Law of supply

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Statement

The law of supply states the following equivalent things:

  • The price-elasticity of supply for a good is positive, or, at best, non-negative.
  • ceteris paribus, as the price of a good increases, the quantity supplied for the good increases (or at best, remains the same).
  • ceteris paribus, as the price of a good decreases, the quantity supplied for the good decreases (or at best, remains the same).
  • The supply curve for a good is upward-sloping.

The law of supply is not an ironclad law, and its applicability is greater for the short-run supply curve than for the long-run supply curve.

Note that the term quantity supplied is typically used for the quantity supplied at a particular price. The term supply is used for the entire relation between price and quantity supplied, keeping all the other determinants of supply constant.

Levels of operation of the law

The law of supply operates at two levels:

Context Verbal explanation More about phenomena
Individual seller For an individual seller, the law of supply partly arises from the law of diminishing returns to the various factors of production, whereby, eventually, the sellers hit the point where the additional expenditure needed on factors of production to increase output is greater than the money that the supplier can earn at the market price. When the price of the good in the market increases, it is possible to justify spending more to produce more units of output. Law of supply for individual sellers follows from diminishing returns, determination of quantity supplied by firm in perfectly competitive market, determination of quantity supplied by monopolistic firm, determination of quantity supplied by firm with market power
For a competing collection of suppliers Apart from the law of diminishing returns that applies to individual suppliers, we also have the fact that new suppliers, or sellers, enter the market attracted by the higher prices. This is explained by the fact that different suppliers have different reservation prices for entering the market, and a higher price brings more suppliers in. (These differences in reservation prices may be due to different degrees of technology or prices for factors of production, that result in different cost curves for the sellers) Law of supply for multiple sellers follows from differences in reservation prices

Causation versus correlation: superficial counterexamples

It is important to understand that the law of supply describes the effect of a change in price on the supply of the good. Thus, it does not predict that an increase in price is always accompanied by an increase in the supply of the good. Rather, it says that ceteris paribus, an increase in price is responsible for an increase in supply.

Independent shifts of the supply curve

In some cases, the supply curve may shift due to other exogenous reasons. For instance, in a region where agricultural output is heavily rain-dependent, fluctuations in the amount of rainfall can cause shifts in the supply curve. A drought may lead to a leftward shift of the supply curve, i.e., less supply for each price. This may lead to a situation of lower supplies and higher prices.

What matters are relative prices -- effects of inflation and simultaneous changes in prices of factors of production

If prices rise across the board as part of general inflation, that does not affect the supply of a particular good. If the sellers think that the price of the good has increased more than that of their factors of production, this is an incentive for them to increase supply, while if the price of the good has increased less than that of their factors of production, this is an incentive for them to decrease supply.

Counterexamples: long-run supply curves

For many kinds of goods, the long-run supply curve, i.e., the supply curve over a longer period of time, appears to be flat (these are called constant cost industries) or downward-sloping (these are called decreasing cost industries). There are two phenomena at work:

  • It may happen that for some industries, diminishing returns do not apply in the long run, but apply in the short run. This happens because in the short run, certain fixed costs need to be incurred (e.g., land, employees) and these fixed costs cannot be changed quickly, so that increasing output with those fixed costs is expensive. However, in the long run, the fixed costs can be altered.
  • Another factor is the role of technology, which improves the processes for using the factors of production to create output. Note that the role of technology is that there is a time-directionality to it -- market incentives may help create new technology, but it is harder for existing technology to get lost even when market incentives are unfavorable.