Factors Affecting Supply

Learning Outcomes

  • Explain the factors that can change supply

How Production Costs Affect Supply

decorative imageA supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus, so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as a shift in demand is represented by a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.

In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. Goods and services are produced using combinations of labor, materials, and machinery, or what we call inputs (also called factors of production). If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it’s more motivated to produce output (goods or services), since the more it produces the more profit it will earn. So, when costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. This can be shown by the supply curve shifting to the right.

Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver packages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.

Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.

Consider the supply for cars, shown by curve S0 in Figure 1, below. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. The same information can be shown in table form, as in Table 1.

The graph shows supply curve S sub 0 as the original supply curve. Supply curve S sub 1 represents a shift based on decreased supply. Supply curve S sub 2 represents a shift based on increased supply. All data points shown on this graph can be found in Table 1. Additionally, there are four points on the graph labeled J, K, L, and M. J is on demand curve S sub 0 at price $20,000 and quantity 18 million. K is on demand curve S sub 0 at price $22,000 and quantity 20 million. L is on demand curve S sub 1 at price $20,000 and quantity 16.5 million. M is on demand curve S sub 2 at price $20,000 and quantity 19.8 million.

Figure 1. Shifts in Supply: A Car Example

Table 1. Price and Shifts in Supply:  A Car Example
Price Decrease to S1 Original Quantity Supplied S0 Increase to S2
 $16,000 10.5 million 12.0 million 13.2 million
$18,000 13.5 million 15.0 million 16.5 million
 $20,000 16.5 million 18.0 million 19.8 million
$22,000 18.5 million 20.0 million 22.0 million
$24,000 19.5 million 21.0 million 23.1 million

Now imagine that the price of steel—an important component in vehicle manufacturing—rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. This can be shown graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.

Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.

Other Factors That Affect Supply 

decorative imageIn the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.

The cost of production for many agricultural products will be affected by changes in natural conditions. For example, the area of northern China that typically grows about 60 percent of the country’s wheat output experienced its worst drought in at least fifty years in the second half of 2009. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied; conversely, especially good weather would shift the supply curve to the right.

When a firm discovers a new technology that allows it to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world was grown with these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.

Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Taxes are treated as costs by businesses. Higher costs decrease supply for the reasons discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace; complying with regulations increases costs.

A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right.

Practice Questions

Summary

Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.

Figure 2, below, summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.

Two graphs. One showing the supply curve shifting to the right and a list of factors that would cause an increase in supply. The other graph shows the supply curve shifting to the left and lists the factors that would cause a decrease in supply. Factors that could increase supply include: Favorable natural conditions for production, a fall in input prices, improved technology, and lower product taxes / less costly regulations. Factors that could decrease supply include: poor natural conditions for production, a rise in input prices, a decline in technology (not common), and higher product taxes / more costly regulations.

Figure 2. Factors That Shift Supply Curves. (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.

Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. Factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.

Practice Question

Worked Example: Shift in Supply Due to Production-Cost Increase

We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to an increase in production cost.

Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. An example is shown in Figure 3.

The graph represents the directions for step 1. A supply curve shows the minimum price a firm will accept (P sub 0) to supply a given quantity of output (Q sub 0). The curve is upward sloping, price is represented on the y axis and quantity represented on the x axis.

Figure 3 Supply Curve. The supply curve can be used to show the minimum price a firm will accept to produce a given quantity of output.

Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the average cost of production: in this case, the cost of the pizza ingredients (dough, sauce, cheese, pepperoni, and so on), the cost of the pizza oven, the rent on the shop, and the wages of the workers. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as shown in Figure 4.

The graph represents the directions for step 2. For a given quantity of output (Q sub 0), the firm wishes to charge a price (P sub 0) which is equal to the cost of production plus the desired profit margin.

Figure 4. Setting Prices. The cost of production and the desired profit equal the price a firm will set for a product.

Step 3. Now, suppose that the cost of production goes up. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as shown in Figure 5.

The graph represents the directions for step 3. An increase in production cost by 75 cents will raise the price a firm wishes to charge (to P sub 1) for a given quantity of output (Q sub 0) by 75 cents because the firm wishes to make the same desired profit. The original supply curve is shown with Q sub 0 and P sub 0, and P sub 1 (the new equilibrium price) is shown above the supply curve.

Figure 5. Increasing Costs Lead to Increasing Price. Because the cost of production plus the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.

Step 4. Shift the supply curve through this point. You will see that an increase in cost causes a leftward shift of the supply curve so that at any price, the quantities supplied will be smaller, as shown in Figure 6. 

The graph represents the directions for step 4. The original supply curve is shown, but the new supply curve poses through P sub 1. An increase in the cost of production will shift the supply curve vertically by the amount of the cost increase.

Figure 6. Supply Curve Shifted Left. When the cost of production increases, the supply curve shifts leftward to a new price level.

Simulation: Supply of Food Trucks

Play the simulation below multiple times to see how different choices lead to different outcomes. All simulations allow unlimited attempts so that you can gain experience applying the concepts.

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