Supply, Demand, and the Invisible Hand

Change Supply!

A change in the overall quantity supplied can occur because of changes in any of the following areas:

  • Capacity and technology
  • Cost structure
  • Prices of substitutes and complements
  • Perceptions of future prices

Capacity and Technology

From time to time you may have heard that there is “too much capacity” in an industry. This has been the case in the telecommunications industry in the first years of the 2000s. So much fiber optic cable, so many cellular systems, and so many factories for making telecommunications equipment were put in place in the 1990s that the industry's ability to supply telecommunications services and equipment has outstripped demand.

When overcapacity occurs in an industry, the entire supply of that industry's product increases. When that happens, producers are willing to deliver a greater quantity of goods and services for the same price. Why shouldn't they? They have more capacity than they can use, so they may as well use as much as they can, at any price (well, almost any price).

An increase in supply also occurs if there are numerous producers for a product or service. Some observers of the business scene have argued that the telecommunications industry has too many providers, which contributed to the overcapacity. Indeed, a large number of producers in any industry adds capacity, which causes supply to increase. Finally, technological developments can lead to a shift in supply. Returning to our beef example, suppose the industry develops better methods of feeding cattle or controlling disease. Or suppose more efficient processing and shipping technologies come along. Under those circumstances, the quantity supplied for a given price would increase.

The converse of these factors also holds true. Too little capacity, a paucity of producers, or lack of technological innovation will decrease the supply.

Cost Structure

If the cost of any factor of production—labor, raw materials, equipment—decreases, the quantity that producers are willing (and able) to supply at a given price increases. Producers with lower costs will always be able to supply more of a product at a given price than those with higher costs. Therefore, a decrease in producers' costs will increase the supply.

Conversely, if production costs increase, the quantity supplied at a given price will decrease. Higher costs mean that producers will have to produce less to be able sell a product at a given price. If you're thinking, “Why don't they just raise their prices when their costs go up?” you're asking a good question. Essentially, consumers will resist the higher prices, and may move to substitutes, do without the product, or buy from a more efficient producer.

Prices of Substitutes and Complements

EconoTalk

Substitutes in production are two or more products or services that a producer can make or deliver in place of one another. For instance, a farmer may be able to grow either corn or soybeans, a manufacturer may be able to produce either men's or women's clothing, or an arena may be able to host either sports events or concerts. A producer or service provider who can supply substitutes in production has the flexibility to offer whichever good is in greater demand.

Complements in production are products created with one another. Often one is a by-product of another, that is, a product created in the course of making another product. For instance, certain lubricants and other petroleum products are byproducts of making gasoline from crude oil.

A producer sees substitutes and complements differently than consumers do. To a producer, a substitute is another product he can make instead. Suppose a major meat producer can devote feed, feedlots, transportation, and other resources to raising either cattle or sheep. That makes cattle and sheep substitutes in production.

If the meat producer has the flexibility to choose to raise cattle or sheep, and the price of lamb rises dramatically, what do you think she will do? She will devote more resources to raising sheep and fewer to raising cattle. In general, if the price of a substitute in production (lamb) rises relative to its related product (beef), then the supply of the related product (beef) will decrease. If a producer can produce either of two products, she's going to produce the one that fetches the higher price.

The reverse is also true. If the price of a substitute in production falls, then the supply of the related product will increase. If the price of lamb nosedives, the outfit will devote fewer resources to sheep and more to cattle. As a result, the supply of beef will increase.

Complements in production are products that are created along with one another. Cowhide and beef are complements in production. (Wool, of course, can be obtained by shearing sheep, rather than slaughtering the poor things.) If the price of a complement (cowhide) rises, so will the supply of the related product (beef).

Why? If the cattle producer makes more money off the cowhide, he can afford to sell the beef at a lower price. If he increases his cowhide production when its price rises, his supply of beef is going to automatically increase as well. That means more beef will be available at a given price, which increases the supply of beef. Conversely, if the price of cowhide falls far enough, so might the supply of beef.

Perception of Future Prices

EconoTip

Think of the supply curve as shifting to the left (for increased supply) or to the right (for decreased supply) rather than thinking of the curve shifting “up” or “down.” It's potentially confusing because an “upward” movement of the curve—to the left—actually depicts a decrease in supply and a “downward” movement—to the right—is signaling an increase. Instead think, rightward is an increase in supply and leftward is a decrease.

Finally, if a producer believes she can get a better price in the future, she will hold off production or delivery and sell when the price has risen. Thus if higher prices for beef are expected four months from now, producers will decrease the quantity they are now supplying. Conversely, if producers can get a better price now than they can expect in four months, they will produce more now, which increases the supply.

Notice that the effect of perceptions of future prices on supply are the opposite of their effect on demand. Higher prices in the future increase current demand, but decrease current supply. Lower prices in the future decrease current demand, but increase current supply. Stated another way, higher prices in the future shift demand into the present and supply into the future. Lower prices in the future shift demand into the future and supply into the present.

Figure 4.4

As Figure 4.4 shows, if supply increases for any reason, the supply curve shifts to the right because producers are willing to supply more beef at a given price. Conversely, if supply decreases, the supply curve shifts to the left because producers will supply less beef at a given price.

Thus the dynamics of supply and demand tend to work at cross-purposes. But that's why we have markets, where these forces working at cross-purposes start working together. Let's turn to the market and see what happens—especially to prices—when demand and supply interact.

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Excerpted from The Complete Idiot's Guide to Economics © 2003 by Tom Gorman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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