemploys fiveworkers?


110 Supply

work. When there are morethan three workers, thefactory will assign more thanone to work at the sewingmachine. While one isworking, the other will haveto wait. She may be able tohelp cut fabric or stuff bagsin the meantime, but everybag must be sewn up at somepoint, so she cannot greatlyincrease the speed of theproduction process.

The problem gets worse asmore workers are hired and

the amount of capital remains constant.Wasted time waiting for the sewingmachine or scissors means that additional

workers will add less and less to totaloutput at the factory.

Negative Marginal ReturnsAs the table in Figure 5.6 shows, addingthe eighth worker at the beanbag factorycan actually decrease output by one bag.At this stage, workers get in each other’sway and disrupt the production process,so overall output decreases. Of course,few companies ever hire so many workersthat their marginal product of laborbecomes negative.

Production CostsPaying workers and purchasing capital areall costs of producing goods. Economists

To understand the diminishing marginal returns of capital, consider an Internet service provider that mailed millions of free copies of its software on compact discs. The first discs sent out got customers interested in the product and provided a good return on investment. After consumers received several additional discs, however, the discs no longer caught their attention and more often than not ended up in the trash.

FAST FACT

Fixed CostManager: Some workers areessential to the founding andrunning of a company and will keep their jobs even ifthe company closestemporarily.

Variable CostPart-time Salesman: In busy times,companies hire workers on short-term contracts and let them gowhen they're no longer needed.

Variable CostGoods: Companies buymost goods only whenthey need them.

Fixed CostRent: A firm mustrent or buy spacebefore it opens for business.

Variable CostElectricity: Lights and other equipmentare turned off when the store is closed.

Figure 5.8 Fixed and Variable CostFigure 5.8 Fixed and Variable Cost

Firms must separate fixed costs from variable costs to determine whether or not toproduce at a given market price.Entrepreneurs Why are some employees considered variable costs?



fixed cost a cost thatdoes not change, nomatter how much of agood is produced

variable cost a costthat rises or fallsdepending on howmuch is produced

total cost fixed costsplus variable costs

marginal cost the costof producing one moreunit of a good

divide a producer’s costs into two cate-gories: fixed costs and variable costs.

Fixed Costs A fixed cost is a cost that does not change,no matter how much of a good is produced.Most fixed costs involve the productionfacility, the cost of building and equippinga factory, office, store, or restaurant.Examples of fixed costs include rent,machinery repairs, property taxes on afactory, and the salaries of workers whokeep the business running even whenproduction temporarily stops.

Variable CostsVariable costs are costs that rise or falldepending on the quantity produced. Theyinclude the costs of raw materials andsome labor. For example, to produce morebeanbags, the firm must purchase morebeans and hire more workers to stuff thebeanbags. If the company wants toproduce less and cut costs, it can stopbuying beans or have some workers workfewer hours a week. The cost of labor is avariable cost because it changes with thenumber of workers, which changes withthe quantity produced. Electricity andheating bills are also variable costs,because the company can cut off heat and

electricity for the factory and its machineswhen they are not in use.

Total CostFigure 5.9 shows some cost data for thefirm that produces beanbags. The firm hasa factory that is fully equipped to producebeanbags. How does the cost of producingbeanbags change as the output increases?

In our example, the fixed costs are thecosts of the factory building and all themachinery and equipment inside. As shownin the second column in Figure 5.9, thefixed costs are $36.00 per hour.

Variable costs include the cost of beans,fabric, and most of the workers hired toproduce the beanbags. As shown in thethird column, variable costs rise with thenumber of beanbags produced. Fixed costsand variable costs are added together tofind total cost. Total cost is shown in thefourth column.

Marginal CostIf we know the total cost at several levels ofoutput, we can determine the marginal costof production at each level. Marginal costis the additional cost of producing onemore unit.

As shown in Figure 5.9, even if the firmis not producing a single beanbag, it still

Variablecost

Total cost(fixed cost +

variable cost)

$364448515663728499

118142172209

$08

1215202736486382

106136173

0123456789

101112

Beanbags(per hour)

$36363636363636363636363636

Fixedcost

—$843579

121519243037

Marginalcost

$24242424242424242424242424

Marginalrevenue

(market price)

$024487296

120144168192216240264288

Totalrevenue

$–36–20

021405772849398989279

Profit(total revenue –

total cost)

Figure 5.9 Production CostsFigure 5.9 Production Costs

Firms consider avariety of costs whendeciding how muchto produce.Markets and PricesWhy is the marginalrevenue alwaysequal to $24?


112 Supply

must pay $36.00 an hour for fixed costs. Ifthe firm decides to produce just onebeanbag an hour, its total cost rises $8.00from $36.00 to $44.00 an hour. Themarginal cost of the first beanbag is $8.00.

For the first three beanbags, the marginalcost falls as output increases. The marginalcost of the second beanbag is $4.00, andthe marginal cost of the third beanbag is$3.00. Each additional beanbag is cheaperto make because of increasing marginalreturns resulting from specialization.

With the fourth beanbag, the marginalcost starts to rise. The marginal cost of thefifth per hour is $7.00, the sixth costs$9.00, and the seventh, $12.00. The risingmarginal cost reflects diminishing returns tolabor. The benefits of specialization areexhausted at three beanbags per hour, anddiminishing returns set in as more and moreworkers share a fixed production facility.

Setting OutputBehind all of the decisions about howmany workers to hire is the firm’s basicgoal: to maximize profits. Profit is definedas total revenue minus total cost. As you

read in Chapter 4, a firm’s total revenue isthe money the firm gets by selling itsproduct. Total revenue is equal to the priceof each good multiplied by the number ofgoods sold. Figure 5.9 shows total revenuewhen the price of a beanbag is $24.00. Tofind the level of output with the highestprofit, we look for the biggest gap betweentotal revenue and total cost. The gap isbiggest and profit is highest when the firmmakes 9 or 10 beanbags per hour. At thisrate, the firm can expect to make a profit of$98.00 an hour.

Marginal Revenue and Marginal CostAnother way to find the best level of outputis to find the output level where marginalrevenue is equal to marginal cost. Marginalrevenue is the additional income fromselling one more unit of a good. If the firmhas no control over the market price,marginal revenue equals the market price.Each beanbag sold at $24.00 increases thefirm’s total revenue by $24.00, so marginalrevenue is $24.00. According to the table,price equals marginal cost with 10beanbags, so that’s the quantity that maxi-mizes profit at $98 an hour.

To understand how an output of 10beanbags maximizes the firm’s profits,suppose that the firm picked a differentlevel of output. If the firm made only 4beanbags per hour, is it making as muchmoney as it can?

From Figure 5.9, we know that themarginal cost of the fifth beanbag is $7.00.The market price for a beanbag is $24.00,so the marginal revenue from that beanbagis $24.00. The $17.00 difference betweenthe marginal revenue and marginal costrepresents pure profit for the companyfrom making and selling the fifth beanbag.The company should increase its produc-tion to five beanbags an hour to capturethat profit on the fifth beanbag.

If we do the same calculations for a sixthbeanbag, we find that the company cancapture a profit of $15.00 by producing the sixth beanbag per hour. The price of the seventh beanbag is $12.00 higher thanits marginal cost, so that beanbag earns an

marginal revenue theadditional income fromselling one more unit ofa good; sometimesequal to price

0 1 2 3 4 5 6 7 8 10 119 12

Mar

gina

l cos

t (in

dol

lars

)

Output (beanbags per hour)

40

30

20

10

0

Figure 5.10 Marginal Cost Curve

Marginalcost

Figure 5.10 Marginal Cost Curve

For most firms, the marginal costof production falls as output risesfrom zero, but eventually beginsto rise. Markets and Prices How many

beanbags an hour should this firm make to produceat the lowest possible marginal cost?



additional $12.00 in profit for thecompany. The profit is available any timethe company receives more for the lastbeanbag than it cost to produce. Anyrational entrepreneur would take thisopportunity to increase profit.

Now suppose that the firm is producingso many beanbags an hour that marginalcost is higher than price. If the firmproduces eleven beanbags an hour, itreceives $24.00 for that eleventh beanbag,but the $30.00 cost of that beanbag wipesout the profit. The firm actually loses $6.00on the sale of the eleventh beanbag. Becausemarginal cost is increasing, and price isconstant in this example, the losses wouldget worse at higher levels of output. Thecompany would be better off producing lessand keeping costs down.

The ideal level of output is wheremarginal revenue (price) is equal to marginalcost. Any other quantity of output wouldgenerate less profit.

Responding to Price ChangesWhat would happen if the price of abeanbag rose from $24.00 to $37.00?Thinking at the margin, we would predictthat the firm would increase production totwelve beanbags per hour. That’s thequantity at which the marginal cost is equalto the new, higher price. At the originalprice of $24.00, the firm would not producemore than ten beanbags, according toFigure 5.11. When the price rises to $37.00,marginal revenue soars above marginal costat that output level. Raising production totwelve beanbags an hour would allow thefirm to capture profits on the eleventh andtwelfth beanbags.

This example shows the law of supply inaction. An increase in price from $24.00to $37.00 causes the firm to increase thequantity supplied from ten to twelvebeanbags an hour.

The Shutdown DecisionConsider the problems faced by a factorythat is losing money. The factory isproducing at a level of output at which

marginal revenue is equal to marginal cost.As you have read, this is the most profitablelevel of output. However, the market priceis so low that the factory’s total revenue isstill less than its total cost, and the firm islosing money. Should this factory continueto produce goods and lose money, orshould its owners shut the factory down?

This may seem like a silly question. Infact, there are times when keeping amoney-losing factory open is the bestchoice. The firm should keep the factoryopen if the total revenue from the goodsand services the factory produces is greaterthan the cost of keeping it open.

For example, if the price of beanbagsdrops to $7, and the factory produces atthe profit-maximizing level of five bean-bags per hour, the total revenue of thebusiness is $35 per hour. Weigh this againstthe factory’s operating cost, or the cost ofoperating the facility. The operating costincludes the variable costs the owners mustpay to keep the factory running, but not thefixed costs, which the owners must paywhether the factory is open or closed.

According to Figure 5.9, if the factoryproduces five beanbags, the variable cost is$27 per hour. Therefore, the benefit ofoperating the facility (total revenue of $35)

Figure 5.11 Output and a Change in Price

10 12

$37

$24

New price

Marginalcost

Original price

Output (beanbags per hour)

Cos

t (pe

r be

anba

g)

Figure 5.11 Output and a Change in Price

The most profitable level of output is whereprice (or marginal revenue) is equal tomarginal cost. Markets and Prices What would happen tooutput if the market price fell to $20?

operating cost the costof operating a facility,such as a store orfactory


114 Supply

is greater than the variable cost ($27), so itmakes sense to keep the facility running.

Consider the effects of the other choice.If the firm were to shut down the factory, itwould still have to pay all of its fixed costs.The factory’s total revenue would be zerobecause it would be producing nothing for

sale. Therefore, the firm would lose anamount of money equal to its fixed costs.

For this beanbag factory, the fixed costsequal $36 per hour, so the factory wouldlose $36 for each hour it is closed. If thefactory were to keep producing fivebeanbags per hour, its total cost would be$63 ($36 in fixed costs plus $27 in variablecosts) per hour, but it would lose only $28($63 in total cost minus $35 in revenue) foreach hour it is open. The factory wouldlose less money while producing becausethe total revenue ($35) would exceed thevariable costs ($27), leaving $8 to coversome of the fixed costs. Although thefactory would lose money in either situa-tion, it would lose less money by contin-uing to produce and sell beanbags.

How long will a business continue tooperate a factory at a loss before it decidesto replace the facility? The firm will build anew factory and stay in the market onlyif the market price of beanbags is highenough to cover all the costs of production,including the cost of building a new factory.


Key Terms and Main Ideas1. How does the marginal product of labor change as more

workers are hired? 2. What is the impact of diminishing marginal returns on

labor?3. Give an example of a fixed cost and a variable cost of a

bakery.4. How does a firm calculate marginal cost?

Applying Economic Concepts5. Critical Thinking A firm has two factories, one twice as

large as the second. As the number of workers at eachfactory increases, which factory will experience dimin-ishing returns first?

6. Decision Making Explain whether each of theseexpenses of a textile mill is a fixed cost or a variablecost, and why. (a) repairs to a leaking roof (b) cotton (c) food for the mill’s cafeteria (d) night security guard (e) electricity

7. Math Practice Use the table below to answer thefollowing questions. (a) What is the total cost whenoutput is 2? (b) What is the marginal cost of the thirdunit? (c) How much should this firm produce if themarket price is $24?

Output12345

Fixed Cost$5$5$5$5$5

Variable Cost$10$27$55$91

$145

� When a factory begins losing money, the owner must consider itsoperating cost and revenue when deciding what to do.

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Economist

Entrepreneur

Robert L. JRobert L. Johnsonohnson (b. 1946)(b. 1946)

In 1979, while working as chief lobbyist for the National CableTelevision Association, Robert Johnson was asked by a businessmanto support a proposed cable channel for older Americans. Existingchannels targeted young white viewers, leaving older Americansunderserved. Johnson immediately realized that this statementapplied to African Americans as well. In that moment, the idea for

Black Entertainment Television—BET—was born.

Launching BETSearching for investors, Johnsonapproached Tele-CommunicationsIncorporated (TCI), a large cable operatorthat was hoping to expand. He pointed outthat a cable company supplying qualityprogramming with appeal to the AfricanAmerican community would have anadvantage over its competitors in cities withlarge black populations. TCI bought a 20percent stake in his venture.

In January 1980, Johnson launchedBET—the first black-owned and -operatedtelevision network. Its first broadcasts werelimited to two hours each Friday night onanother cable network’s channel. However,he soon added a gospel show, coverage ofcollege sports, and a music programfeaturing black recording artists. By 1982,using music videos that record companiesprovided for free, BET had increased itsairtime to six hours a day.

In 1984, Johnson sold another share inBET to Home Box Office (HBO), a divisionof Time Warner. This provided the moneyhe needed to expand his programming.Johnson now had access to the country’stwo largest cable providers, Time Warnerand TCI, as well as to HBO’s satellite, so hecould broadcast 24 hours a day. By 1989,

BET was reaching 23 million homes. Fifteenyears later, that figure had grown to nearly75 million households, including more than90 percent of African American householdswith cable.

Creating a Brand“When I see BET, I don’t see a cablenetwork,” Johnson says. “I see a blackmedia conglomerate.” In the 1990s,Johnson used the network’s commercialairtime and its strong reputation amongAfrican Americans to create a BET“umbrella brand.”

Besides adding four more cablechannels, Johnson launched BETArabesque Films to produce movies fortheaters and for his cable network.Arabesque Books, a line of AfricanAmerican romance novels that Johnsonpurchased in 1998, provided the materialfor the first movies. “I want to grow mybrand to be like Disney,” Johnson said ofhis goals.

Viacom bought BET for $2.3 billion in2000, making Johnson a billionaire. In2002, Johnson broke new ground bylaunching the first majority African-American-owned team in major prosports—the NBA’s Charlotte Bobcats.

1. Source Reading Describe howJohnson’s BET affected the supply oftelevision entertainment available tocable viewers.

2. Critical Thinking Using clues inthe text above, explain the meaning ofthe term umbrella brand.

3. Learn More Use the Internet andother sources to research and reporton the variety of products and servicesthat BET currently has or is planningfor the future.

CHECK FOR UNDERSTANDING

ECONOMIC

115

ECON_05_se_PR_CH05 6/20/05 7:20 AM Page 115

JJust as several factors can affect demandat all price levels, a separate set of

factors can affect supply. In this section,you will read about these factors that canaffect supply, and the factors that shift anentire supply curve to the left or right.

Input CostsAny change in the cost of an input used toproduce a good—such as raw materials,machinery, or labor—will affect supply. Arise in the cost of an input will cause a fallin supply at all price levels because thegood has become more expensive toproduce. On the other hand, a fall in thecost of an input will cause an increase insupply at all price levels.

Effect of Rising CostsThink of the effects of input costs on therelationship between marginal revenue(price) and marginal cost. A supplier setsoutput at the most profitable level, whereprice is equal to marginal cost. Marginalcost includes the cost of the inputs that gointo production, so a rise in the cost oflabor or raw materials will translate directlyinto a higher marginal cost. If the cost ofinputs increases enough, the marginal costmay become higher than the price, and thefirm may not be as profitable as it could be.

If a firm has no control over the price,the only solution is to cut production andlower marginal cost until marginal costequals the lower price. Supply falls at eachprice, and the supply curve shifts to the left,as illustrated in Figure 5.12.

Changes in Supply

116 Supply

Section FocusChanges in the costs of inputs canraise or lower the supply of a good atall prices. The number of firms in amarket and the price and supply ofother goods can also have an effecton the supply of a good.

ObjectivesAfter studying this section you will be able to:1. Identify how determinants such as input

costs create changes in supply. 2. Identify three ways that the government

can influence the supply of a good.3. Understand supply and demand in the

global economy.4. Analyze the effects of other factors that

affect supply.

Key Termssubsidyexcise taxregulation

Preview

� New technology has lowered the costs of production in many markets.



TechnologyInput costs can drop as well. Advancesin technology, for example, can lowerproduction costs in many industries.Sophisticated robots have replaced manyworkers on assembly lines and allowedmanufacturers to spend less on salaries.Computers have simplified tasks and cutcosts in fields as diverse as journalism andarchitecture. E-mail that can be sent andreceived in an instant can replace slowlydelivered letters and expensive long-distance phone calls.

Technology lowers costs and increasessupply at all price levels. This effect is seenin a rightward shift in the supply curve inFigure 5.12.

Government’s Influence on SupplyThe government has the power to affect thesupplies of many goods. By raising orlowering the cost of producing goods, thegovernment can encourage or discouragean entrepreneur or an industry within thecountry or abroad.

Subsidies One method used by governments to affectsupply is to give subsidies to the producersof a good, particularly food. A subsidy is agovernment payment that supports abusiness or market. The government often

pays a producer a set subsidy for each unitof a good produced.

Governments have several reasons forsubsidizing producers. European countriesfaced food shortages during and afterWorld War II. Although imported food ischeaper, European governments protectfarms so that some will be available togrow food in case imports are ever cut off.The government of France also subsidizessmall farms because French citizens wantto protect the lifestyle and character of theFrench countryside.

Governments in developing countriesoften subsidize manufacturers to protectyoung, growing industries from strongforeign competition. In the past, countriessuch as Indonesia and Malaysia have subsi-dized a national car company as a source ofpride, even though imported cars were lessexpensive to build. In Western Europe,banks and national airlines were allowed tosuffer huge losses with the assurance thatthe government would cover their debts. Inmany countries, governments have stoppedproviding industrial subsidies in the interestof free trade and fair competition.

In the United States, the federal govern-ment subsidizes producers in many indus-tries. Farm subsidies are particularlycontroversial, however, especially whenfarmers are paid to take land out of cultiva-tion to keep prices high. In these cases,more efficient farmers are penalized, andfarmers use more herbicides and pesticides

subsidy a governmentpayment that supportsa business or market

Increase in Supply Decrease in Supply

Output

Pric

e

Pric

eOutput

SupplyCurve

SupplyCurveNew

SupplyCurve

NewSupplyCurve

Figure 5.12 Shifts in the Supply CurveFigure 5.12 Shifts in the Supply Curve

Factors that reducesupply shift the supplycurve to the left, whilefactors that increasesupply move the supplycurve to the right. Supply and DemandWhich graph bestrepresents the effectsof higher costs?


118 Supply

on lands they do cultivate to compensatefor production lost on the acres the govern-ment pays them not to plant.

TaxesA government can reduce the supply ofsome goods by placing an excise tax onthem. An excise tax is a tax on the produc-tion or sale of a good. An excise taxincreases production costs by adding anextra cost for each unit sold.

Excise taxes are sometimes used todiscourage the sale of goods that thegovernment thinks are harmful to thepublic good, like cigarettes, alcohol, andhigh-pollutant gasoline. Excise taxes arebuilt into the prices of these and othergoods, so consumers may not realize thatthey are paying them. Like any increase incost, an excise tax causes the supply of agood to decrease at all price levels. Thesupply curve shifts to the left.

RegulationSubsidies and excise taxes represent waysthat government directly affects supply bychanging revenue or production costs.Government can also raise or lower supplythrough indirect means. Government regu-lation often has the effect of raising costs.Regulation is government intervention in amarket that affects the price, quantity, orquality of a good.

For many years, pollution from automo-biles harmed the environment. Starting in

1970, the federal government required carmanufacturers to install technology toreduce pollution from auto exhaust. Forexample, new cars had to use lead-free fuelbecause scientists linked health problems tolead in gasoline. Regulations such as theseincreased the cost of manufacturing carsand reduced the supply. The supply curveshifted to the left.

Supply in the Global EconomyAs you read in earlier chapters, a large andrising share of goods and services isproduced in one country and imported byanother to be sold to consumers. Thesupplies of imported goods are affected bychanges in other countries. Here are someexamples of possible changes in the supplyof products imported by the U.S.

• The U.S. imports carpets from India. Anincrease in the wages of Indian workerswould decrease the supply of carpets tothe U.S. market, shifting the supply curveto the left.

• The U.S. imports telephones from Japan.A new technology that decreases the costof producing telephones would increasethe supply of telephones to the U.S.market, shifting the supply curve to theright.

• The U.S. imports oil from Russia. A newoil discovery in Russia would increase thesupply of oil to the U.S. market and shiftthe supply curve to the right.

Import restrictions also affect the supplycurves of restricted goods. The total supplyof a product equals the sum of imports anddomestically produced products. An importban on sugar would eliminate foreign sugarsuppliers from the market, shifting themarket supply curve to the left. At anyprice, a smaller quantity of sugar would besupplied. If the government restrictedimports by establishing an import quota,the supply curve would shift to the left, butthe shift would be smaller than it would befor an absolute ban on sugar imports.

excise tax a tax on theproduction or sale of agood

regulation governmentintervention in a marketthat affects theproduction of a good

Common Agricultural Policy The European Union, a group offifteen countries in Europe, protects its farms through its Common AgriculturalPolicy (CAP). Under CAP, the European Union subsidizes farms to keep themrunning and to encourage farmers to produce more food. Although this mayhave made sense in difficult times after World War II, farms have sincemodernized, and subsidies have led to a tremendous amount of unneededfood. In 1994, the CAP cost Europe $40 billion while producing a “wine lake”and “butter mountain” that no one would buy. Since then, Europe has tried tocut subsidies and introduce voluntary limits on production.

Global Connections



Other Influences on SupplyWhile government can have an importantinfluence on the supply of goods, there arealso other important factors that influencesupply.

Future Expectations of Prices If you were a soybean farmer, and youexpected the price of soybeans to doublenext month, what would you do with thecrop that you just harvested? Would yousell it right now, or hold on to it untilsoybean prices rise? Most farmers wouldstore their soybeans until the price rose,cutting back supply in the short term.

If a seller expects the price of a good torise in the future, the seller will store thegoods now in order to sell more in thefuture. On the other hand, if the price ofthe good is expected to drop in the nearfuture, sellers will earn more money byplacing goods on the market immediatelybefore the price falls. Expectations ofhigher prices will reduce supply now andincrease supply later, and expectations oflower prices will have the opposite effect.

Inflation is a condition of rising prices.During periods of inflation, the value ofcash in a person’s pocket decreases fromday to day as prices rise. Not too long ago,one dollar could buy a movie ticket or asmall meal, but inflation over many yearshas reduced the value of the dollar.However, a good will continue to hold itsvalue, provided that it can be stored for along period of time. When faced with infla-tion, suppliers prefer to hold on to goodsthat will maintain their value rather thansell them for cash that loses its valuerapidly. As a result, inflation can affectsupply by encouraging suppliers to hold onto goods as long as possible. In the shortterm, supply can fall dramatically.

During the Civil War, the South facedterrible inflation. The prices of most goodsrose very quickly. There were shortages offood, and shopkeepers knew that priceson basic food items like flour, butter, andsalt would rise each month. A few decided

to hoard their food and wait for higherprices. They succeeded too well; the supplyof food fell so much that prices rose outof the reach of many families. Riots brokeout in Virginia and elsewhere when hungrypeople decided they weren’t going to waitfor the food to be released from the ware-houses, and the shopkeepers lost theirgoods and their profits.

Number of SuppliersOne additional factor to consider whenlooking at changes in supply is the numberof suppliers in the market. If more suppliersenter a market to produce a certain good,the market supply of the good will rise,and the supply curve will shift to the right.On the other hand, if suppliers stopproducing the good and leave the market,the supply will decline. There is a positiverelationship between the number ofsuppliers in a market and the marketsupply of the good.

Where Do Firms Produce?So far we have ignored the issue of wherefirms locate their production facilities. Formany firms, the key factor is the cost oftransportation—the cost of transporting

� As prices for fossil fuels have risen, electric companies have lookedto alternative sources of supply, such as wind.


120 Supply

inputs to a production facility and the costof transporting the finished product toconsumers. A firm will locate close toinput suppliers when inputs, such as rawmaterials, are expensive to transport. Afirm will locate close to its consumers whenoutput is more costly to transport.

For an example of a firm that locatesclose to its input suppliers, consider a firmthat cooks tomatoes into tomato sauce.Suppose that a firm uses seven tons oftomatoes to produce one ton of sauce. The

firm locates its plant close to the tomatofields—and far from its consumers—because it is much cheaper to ship one tonof sauce to consumers than to ship seventons of tomatoes to the plant. Tomatosauce producers cluster in places likeCalifornia’s Central Valley where weatherand soil conditions are favorable for thegrowing of tomatoes.

For an example of a firm that locates closeto its consumers, consider a firm that bottlessoft drinks. The firm combines concen-trated syrup with local water, so the firm’soutput (canned drinks) weighs more than itstransportable input (syrup). As a result, thefirm locates close to its consumers—and farfrom its syrup supplier—because the firmsaves more on transporting soft drinks thanit pays to transport its syrup. In general, if afirm’s output is bulky or perishable, the firmwill locate close to its consumers.

Other firms locate close to inputs thatcannot be transported at all. Some firmsare pulled toward concentrations ofspecialized workers such as artists, engi-neers, and programmers. Other firms arepulled toward locations with low energycosts. Many firms locate in cities becauseof the rich variety of workers and businessservices available in urban areas.


Key Terms and Main Ideas1. How does a subsidy affect supply?2. Why does the government impose excise taxes?3. How can regulation affect a producer’s output decisions?

Applying Economic Concepts4. Using the Databank Turn to the graph on page 534 that

lists the production of the American agriculture, timber,and mining industries. If the government wanted themining industry to produce $120 billion next year, whatstep could it take?

5. Decision Making Decide whether each of these eventswould cause an increase or decrease in the supply ofAmerican-made backpacks. (a) The government raisesthe minimum wage of backpack workers to $40 an hour.

(b) A new regulation requires firms to make backpacksout of expensive clear plastic. (c) An engineer invents amachine that can sew ten backpacks a minute, speedingup production.

6. Critical Thinking Explain why a change that lowers themarginal revenue (price) changes the quantity producedin the same direction as a change that raises themarginal cost of production.

� High levels of inflation, like the 70 percent annual price increasesaffecting Turkey, can cause suppliers to hoard their goods to sell later at ahigher price.

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Are Baseball Players Paid Too Much?

Major league baseball provides us with a prime example of the ways in whichsupply and demand affect wages. Millions of people are willing to buy tick-

ets to watch major leaguers in person. Even more watch the games on television.Most team owners make enormous amounts of money from the sale of ticketsand television rights, as well as licensing fees.

Supply and Demand The salaries of top baseballplayers are determined by supply and demand. Thepublic creates a high demand for watching profes-sional sports, but the supply of truly talented ath-letes is relatively small. This drives their salariesup. On the other hand, most people could betrained to work as store clerks or fast-food restau-rant employees, so wages for those positions tendto be low.

Free Agency Up until the 1970s, players receivedrelatively low salaries. This was because most wererequired to play only for the team that first signedthem to a contract, or to the team that they hadbeen traded to. In the mid-1970s, players went tocourt seeking the right to become “free agents.”Free agency would allow them, after playing for ateam for a certain number of years, to sell theirservices to any other team willing to pay them the salaries they asked for.Although team owners strongly opposed free agency, the players won their case.

A Price to Pay This victory has led to bidding wars which have resulted in theastronomical salaries that top stars now receive. Yet, while these players havebenefited greatly from free agency, both fans and major league baseball itselfhave had to pay a price. The intense loyalty that fans once demonstrated towardtheir favorite teams has diminished as players switch from one team to anotherin search of higher salaries. Owners have sharply increased ticket prices to affordthe huge increases in players’ salaries.

Now, only teams that operate in the largest television markets or have thewealthiest owners can afford to pay the best players. Some fans believe that onlythe richest teams can make it to the World Series, while the less-wealthy teamsare left behind. The result of this development has been a growing cynicism onthe part of many fans who feel—rightly or wrongly—that baseball champi-onships are now purchased rather than won.

Applying Economic Ideas1. What arguments might players make for free agency?

2. How do the laws of supply and demand affect baseball players’ salaries?

� Baseball commissioner Bud Selig haspresided over a 232-day players’ strike thatresulted in the cancellation of the WorldSeries for the first time since 1904.

121

Supply and Demand

ECON_07NA_se_CH05_CS 6/20/05 7:26 AM Page 121

122

Chapter SummaryChapter Summary

AA summary of major ideas in Chapter 5 appearsbelow. See also the Guide to the Essentials

of Economics, which provides additional review andtest practice of key concepts in Chapter 5.

Section 1 Understanding Supply (pp. 101–106)The law of supply states that when the price of a goodrises, the quantity supplied of that good also risesbecause existing firms produce more and new firmsjoin the market. Economists list the quantity sup-plied of a good at each price in a supply schedule andgraph this data on a supply curve that rises from leftto right. Supply can be elastic or inelastic dependingupon how easily a producer can change the level ofoutput.

Section 2 Costs of Production (pp. 108–114)As an entrepreneur invests more in labor while keep-ing capital constant, the marginal product of labor firstincreases, then falls. A firm adds its fixed costs andvariable costs to determine its total cost at each levelof output. The most profitable level of output iswhere the marginal cost of producing the last unit isthe same as the marginal revenue the firm receiveswhen that unit is sold.

Section 3 Changes in Supply (pp. 116–120)Several factors can raise or lower the supply of agood at all prices. When inputs such as capital andlabor become more expensive, supply falls and thesupply curve shifts to the left. New technology canlower the cost of production and increase supply,shifting the supply curve to the right. Governmentencourages suppliers with subsidies and reduces sup-ply with excise taxes. Other factors that affect supplyare the number of suppliers in the market and com-petition from suppliers in other countries.

Key TKey TermsermsMatch the following definitions with the termslisted below. You will not use all of the terms.

1. An expense that costs the same whether ornot a firm is producing a good or service

2. The income that the supplier receives fromselling one more unit

3. A tax on the sale or manufacture of a good4. A measure of how suppliers will respond to

a change in price5. A government payment to support a busi-

ness or market6. The tendency of suppliers to offer more of

a good at a higher price7. The additional cost of producing one more

unit of output

Using Graphic OrganizersUsing Graphic Organizers8. On a separate sheet of paper, copy the multi-

flow map below. Organize information onhow firms determine their total costs bycompleting the multiflow map with exam-ples of fixed and variable costs.

marginal costsmarginal revenueelasticity of supplylaw of supplysubsidy

supply scheduleregulation excise taxvariable costsfixed cost

Fixed Costs Variable Costs

Supplier’s Total Costs

ECON_07NA_se_CH05_CA 8/3/05 11:04 AM Page 122

123

Reviewing Main IdeasReviewing Main Ideas9. How does the marginal product of labor change

as more people are hired? 10. What categories of costs combine to create a

firm’s total cost?11. Name and describe three factors that can cause a

change in supply.12. What circumstances cause a firm to experience

diminishing marginal returns?13. How can the global economy affect the supply of

a good in the United States?

Critical ThinkingCritical Thinking14. Recognizing Cause and Effect Assume that a $1

per pound tax has been placed on fish. Whateffect will this have on the supply curve for fish?

15. Analyzing Information A local coffee shop has thefollowing expenses: $5,000 a month for rent;$3,000 a month for a full-time manager; $4,000a month for part-time workers; and $2,000 amonth for coffee beans, milk, and cups. In July,the owner can expect to earn $7,000 in revenue.If she chooses to close down the store, she willnot have to pay for part-time workers or sup-plies. Explain whether she should close the shopfor the month of July, and why or why not.

16. Making Comparisons Compare the two termsincreasing marginal returns and diminishingmarginal returns. Describe two scenarios, one toexplain and demonstrate each term.

Problem-Solving ActivityProblem-Solving Activity17. Suppose that you plan to open a T-shirt factory.

Create a list of fixed costs and variable costs thatyou would encounter. How would each of thesecosts affect the number of T-shirts you make?

Skills for LifeSkills for LifeEnvironmental Policy Review the steps shown onpage 107, and then complete the following activitybased on your own experiences.18. (a) What natural landscapes are identified in the

report? (b) Identify three locations in the reportthat are defined by human settlement.

19. What are the human needs for the land describedin this report?

20. What environmental considerations are balancedagainst these human needs?

21. (a) How does the report propose to meet boththe environmental and human needs of theregion? (b) List two possible benefits and twopossible negative results from this solution.

Recognizing Cause and Effect For each itemon your list, explain if you think supply is elasticor inelastic, and why. Brainstorm five specificevents that could increase the supply of each item.

Economics Journal

The announcement that the Navy wouldclose the Naval Weapons Station inConcord, California, brings new opportu-nities to this city of about 120,000. Thebase includes 5,170 acres inland next to thecity and 7,630 acres of islands, tidal lands,and port facilities on the water. The SanFrancisco metropolitan area faces anaffordable housing crisis that can be helpedby building new homes on the former base.

The tidal portion of the base is home tomany species of birds, fish, and shellfish.Industrial development in the port threat-ened their habitat in the past. We expectwildlife to flourish on the islands if theybecome free of human interference.

The inland portion of the base provides aless fragile environment that is better suit-ed to development. The city proposes tobuild multi-family housing and schools onsections of this parcel of land. By settingaside 30% of the land for parks and openspaces, we believe that the city can meetboth the environmental demands of theinland ecosystem with the housing needs ofthe San Francisco area.

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