unit 5 - Law of Supply

8/7/2019 unit 5 - Law of Supply

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Business Economics Unit 5 – The Theory of Production B.Com 1st Sem___________(Do your best and let the best of all, find and reach you. Good luck )__________

Meaning of Production:

The term production means transformation of physical inputs into physicaloutputs. The term ‘inputs’ refers to all those things or times whichare required by the firm to produce a particular product like raw

materials, power, fuel and services like transport andcommunications, warehousing, banking, shipping and insurance.‘Output’ refers to finished products.

Production always results in either creation of new utilities or addition of values. It is an activity that increases consumer satisfaction of goodsand services. Production is undertaken by producers and mainly itdepends on cost of production. Production is always done in physicalterms and it shows the relationship between physical inputs andphysical outputs.

Inputs Transformation

Process

Output

Entry intofirm

Transformation

Process

Exit out of firm

Importance:

It helps an individual to fulfill his requirements or wants by consumingdifferent kinds of goods and services.

Higher levels of production is an indication of a progressive societyHigher levels of production leads to higher income, employment and

economic prosperity. It is an index of the rate of economic growth inan economy.

Production of different type of goods and services in different nationsindicate the nature of economic inter dependence between different

nations.

Production Function:

A production function expresses the technological or engineeringrelationship between quantity of physical inputs and physical outputs

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"Every truth has four corners: as a teacher I give you one corner,and it is for you to find the other three." –Confucius. “The best

use of knowledge is human welfare”____________________________________________________________________

M.S. Ramaiah Degree College (MSRCASC) M. Maliny M. Maliny Page Number: 1 of

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of a firm. It is table or graph or an equation specifying maximumoutput rate from a given amount of inputs used. Since it relatesinputs to outputs, it is also called as “Input-Output relation”. Theproduction is purely physical in nature and is determined by thetechnology, availability of equipment, labour, materials, efficiency

and productivity and managerial and so on.

Mathematically production function is:Q = f(L, N, K etc)Q is the quantity of output per unit of timeL, N, K etc., are the various inputs like land, capital, labour etc

Thus rate of output Q is thus, a function of the factor inputs L, N, K etc.,employed by the firm per unit of time.

Inputs factors are of 2 types:

Fixed Factors: They remain constant irrespective of the level of output.For e.g. Land, buildings, machines, tools, equipments, superior typesof labour etc.

Variable Factors: Its quantity varies with variations in the level of outputof production. For e.g. Raw materials, power, fuel, transport andcommunication etc.

The distinction between the two will hold good only in the short run, inthe long run, all factor inputs will become variable in nature.

Production Function is of 2 types:

Short Run Production Function: In this case, the producer will keep allfixed factors as constant and change only a few variable factorinputs. In the short run, we come across two kinds of productionfunctions:

Quantities of all inputs both fixed and variable will be kept constant andonly one variable input will be varied. For e.g., the law of variableproportions.

Quantities of all factor inputs are kept constant and only two variable factorinputs are varied. For e.g., ISO-Quants and ISO-Cost Curves.

Long Run Production Function: In this case, the producer will vary thequantities of all factor inputs in the same proportion. For e.g., thelaws of returns to scale.

Improvements in production function can be brought about asbelow:

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The quantities of input may be reduced while the quantity of output mayremain same.

The quantity of output may increase while the quantities of input mayremain same.

The quantities of output may increase and quantities of inputs may

decrease.

Uses of Production Function:It can be used to calculate the least cost input combination for a given

output or the maximum output-input combination for a given cost.It is useful in working out an optimum and economic combination of inputs

for getting a certain level of output. Additional employment of thevariable factor input is desirable only when the marginal revenueproductivity of a variable factor input is equal to its cost of employingor it should be greater than its employment cost.

It helps in making long run decisions. If returns to scale (large scaleproduction) are increasing, it is wise to employ more factor inputsand increase production. If returns to scale are diminishing, it wouldbe unwise to increase factors inputs. Incase of constant returns onscale, the manager will be indifferent to the increase or decrease inproduction.

Thus production functions of immense utility to the mangers andexecutives in decision making process in the short and long run.

Production Function: One variable input case

The law of variable proportions:

The law of variable proportions or the law of non-proportional output willexplain how variation in one factor input give place for variations inoutputs. In order to expand the output, scarce factors must be keptconstant and variable factors are to be increased in greaterquantities. Additional units of a variable factor on the fixed factorswill certainly mean a variation in output. The law states that “as thequantity of different units of only one factor is increased to agiven quantity of fixed factors, the total average andmarginal output decreases in different proportions”.

The law of variable proportions is the new name for the famous “Law of diminishing returns” of classical economists. According to Prof.Benham, “As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and thenthe average product of that factor will diminish.

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Assumptions:Only one factor unit is to be varied while all other factors should be kept

constant.Different units of a variable factors are homogenous

Plant size, its capacity, efficiency and scale of production remains constantTechniques of production remain constantThe law will hold good only for a short or given periodThere is possibilities of a varying the proportion of factor inputs.

Illustration:A hypothetical production schedule is worked out to explain the operation

of the law. Fixed factors = 1 acre of land + Rs.5,000 capital.Variable factor = Labour

Units of variable

inputs(labou

r)

TP(TotalProduc

t orOutpu

t)

AP(AverageProduc

t orOutpu

t)

MP(MarginalProduc

t orOutpu

t)

Stages

01234

010243952

010121313

010141513

1st Stage

56789

6066707272

12111098

86420

2nd Stage

10 70 7 -2 3rd Stage

Total Product or Output (TP): It is the output derived from all factorinputs, both fixed and variable employed by the producer per unit of time. It is also a sum of marginal output.

Average Product or Output (AP): It is obtained by dividing total outputby the number of variable factors employed. AP = TP/Qty of variablefactors.

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Marginal Product or Output (MP): It is the output derived from theemployment of an additional unit of variable factor MP = ∆TP/∆Qty of variable factors.

Trends in Output:

From the table, one can observe the following tendencies in the TP, AP andMP.

Total output goes on increasing as long as MP is positive. It is the highestwhen MP is zero and TP declines when MP becomes negative.

MP increases in beginning, reaches the highest point and diminishes at theend.

AP will also have the same tendencies as the MP. In the beginning MP willbe higher than AP but at the end AP will be higher than MP.

Stage 1: The law of increasing returns: In this case, as the quantityof variable inputs are increased to given quantity of fixedfactors, output increases more than proportionately. The totaloutput increases upto the point P because corresponding to this pointP, the MP is rising and reaches its highest point. AP of the variablefactors increases through out this stage. After the point P, MPdeclines due to abundant quantity of fixed inputs and as such TPincreases gradually.

The first stage comes to an end at the point where MP curve cuts the APcurve at N when the AP is maximum and AP = MP (at the 4th input inthe illustration, AP = MP = 13 units).

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The 1st stage is called as the law of increasing returns because when theproducer increases the quantity of variable factors, intensive andeffective utilization of fixed factors become possible leading to higheroutput. The efficiency of variable factors is increased as it createsopportunity for division of labour and specialization resulting in higher

output.Stage 2: The law of diminishing returns: In this case as thequantity of variable inputs are increased to a given quantity of fixed factor, output increases less than proportionately. In thisstage, TP increases at a diminishing rate since both AP and MP aredeclining continuously. The 2nd stage comes to an end at the pointwhere TP is the highest at the point E and MP is zero at the point B. (Atthe 9th input in the illustration, TP is 72 units and MP is zero).Diminishing returns arises due to:

The proportions of variable factors are greater than the quantity of fixed

factors. Hence both AP and MP declineTotal output diminishes because there is a limit to the full utilization of indivisible factors and introduction of specialization

Diseconomies of scale will operate beyond the stage of optimum productionDiminishing returns are bound to appear as long as one or more factors is

fixed and cannot be substituted by the others

Stage 3: Negative Returns

In this case, as the quantity of variable input is increased to a givenquantity of fixed factors, output becomes negative (<0). During this stage,

TP starts diminishing, AP continues to diminish and MP becomes negativeat 10th unit of input in the illustration. The negative returns are the result of excessive quantity of variable factors to a constant quantity of fixedfactors.

The 1st and 3rd Stage is described as Non-Economic Region or UneconomicRegion or irrational phase of production since 1st stage results in underutilization of fixed inputs and plant capacity, whereas 3rd stage results inover utilization of fixed factor inputs and plant capacity. Hence theproducer will select the 2nd stage (which is also called the most economicregion) since he can maximize the output. The 2nd stage represents theemployment of the most ideal combination of factor inputs.

Uses in Decision making:

1. It helps to work out the most ideal combination of factor inputs or theleast cost combination of factor inputs

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2. It is useful to a businessman in the short run production planning atthe macro level

3. The law gives guidance that by making continuous improvements inscience and technology, the producer can postpone the occurrence of diminishing returns.

Production Function with 2 variable inputs:

Meaning of ISO-Quant and ISO-Costs: The prime concern of a firm is to workout the cheapest or lowest costmethod to produce a given output out of several alternative methods opento it. The term ISO Quant has been derived from ISO meaning equal andQuant meaning quantity. Hence ISO-Quants are also called as EqualProduct Curve or Product Indifference Curve or constant product curve. An

ISO-Product curve represents all the possible combinations of twofactor inputs which are capable of producing the same level of output. According to Prof. Keirstead “ISO-Product curve represents allpossible combinations of two factors that will give the same total product”.

Each ISO-Quant represent only one particular level of output. If there aredifferent ISO-Quant Curves they represent different ISO-Quant curves theyrepresent different levels of output. Any point on an ISO-Quant Curverepresent same level of output. Since each point indicates equal level of output, the producer becomes indifferent with respect to any one of thecombination. An ISO-Quant Curve shows the exact physical units of output

produced by different combinations of two factors. Hence themeasurement of output is possible.

Example:

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ISO – Quant Map: A number of ISO-Quants representing different amountof output are known as ISO-Quant Map.

Marginal Rate of Technical Substitution: It may be defined as the rateat which a factor of production can be substituted for another at the marginwithout affecting any change in the quantity of output.

Combinations Factor X Factor Y MRTS of x:yA 12 1 NilB 8 2 4:1C 5 3 3:1D 3 4 2:1

E 2 5 1:1In the above example, in the second combination the producer issubstituting 4 units of X for 1 unit of Y. Hence in this case, MRTS is 4:1.MRTS will be diminishing. In the above table, we can observe that as thequantity of factor Y is increased relative to the quantity of X, the number of units of X that will be required to be replaced by one unit of factor Y will

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diminish, quantity of output remaining the same. This is known as the lawof Diminishing Marginal Rate of Technical Substitution (DMRTS).

Properties of ISO-Quant:

Properties of ISO-Quant Curve are similar to those of indifferent curves:1. An IQ Curve slope downwards from left to right2. It is convex in origin3. No two ISO-Product Curves intersect each other4. An ISO-Product Curve lying to the right represents higher output and

vice-versa.5. IQ Curves need not be parallel to each other6. It will not touch either x or y – axis

ISO-Cost Line or Curve:

It is a parallel concept to the budget or price line of the consumer. Itindicates the particular combinations of the two inputs which thefirm can purchase at given prices with a given outlay. It shows twothings (a) price of two inputs (b) total outlay of the firm. Each ISO-Cost Linewill show various combinations of 2 factors which can be purchased with agiven amount of money at the given price of each input.

For Ex.

A producer has Rs.3000 to spend. If he purchases commodity/factor X at

Rs.100 per unit he can purchase 30 units for Rs.3000 whereas he canpurchase 60 units of commodity/factor Y for Rs.3000. When 30 units arepointed on y axis and 60 units are pointed on x axis and the points arejoined, we get AB ISO-Cost Line. This line represents the differentcombinations of factor X and Y.

The ISO-Cost line will shift to right if the producer increases the outlay fromRs.3000 to Rs.4000. On the contrary, if his outlay decreases to Rs.2000,there will be backward shift in the position of ISO-Cost Line.

The slope of the ISO-Cost line represents the ratio of the price of a unit of factor X to the price of a unit of factor Y. In case, the price of any one of them changes there would be corresponding change in the slope andposition of ISO-Costline.

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Producers Equilibrium:(Optimum factor combination or least cost combination)

The optimal combination of factor input may help in either minimizing costfor a given level of output or maximum output with a given level of investment expenditure. In order to explain producer equilibrium, theproducing firm requires two instrument: (1) Its ISO-Quant Map (2) its ISO-

Cost line to hit upon the optimum (or minimum cost) factor combinations.

The intention of the producer is to maximize profits. This will becomepossible when he produces optimum output at the lowest cost of production. Hence, the producer selects the least cost combination of thefactors of production. The following diagram explains how the producerreaches the position of equilibrium.

In the diagram the producer will reach the position of equilibrium at thepoint E where the ISO-Quant line IQ and ISO-Cost line AB are tangent toeach other. With a given total of Rs.5000, the producer will be producingthe optimum output of 500 units by employing 25 units of factor X (at pointA in X axis) and 50 units of factor Y A(at point B in Y axis) (assumingRs.2500 is spent for each factor and the price per unit of factor X is Rs.100and Y is Rs.50).__________________________________________________________________________




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He will not reach the position of equilibrium at E1 and E2 because they areon higher ISO-Cost line. Similarly he cannot move to the left side of E, asthey are on the lower ISO-Cost line and he will not be able to produce 500units of output with any combination of input other than E.

Thus, the point at which the ISO-Quant is tangent to the ISO-Cost linerepresents the minimum cost or optimum factor combination for producinga given level of output. At the point, MRTS between the two points is equalto the ratio between the prices of the inputs.

Economies of Scale:

The study of economies of scale is associated with large scale production.“The advantages or benefits that accrue to a firm as a result of

increase in its scale of production are called Economies of scale”.They help in reducing production cost and establishing an optimum size of a firm. According to Prof. Marshall these economies are of two types viz.,Internal Economies and External Economies.

Internal Economies:

Internal economies are those economies which arise because of the actionsof an individual from to economise its cost. They arise due to increaseddivision of labour or specialization and complete utilization of indivisiblefactor inputs. According to Prof. Cairn cross “Internal economies are

those which are open to a single factory or a single firmindependently of the action of other firms”. They result from anincrease in the scale of output of a firm and cannot be achieved unlessoutput increases. The following are some of the important aspects of internal economies:

1. They arise within or inside a firm2. They arise due to improvements in internal factors3. They arise due to specific efforts of one firm4. They are particular to a firm and enjoyed by only one firm5. They arise due to increase in the scale of production6. They are dependent on the size of the firm7. They can be effectively controlled by the management of a firm8. They are called as “Business Secrets” of a firm

Classification of Internal Economies:

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1. Technical Economies: These economies arise on account of technological improvements and its practical application in the fieldof business.

a. Economies of superior techniques: When the size of firmgrows, it becomes possible to employ bigger and better types

of machinery and increase production, thereby reducing cost.For e.g., use of computer instead of human labour etc.

b. Econimies of increased dimension: A large firm avoidswastage of time and by the use of increased dimension willreduce cost of production. For e.g., use of double deckerinstead of two separate buses.

c. Economies of linked process: By linking the variousprocesses of production a large firm saves the expensesincurred on intermediaries thereby reducing unit cost of production.

d.Economies arising out of research and by product: A firmcan invest adequate funds for research and the benefits of research and its costs can be shared by all other firms.Similarly large firm can make use of its wastes as by-productsin the most economical manner by producing other products.

e. Inventory Economies: A big firm can save a lot of money byadopting latest inventory management techniques. For e.g.,J.I.T. or zero level inventory techniques. The rationale of theJust In Time technique is that instead of having huge stocksworth of lakhs and crores of rupees, it can ask the seller of theinputs to supply them just before the commencement of work

in the production department each day. Thus it can save a lotof money by avoiding huge stocks of input which lie idle leadingto dead investment.

f. Economies of increased specialization: A large firm is ableto reap economies by dividing its production process into subprocesses thereby leading to greater division of labour andincreased specialization.

2. Managerial Economies: They arise because of better, efficient andscientific management of a firm.

a. Delegation of details: Delegation of powers and functions totrained or specialized personnel by the general manager of thefirm, will enable him to bring about improvements in productionprocess and in bringing down the cost of production.

b. Functional specialization: By dividing the work of management into several separate departments specialized invarious functions, will lead to higher efficiency and reduction inthe cost of production.

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3. Marketing or Commercial Economies: These economies will ariseon account of buying and selling goods on large scale basis atfavourable terms. A large firm can buy raw materials and otherinputs in bulk at concessional rates. A firm can have its own salesagency and channel.

4. Financial Economies: They arise because of the advantagessecured by a firm in the mobilizing huge financial resources. A largefirm has wider reputation and greater influence in the money andcapital market which helps in securing sufficient funds more easilyand cheaply.

5. Labour Economies: These economies arise as a result of employingskilled, trained, qualified and highly experienced persons by offeringhigher wages and salaries. All measures will definitely raise theaverage productivity of a worker and reduce the cost per unit output.

6. Transport and Storage Economies: They arise on account of the

provision of better organized and cheap transport and storagefacilities and their complete utilization.7. Over Head Economies: The expenses on establishment,

administration, book-keeping etc., are more or less the same whetherproduction is carried on small or large scale. Hence cost per unit willbe low if production is organized on large scale.

8. Economies of Vertical Integration: Because of verticalintegration, most of the costs become controllable costs which helpan enterprise to reduce cost of production.

9. Risk bearing or survival economies: These economies will ariseas a result of avoiding or minimizing several kinds of risks and

uncertainties.a. Diversification of output by producing more than one productb. Diversification of market by selling in different marketsc. Diversification of source of supply for inputs so that even if

person fails to supply, a firm can buy from several sourcesd. Diversification of the process of manufacture for the same

commodity so as to avoid the loss arising out of the failure of any one process

External Economies: External Economies are those economies whichaccrue to the firms as a result of the expansion in the output of wholeindustries and they are not dependent on the output level of individualfirms. In the words of Stonier and Hague “External Economies are thoseeconomies in production which depend on increase in the output of thewhole industry rather than increase in the output of the individual firm”.The following are some of the important aspects of external economies:

1. They arise outside the firm__________________________________________________________________________




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2. They arise due to improvements in external factors3. They arise due to collective efforts of an industry4. They are general and common and enjoyed by all firms5. They arise due to overall development, expansion and

growth of an industry or region

6. They are dependent on the size of industry7. They are beyond the control of management of a firm8. They are called as “open secrets” of a firm

Classifications of External Economies:

1. Economies of concentration or localization of industry orAgglomeration: They arise because in a particular area a verylarge number of firms which produce the same commodity areestablished. The benefits are better and cheap labour, trained and

skilled labour, quicker transport and communication, financialassistance at cheaper rate of interest, marketing facilities etc whichresult in reducing the cost of operation of a firm.

2. Economies of information: These economies will arise as a resultof getting quick latest and upto date information from varioussources. Since large number of firms are located in a region, itbecomes possible for them to exchange their views frequently bydiscussions, lectures, seminars etc. Revolution in the field of computers, internet, mobile, publication of journals, magazine etc.,have strengthened inter-firm communication network therebyreducing cost.

3. Economies of disintegration: These economies will arise as aresult of dividing one big unit into different small units for the sake of convenience of management and administration. It leads to internaleconomies of large scale production. All the firms in the industry willbe able to get the work done at a low cost instead of attempting tomeet their own needs by carrying it out themselves on a small scaleat high cost.

4. Economies of Government Action: These economies will arise asa result of positive support and assistance given by the governmentto stimulate production in the private sector units. For e.g., tax-concessions, tax-holidays, subsidies

5. Economies of physical Factors: These economies will arise due toavailability of favourable physical factors or environment. For e.g.,climate, weather conditions, fertility of the soil etc.

6. Economies of Welfare: These economies will arise on account of various welfare programs under taken by an industry to help its ownstaff. For e.g., health care units, training units, education institutions,

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concessions etc. Tall these measures would help in raising theoverall efficiency to productivity of labourers.

Diseconomies of Scale:

When a firm expands its size of operation and output beyond the optimumlimit, the economies scale turns out to be diseconomies of scale. Thesediseconomies of scale by raising the average cost of production, acts as alimiting factor on the further expansion of the firm. These limitations arisebecause of human, technical, economic an other factors in production.Hence additional output is to be obtained at higher cost. The following arethe major diseconomies of scale:

1. Financial Diseconomies: As there is over growth, the requiredamount of finance may not be available for a firm.

2.Managerial Diseconomies: Excess growth leads to loss of effective supervision leading to wastages, indiscipline and rise inproduction and operating costs.

3. Marketing Diseconomies: Excess production leads to mismatchbetween demand and supply, thereby leading to stock pile up and fallin price, sales, revenue and profits.

4. Technical Diseconomies: When output is carried beyond the plantcapacity, per unit cost and operation cost will go up.

5. Diseconomies of Risk-Bearing: If output expands beyond a limit,investment increases, stocks pile up. Business risks appear in allfields of activities. Supply of factor inputs may become inelastic

leading to higher prices.6. Labour Diseconomies: In a larger firm, contact between

management and employees is limited. Labourers may demandhigher wages, bonus, perquisites etc. Industrial disputes may arise.Labour unions may not cooperate with the management.

7. External Diseconomies: When several business are concentratedonly in one place or locality, it may lead to congestion, environmentalpollution, scarcity of water, houses, schools etc. leading to higherproduction and operational costs.

Hence there should be proper check on the growth and experience of eitherone firm or an industry. Otherwise instead of benefits, they have to faceinnumerable problems.

Supply:

Supply is made by the producer. It is the opposite of demand. Supply of aproduct basically depends on cost of production and management decision.__________________________________________________________________________




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Hence it covers such problems like where to sell, when to sell, for whom tosell and how much to sell and at what price to sell etc.

According to Prof. Macconnel, Supply may be defined as “supply may bedefined as a schedule which shows the various amounts of a product which

a producer is willing to and able to produce and make available for sale inthe market at each specific price in a set of possible prices during somegiven period.

Difference between stock and supply:

Stock refers to total quantity of output kept in a warehouse which can beoffered for sale in the market by the seller. On the other hand, the termsupply refers to the amount that is actually offered for sale in the market ata price per unit of time. Hence supply is a part of stock.

Supply Schedule:

Change in supply consequent upon changes in price, whenrepresented in a tabular column constitutes a supply schedule. Itrepresents the functional relationship between quantity suppliedand price. No producer wants to charge cost price to customers since theproducer has to gain profit. Hence supply is zero at cost price. It is calledthe reserve price. Reserve price is a minimum price below which aseller will not sell his commodity.

Individual Supply schedule is the supply schedule for an individualbuyer.

Price inRs.

Quantitysupplied in

units5 5004 4003 3002 200

1 1000.75 00

Market Supply Schedule:

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The total quantity of commodity supplied at different prices in amarket by the whole body of sellers is called as market supplyschedule. It refers to the aggregate behaviour of the market rather thanmere totaling of all individual supply schedule.

Price in Rs. Quantity supplied in units TotalA B C (A + B + C)

5 500 600 700 18004 400 500 600 15003 300 400 500 12002 200 300 400 9001 100 200 300 600

The market supply schedule help a firm to formulate its sales policy bymanipulating the prices. It helps to know how much sales can be increasedby raising the price without loosing the demand for a product.

Supply Curve:

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The law of supply:

“Other things remaining constant, the quantity supplied variesdirectly with the price i.e. when the price falls, supply will contract

and when price rises, supply will extend”. According to S.E. Thomas,“A rise in price tends to increase supply and a fall in price tends to reducesupply. Mathematically S=F(P). Supply is the function of price. It does nothave universal validity. It is conditional in nature. The other things thatshould remain constant when we study law of supplies are:-

1. Number of firms, the scale of production and the speed of production2. Availability of other inputs3. Techniques of production4. Cost of production

5. Market prices of other related goods6. Climate and weather conditions

Special features of law of demand:

1. Direct Relation: There is a direct relationship between price andsupply i.e. higher the prices higher would be the supply and viceversa.

2. Price is an independent variable and supply is a dependentvariable: In this case we analyse the effect of price on supply only.

3. Importance of the qualifying phrase other things being equal:

The applicability of the law is conditioned by the phrase “Other thingsbeing equal”. Thus the law is not universal in nature.

4. Qualitative statement: It tells us only the direction of change inprice and supply but does not indicate the quantitative changes inboth price and supply.

5. Upward sloping curve: Supply curve normally slopes upwardsfrom left to right.

Exceptions to the law of demand:

In certain circumstances, inspite of rise in price supply may not expand oreven at a lower rate more quantity may be sold. This will happen underexceptional situations. In this case, the supply curve slopes backward.

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The following are some of the exceptions to the law of supply:1. If the seller is badly in need of money, he will sell his product even at

lower prices2. If the seller wants to get rid of his products, then also he will sell hisproducts at reduced rates.

3. When further heavy fall in prices is anticipated the seller may becomepanic and sell at a lower price

4. In case of auction, the auctioneer is not interested in maximizingprofits by selling more units at a higher price. Thus, an auction saleis an exception to the law of supply.

Changes or shifts in supply:

When supply of a product change only due to change in the price of thatproduct alone, it is called as expansion or contraction in supply. Expansionin supply means, the more quantity is supplied at a higher price andcontraction in supply means, less quantity is supplied at a lower price. Inthis case, the supply curve shows a upward direction from left to right.

In the above diagram, 20 units are purchased at Price Rs.6 and 30 units arepurchased even after price increase to Rs.8.

Increase or decrease in supply:

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If supply changes not because of changes in price, but because of changes in other determinations, then, it will be a case of eitherincrease or decrease in supply.

Increase in supply: It implies more supply at the same price or same

quantity supplied at a lower price. In this case a new supply curve is drawnas given below:

Decrease in supply: It implies that less quantity is supplied at the sameprice or same quantity is supplied at a higher price. In this case, also wehave to draw a new supply curve.

Managerial uses of law of supply:1. it helps in deciding what and when to produce and sell, what quantity

to sell, At what price to sell, when and where to sell2. Helps in maintaining a balance between stock and supply3. Helps in preparing sales budget policy4. Helps in estimating the present and future expected revenue and

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5. Helps to analyse the effects of taxes on total sales in the market6. Helps to analyse the impact of various government policies on the

supply of a product7. Helps in identifying the factors which affect supply of a product

Determinants of supply:1. Natural Factors: Favourable natural factors like good climatic

conditions, adequate rainfall etc., helps in higher production andexpansion of supply, whereas adverse factors like floods etc., willdecline the production and supply.

2. Changes in techniques of production: Primitive techniques resultin lower production and supply. Improvements in technology orsophisticated machines and equipment result in higher productionand supply.

3. Cost of production: If the cost of production rises due to higher

wages, interest etc., the supply decreases and vice versa.4. Prices of related goods: If prices of related goods fall, the seller of a given product will supply more units in the market even though theprice of his commodity has not fallen.

5. Government policy: When the government follows a positive policylike granting of subsidies etc., it encourages production in the privatesector. Whereas if the government follows a negative policy likewithdrawal of all concessions etc., the supply reduces.

6. Monopoly power: Supply tends to be low in monopolist market orwhen there are few sellers as in oligopoly. Supply is more undercompetitive conditions.

7. Number of sellers or firm: Supply would be more when there area large number of sellers and vice versa.

8. Complementarity of goods: In case of joint demand, theproduction and sale of one product may lead to production and saleof other product also.

9. Discovery of new sources of inputs: Discovery of new sources of inputs helps the producers to supply more at the same price and viceversa.

10. Improvements in transport and communication: this willfacilitate free and quick movements of goods and service fromproduction centres to marketing centres.

11. Future rise in prices: When sellers anticipate a further rise inprice, in that case supply tends to fall and vice versa.

Thus the firm should have a thorough knowledge of all these factors beforepreparing its production plan or sales strategy.

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Supply Function: Supply of a product, apart from price changes alsodepends upon many factors. When we analyse the influence of thesefactors on supply, supply schedule will be converted into supply function.Supply function is a comprehensive one as it analyses the causes forchanges in supply in a detailed manner. Mathematically a supply function

can be represented in the following manner:

Sx = f(Pf, T, Cp, Gp, N……..etc)

Where Sx = Supply of a given product xPf = Price of factor outputT = TechnologyCp = Cost of productionGp = Government policyN = Number of firms etc

Supply function is also called as shifts

Distinction between Demand and Supply:

Sl.No.

Demand Supply

1 It is concerned with the studyof consumer’s behaviour

It is concerned with the study of producer’s behaviour

2 The basic objective of a

consumer is maximization of satisfaction

The basic objective of a producer is

profit maximization

3 Demand basically depends onthe utility of a product orservice

Supply of a product dependsbasically on the cost of production

4 A consumer wants to buy atthe lowest price in the market

A seller wants to sell at the highestprice in the market

5 A consumer wants to savemore money

A producer wants to earn moremoney

6 There is an inverse

relationship between priceand demand

There is a direct relationship

between supply and price

7 Demand Curve slopedownwards from left to right

Supply curve slopes upwards fromleft to right

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Effects of supply on cost of production: When supply of factor inputsis elastic to a producer, he can buy them at lower prices. On the otherhand, if they are inelastic to a producer, he can buy them at lower prices.On the other hand, if they are inelastic in supply, then he has to pay ahigher price for them leading to higher production cost either in the short

run or in the long run. Thus, the supply of factors of production in themarket affects production cost of different goods and services.

Elasticity of Supply:

It refers to the sensitiveness or responsiveness of the supply to agiven change in price. In short, it measures the degree of adjustabilityof supply to a given change in price. The formula to calculate elasticity of supply is as follows:

Percentage change in supply 8%

ES = -------------------------------------------= ------ = 4Percentage change in price 2%

It implies that at the present level with every change in price, there will bea change in supply four times directly.

Types of elasticity of supply:

Just like elasticity of demand, elasticity of supply is also equal to infinity,zero, greater than one, lower than one and equal to one.

1. Perfectly Elastic Supply: Supply is said to be perfectly elasticwhen a slight change in price leads to immeasurable change insupply. Hence supply curve would be a horizontal and parallel line toOX axis.

2. Perfectly Inelastic Supply: When supply of a commodity remainsconstant and does not change whatever may be the change in price,it is said to be absolutely or perfectly inelastic supply. Here thesupply curve tends to be a vertical straight line (ES = 00 Zero).

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3. Relatively Elastic Supply: If the change in supply is more thanproportionate to the change in price, in that case, elasticity of supplyis greater than one.

4. Relatively Inelastic Supply: If the supply is less than

proportionate to a given change in price then, elasticity of supply issaid to be less than one.

5. Unitary Elastic Supply: If proportionate change in supply is exactlyproportionate to change in price, then elasticity of supply is equal toone.

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Factors determining Elasticity of supply: (Determinants)

1. Time Period: Generally supply tends to be inelastic in the short runbecause time available to organize and adjust supply to demand isinsufficient. Supply would be more elastic in the long run.

2. Availability and mobility of factors of production: When factors

of production are available in plenty and freely mobile from oneoccupation to another, supply tends to be elastic.3. Technology improvements: Modern methods of production,

expands output and hence supply tends to be elastic. Old methodsreduce output and supply tends to be inelastic.

4. Cost of production: If cost of production rise rapidly as outputexpands, then there will not be much incentive to increase output asthe extra benefit will be choked off by increase in cost. Hence supplytends to be inelastic and vice versa.

5. Kinds and nature of markets: If seller is selling his product indifferent markets, supply tends to be elastic in any one of the market

because, a fall in the price in one market will induce him to sell inanother market. Again if he is producing several types of goods andcan switch over easily from one to another, then each of his productwill be elastic in supply.

6. Political conditions: Political conditions may disrupt production of a product, in this case, supply tends to become inelastic.

7. Number of sellers: Supply tends to become more elastic if thereare more sellers freely selling their products and vice versa.

8. Prices of related goods: A firm can charge a higher price for itsproducts, if prices of other products are higher and vice versa.

9. Goals of the firm: If the seller is happy with small output, in thatcase supply tends to be inelastic and vice versa.

Practical importance of Elasticity of supply:

1. The concept of elasticity of supply is of great importance to thefinance minister while formulating the taxation policy of the country.

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If the supply is inelastic, the imposition of tax may not bring aboutany change in the supply. If supply is elastic reasonable tax may belevied.

2. The price of commodity depends upon the elasticity of demand andsupply

3. The concept has a theoretical value. It is used in the theory of incidence of taxation. The money burden of taxation is shared by thetax payers and the sellers in the ratio of elasticity of supply anddemand.

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M.S. Ramaiah Degree College (MSRCASC) M. MalinyM. Maliny Page Number: 26 of

unit 5 - Law of Supply

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