© University of South Wales

Economies Markets and Decision Making in International Contexts

Professor David Pickernell

Topic 5 : Supply Theory

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some key terms• Market

• a set of arrangements by which buyers and sellers are in contact to exchange goods or services

• Supply• the quantity of a good sellers wish to sell at each conceivable

price

1.2

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the supply curve shows the relation between price and quantity supplied holding other things constant

• “Other things” include:• input costs (factors of

production• Prices of related good• technology change• government regulations

• Changes in these other things affect the position of the supply curve

1.3

Quantity

Pric

e S

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a shift in supply

1.4

Q0

P0

Pric

e

Quantity

Suppose wages rise, increasing producers’ costsS0

S0

S1

S1

The supply curve shifts to S1S1

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Price Elasticity of Supply

• Meaning of price elasticity of supply…

• PES = % Change in Quantity Supplied

% Change in Price

1.5

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Price Elasticity of Supply

• Measuring price elasticity of supply %QS / %P• elastic and inelastic supply

• Determinants of price elasticity of supply• amount that costs rise as output increases• time period

1.6

6

market equilibrium

• Market equilibrium is at E0 where quantity demanded equals quantity supplied

• with price P0 and quantity Q0

D0

D0

S

S

Q0

P0 E0

Pric

e

Quantity

7

a shift in demand

D0

D0

S

S

Q0

P0 E0

Pric

e

Quantity

If the price of a substitute good increases ...

more will be demanded ateach price

D1

D1

The demand curve shiftsfrom D0D0 to D1D1.

E1

Q1

P1

The market moves to a new equilibrium at E1.

8

a shift in supply

D

D

Q0

P0 E0

Pric

e

Quantity

Suppose safety regulations are tightened, increasing producers’ costs

S0

S0

S1

S1

The supply curve shifts to S1S1

If price stayed at P0 there would be excess demand

Q1

P1

E2

So the market moves to a new equilibrium at E2.

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the production function

• The amount of output produced depends upon the inputs used in the production process

• A factor of production (“input”) is any good or service used to produce output

• The production function specifies the maximum output which can be produced given inputs

1.10

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short run vs. long run• The short run is the period in which a firm can

make only partial adjustment of inputse.g. the firm may be able to vary the amount of labour,

but cannot change capital.• The long run is the period in which a firm can

adjust all inputs to changed conditions.• The long-run total cost curve describes the

minimum cost of producing each output level when the firm is free to vary all input levels.

1.11

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the law of diminishing returns• Holding all factors constant except one, the law of

diminishing returns says that:• beyond some value of the variable input,• further increases in the variable input lead to steadily

decreasing marginal product of that input.e.g. trying to increase labour input without also increasing

capital will bring diminishing returns.

1.12

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the marginal product of labour• The marginal product of labour is the increase in output obtained by

adding 1 unit of the variable factor but holding constant the inputs of all other factors.

• Labour is often assumed to be the variable factor • with capital fixed.

1.13

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the short run• Fixed factor of production

• a factor whose input level cannot be varied• Fixed costs

• costs that do not vary with output levels

• Variable costs• costs that do vary with output levels

• STC = SFC + SVC

1.14

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Short-run Costs

• Average and marginal cost• marginal cost (MC) and the law of diminishing returns• relationship between MC and TC curves• average fixed cost (AFC)• average variable cost (AVC)• average (total) cost (AC)• relationship between AC and MC

1.15

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Cos

ts (£

)

AFC

AVC

MC

x

AC

y

z

Average and marginal costs

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short run vs. long run• The short run is the period in which a firm can

make only partial adjustment of inputse.g. the firm may be able to vary the amount of labour,

but cannot change capital.• The long run is the period in which a firm can

adjust all inputs to changed conditions.• The long-run total cost curve describes the

minimum cost of producing each output level when the firm is free to vary all input levels.

1.17

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the long-run average cost curve LAC

1.18

Output

Aver

age

cost SATC1

Each plant sizeis designed fora given outputlevel

SATC2

SATC3

SATC4

So there is a sequence of SATCcurves, eachcorresponding toa different optimal output level.

LAC

In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs

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long-run costs

1.19

The average cost of production is total cost divided by the level of output.

Long-run average cost (LAC) is often assumedto be U-shaped:

LAC

Aver

age

cost

Output

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economies of scale

1.20

Economies of scale – or increasing returns toscale – occur when long-run average costs decline as output rises:

LAC

Aver

age

cost

Output

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decreasing returns to scale

1.21

– occur when long-run average costs rise as output rises:

LAC

Aver

age

cost

Output

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constant returns to scale

1.22

– occur when long-run average costs areconstant as output rises:

LACAver

age

cost

Output

Topic 6 : Tasks

Task 1 The production function

Task 2 Low cost strategy

Task 3 The business model