Question

Explain the law of supply? Or, what is the relationship between price and quantity supplied?

Answer 1

When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves, drill for more oil, invest in more pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline, build new oil refineries, purchase additional pipelines and trucks to ship the gasoline to gas stations, and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply are held constant.

In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices—a relationship that can be illustrated with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve, and quantity supplied refers to a specific point on the curve.

Price and quantity supplied are directly related. As price goes down, the quantity supplied decreases; as the price goes up, quantity supplied increases.

When economists focus on the relationship between price and quantity supplied, a lot of other things are held constant, such as production costs, technology, and the prices of goods producers consider related. When any one of these things changes, the entire supply curve shifts. If an increase in supply occurs, the curve shifts to the right.

Price changes for other goods are a little complicated. First, in order to affect supply, producers must think the goods are related. What consumers think is irrelevant. For example, ranchers think beef and leather are related; they both come from a steer. However, customers don’t want to eat leather for dinner.

Beef and leather are an example of joint products, products produced together. For joint products, a direct relationship exists between a good’s price and the supply of its joint product. If the price of beef increases, ranchers raise more cattle, and the supply of beef’s joint product (leather) increases.

Producer substitutes also exist; using the same resources, a business can produce one good or the other. Corn and soybeans are examples of producer substitutes. If the price of corn increases, farmers grow more corn, and less land is available to grow soybeans. Soybeans’ supply decreases. An inverse relationship exists between a good’s price (corn) and the supply of its producer substitute (soybeans).