5.0 Product Market Supply

5.1.1Economists argued for years about

the shape of the supply line1817- David Ricardo – Principles of a

Political Economy – argues supply was perfectly elastic – a horizontal line

Whatever the cost of production was determined the supply, and therefore the price

In the 1870s,Jevons/Menger/Walras all argued

Ricardo had it all wrongThey said the level of supply was fixed

by the quantity available in the market

This implies a vertical or perfectly inelastic supply line

They said that where demand intersects this line, that will be the price

5.1.2Alfred Marshall – Principles of

EconomicsSaid that these two analyses were just

special cases of a larger possible setHe called Ricardo’s case the long run

condition – when the entire scale of production has time to fully adjust

He called the Jevons/Menger /Walras

caseThe market period condition – an

immediate position where there is a fixed amount of something available

Marshall says there is an intermediate case between these two extremes

The Short RunScale of production is fixed, butsome factor inputs are variableYou can make more things by adding

more of the variable factorThis implies an upward-sloping supply lineMarshall argues it is this intersection of

supply and demand that determines price

5.1.3Diminishing marginal productivity-Holding all other factors constant, as you increase one input, you

eventually get less output from each successive unit

Output

MP

Figure 5.1.1 - Marginal Productivity

Units of Input

5.1.4

Unit of labor MP for labor in candy bars

1 252 1003 2004 1805 1606 1407 1208 1109 100

10 90

This is consistent withThe shape of the MP curveMP rises, then fallsNow, assume a unit of labor costs

$20We can calculate marginal cost

Unit of labor MP for labor in candy bars

Marginal cost/unit of

candy in dollars1 25 .802 100 .203 200 .104 180 .115 160 .136 140 .147 120 .178 110 .189 100 .20

10 90 .22

Since we pay a constant price for the input,

and since output rises then falls, the marginal cost of the output will

fall then riseWhen workers are most productive,

the stuff costs less per unitWhen workers get less productive,

the marginal cost begins to rise

$

MC

Figure 5.1.2 - Marginal Cost

Units of Output

5.1.5The upward sloping segment of the MC

curve is the firm’s supply lineHow far do we expand production as

MC keeps risingThe firm gets the market signal – the

priceThe signal says “we’re willing to pay

this much, how many will you produce?”

FIRM MARKET

Figure 5.1.3 - Price Signal and a Firm's Response

$

p0

Q

p

D

Q

S

p0

Q0

MC,Supply Line

The firm looks at the market price and its marginal cost curve

They can produce up to that point and still cover costs, but to produce more

means that rising costs don’t make it worthwhile

If market price adjusts upward, then they will produce more

5.1.6Firms consider all costs they incurYou have to pay yourself, tooNormal return – the amount that

covers the opportunity cost of working for yourself

5.1.7People who run their own business

have many skillsThey could easily work for someone

elseThe normal return might be in cash,

pride of ownership, satisfaction, or any combination, but

it must exceed the opportunity cost of working for another

Normal returns arean essential part of any firm’s costsThey are built right into the marginal

cost curve

5.1.8A firm’s cost structure is based upon

The prices of inputs into productionLevel of technologyThe Environment of production

When one of the changes,it changes the level of the cost

structure, and shifts the whole MC line

Since the MC line is a firm’s supply curve, it is these variables that shift supply

Q1s = S1 (p1 | pI, Tech.,

Env.)Where:pI is the price of inputsTech. Is the level of technologyEnv. Stands for the environment of

production

5.1.9If an input price goes up, the whole

cost structure of the firm goes upIt costs more to produce at any

quantityThis increase in input prices will shift

the supply curve upEx. Increase in price of leather shifts

supply of gloves up

p

Figure 5.1.4 - A Shift Up in Supply

Q

S

S'

5.1.10If a new technique is developed that

allows production at a lower cost,the supply line will shift down

5.1.11If the environment of production

deteriorates, supply will shift upEx. Horrible weather for farmers

ruins crops

In each of these three cases,

What happens to the price and total revenue for the firm depends on

the own price elasticity of demand for that product

If supply shifts upTotal revenue would increase if the

demand curve were inelasticTotal revenue would decrease if the

demand curve were elastic

If supply shifts downTotal revenue would decrease if the

demand curve were inelasticTotal revenue would increase if the

demand curve were elastic

5.1.12

The market supply curveis the sum of individual firms’ supply

curves

Figure 5.1.5 - From Individual to Market Supply

Q

1

2

3

4

5

6

1 3 7542 86 9 10 11 12 13 140 15

S

Q1 3 542 60

p S

1

2

3

4

5

Q1 3 542 60

p S

1

2

3

4

5

Q1 3 542 60

p S

1

2

3

4

5

pp

5.1.13Entry and exit of firms shifts the

market supply curveCeteris paribus, More firms, more supply at each

price level, supply shifts rightFewer firms, less supply at each

price level, supply shifts left

5.1.14Under the nice assumptions that ensure

perfect competition,the market sets the priceFirms and households just have to deal with

it, as they have no powerThe firm faces a perfectly elastic demand

lineThe household faces a perfectly elastic

supply line

Figure 5.1.6 - Individuals and Firms as Price Takers

p

Dp0

S

Q

FIRM

p0

p

D

S

Q

MARKET

p

D

p0S

Q

INDIVIDUAL

FIRM MARKET

Figure 5.1.7 - The Firm and the Market

$

p0

Q

p

D

Q

S

p0

Q0

MC, S

D

Suppose new firms enter the market

FIRM MARKET

Figure 5.1.8 - The Firm in a Changing Market - As New Firms Enter

p

p0

Q

p

D

Q

S0

p0

Q0

MC, S

D0p1

Q1

D1

p1

S1

As market supply expands, price falls

Intersection of price and MC for the firm falls down to the left

The firm will be at a new position with a lower quantity supplied

Suppliers and demanders are

constantly responding to the price signalUnder the nice assumptions, all these individual

behaviors lead to an incredibly efficient outcome