The reasons why supply of a product increase are cause by three reason below. Firstly is the decrease of cost of production. Supply will increase when the cost of production decrease. Regardless of the price that a firm can command for its product, revenue must exceed the cost of product in order to make a profit. Hence, the lower the cost of product will make more profit to the firm. Cost of production will decrease because the fall in price of the raw material to produce the output. If raw materials are cheap, the production cost will fall and supply of that goods will increase same as the total revenue. For example, the supply of table will increase if the price of its raw material(woods) fall.
Second is the price of complement increase and substitute decrease. Sometimes when one good is produced, another related good will also produced at the same time. According to this, if the price of either one of the good increase, supplier is willing to produce more of that good and the supply of another related good will also rise automatically. For example, the price of chicken increase will rise the supply of feather duster. Besides, the decrease of the price of substitute will increase the supply of a good. It is because the profit that may be earned through the substitute is lesser. For instance, a farmer will supply more apples to earn more money when the price of oranges is fall because both of the goods are planted in the same orchard.
Thirdly is the technological development of a product. When a technology to produce a product become more advance, it will lowers the cost of production, and output is likely increase. So, the total revenue will increase and supply will also rise. Example, there is an efficiency technology founded to produce bread. Therefore, more bread will produce using the same costs.
Price floor is the minimum price that set above equilibrium price by governments or regulatory bodies may intervene in markets. The governments may seek to establish a price floors for not allowing the price fall below it. When a minimum price established, it results surplus. In figure 3.1 illustrates a price floor. Equilibrium price would be $30 and the equilibrium quantity demanded would be 20 units, but there is a price floor has been established at the price $45. Hence, at the price floor the business will not be able to sell everything they supply. It is because the quantity supplied is larger than quantity demanded. At $45, there is a surplus of 20 units of goods.
Price ceiling is a maximum price in the market which set below the equilibrium price and the price is not allowed to rise above the ceiling. This maximum price shows that the higher price that sellers may charged for a good and it's usually set by government as a price control. When a price ceiling has been established, it cause shortages which means excess of demand. In figure 3.2 illustrates the price ceiling. In this case, equilibrium price would be $50 and the equilibrium quantity demanded is 100 units. If a price ceiling is set to be $30, a shortage of 90 units will come out. Hence, supply of the good will not enough to cover the quantity demanded.
Rationing function of prices is the ability of the competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent. For example, the equilibrium price of good A is $5. All producers who are willing to sell their products in this price will gain profit. As well as the consumers who are willing to pay for it in this price will buy the product. But if a price ceiling and floor were established, it will cause a surplus and shortages.
In the other hand, price ceiling and floor will also cause the inefficient of resources allocation. Competition among producers forces them to use the best technology to make their costs lower. Otherwise, they will be unprofitable. In this case, market equilibrium price is $4 for good B. Not every producers and consumers will able or willing to sell or buy good B if the price ceiling and floor were established. Originally, the producers have already discussed how the resources might be allocates, but the price ceiling and floor distort them.
Price elasticity of supply (PES), which measures the responsiveness of quantity of a good supplied to a change in price of that good. For calculating the PES we can use the formula below:
In the markets, the elasticity of supply is likely to be a positive number. That means a higher price leads to a higher quantity supplied. There are several determinants that affecting PES included the time period of market and the excess capacity that the producers have.
The time period is the main determinant of PES. It is because the supplier needs some time to react to the price changes. So it can be conclude as the more time a producer to respond to the price changes the more elastic of the supply. There are two types of time period (long run and short run) that affect the PES. In fact, the supply is more elastic in the long run period than a short run period. In the short run, a producer has a fixed productive capacity. If there is a change in price suddenly on the market, produces can't respond quickly of this change although the labor might be increase. Besides, in the long run period, there is enough and sufficient time for a producer to change its plan or productive capacity. All factors of production can be utilized to increase supply and become more elastic. For instance, price of good A increase suddenly in the market. Supposed the supply will increase if the price of good A increases. But in short run period, producers cannot change their plan or increase the input immediately and thus it's become less elastic because the quantity demanded will decrease. Contrary, in the long run period, producers can change their plan and add more input to make more supply.
Next, the determinant of PES is the excess capacity that the producers have. A producer that has more unused capacity may quickly respond to the price changes.
Assume that a company has more inventory or input to produce their products, that company will be able to alert when a change in price in the market than a company who only has certain amount of input that only enough to produce currently for supply. For example, company A has more capacity and company B has less capacity. When price raise suddenly, company A can produce more supply and company B can't. It is because company A has more productive capacity or variable factors that are already available to use.
(References: Economics (9th Edition) Mc Graw-Hill/Irwin; Principles of Economics 7th edition, Karl E. Case & Ray C.Fair http://en.wikipedia.org/wiki/Price_elasticity_of_supply#cite_note-Parkin84-6)
There are five types of price elasticity of demand which are inelastic demand, elastic demand, unitary elastic demand, perfectly inelastic demand and perfectly elastic demand. In order to make a successful business, they must decide their pricing strategy according to the elasticity of the good that they sell. If the good is inelastic, which means the percentage change in quantity is less than the percentage change in price and the price elasticity is between zero and one. In this case, business will not lower the price of good to gain more profit such as necessities. For example soap is a good which its price elasticity is inelastic. Producers will not lower the price of soap to attract more customers to buy it, because it is no use to do that.
Next, elastic demand is a condition where the percentage change in quantity is greater than the percentage change in price. And its price elasticity is greater than one. A business will lower the price of a good if the price elasticity of the good is elastic. This is because a small percentage change in price will lead a big percentage change in quantity demanded such as luxury goods. For instance, the price of LV handbag supposed to decrease in order to gain more profit. It is because small changes in price will helps to increase more in quantity demanded and total revenue.
Unitary elastic shows that %change in quantity equal to %change in price. This is the best condition for supplier and consumer. It is because supplier is willing to supply certain amount of good and consumer will also willing and able to buy that good.
Lastly the perfectly inelastic demand and perfectly demand elastic is occur when the percentage change in quantity equal to zero and infinite. For example, agricultural goods for perfectly inelastic. Whatever the price is, the amount that produce still zero, because it need time to respond. For the perfectly elastic, the price is already fixed. Any price above and below the fixed price, supplier will produce nothing.
Demand is the quantity of a good that buyers would be willing and able to buy in a given period if it could buy all it wanted at different price level. The law of demand shows that a price of a good rises, the quantity demanded will falls and vice versa, ceteris paribus. It means that only the price of good changing, others remain the same.
The relationship between price and quantity demanded is negative, so there is a downward sloping curve.
A decrease in quantity demanded shows that raise in the price of the good itself and affects a movement upward of points along the demand curve. Decrease in quantity demanded is assumed as ceteris paribus and its changes in the price itself only and this theory is illustrates in figure 5.1 below. For instance, a price of pencil increase, the quantity demanded will falls.
In the other hand, decrease in demand means that there is a change in any one of the determinants of demand, other than the price of good itself. It may cause a shift of the demand curve to leftward from the original demand curve if there is a decrease in demand (shown at figure 5.2 below). The determinants of demand included the price of related goods (substitute or complement), income of individuals, taste and fashion, expectations and many more. For example, if the price of petrol increases, the demand of car will fall, because the relation between them is complement. Besides, the demand curve of car will shift leftward from the origin.
The definition of income elasticity of demand (YED) is the ratio of the percentage change in quantity demanded of a good or service to a given percentage change in household income. Its measure the responsiveness of demand to changes in income and is defined as the equation below:
Income elasticity of demand=
There are three degrees of income elasticity which is positive, negative and zero. Firstly, positive YED is occur when YED is greater than 0 and it also can categorized into two types: income inelastic and income elastic. Income inelastic shows that the good is a normal good when quantity demanded rises smaller than rise in income. However, income elastic says that the good is luxury good, because the quantity demanded rises by a larger percentage than the rise in income.
The second degree is negative (YED<0). This degree shows that the good is an inferior. It is because the demand falls as income rises. According to the law of demand, suppose the demand will increase when the income increase. But in this case it's inverted.
Thirdly, it's exactly zero degree of YED. It means the YED equals to zero. The quantity demanded does not change when the income changes. This kind of good is likely to be a necessity.
Consumer surplus is an “excess satisfaction” the consumer gets. So, it can be define as the difference between the maximum price a consumer is willing to pay for a product and the actual price in the market. The main goal of consumer to consume is to gain the maximum satisfaction. If consumer surplus occur, it means the amount consumer benefit from paying less than the amount they are willing to pay and it's already over their maximum satisfaction. In figure 6.1 illustrates the consumer surplus. The demand curve (D) shows that the quantity demanded of consumer willing to pay and buy good A on each level of price. When the price is $5, consumers are willing to purchase 20 units of good A. There is only one price in the market, and the demand curve shows us how many units of good A they are willing to buy. However, in the price of $10, there are still have some people willing to buy the good. And for these type of consumers they gain the benefit of $5, the consumer surplus that earned by these people is equal to the shaded region.
Producer surplus is the amount that the producers receive over what they are willing to sell for rather than forgo a sale. It is also can be define as the difference between the actual price a producer received and the minimum acceptable price. In figure 6.2, it illustrates the producer surplus. The supply curve (S) shows the quantity that producer willing to supply on each level of price. When the price of good B is $20, producers are willing to supply 1500 units of good B. However, in the price of $10, there are still have some producers think that this is an acceptable price for them to give supply. In this case, those people who are willing to supply in the lower price than the equilibrium price will earned their producers surplus and it's equal to the shaded area.
Production possibility frontier (PPF) is a graph that shows all the combinations of two goods and services that the economy and possibly produce if all of society's resources are used efficiently. But, there are several assumptions in the PPF
- There are only two products produce
- The economy is operating at full employment and achieving full production to produce greatest output without waste.
- The resources are assumed as fixed during the time period.
- The state of technology that uses to produce output is fixed.
shows the PPF of good A and B. When a firm is going to produce 20 units of good A, none of good B will be able to produce. If the firm wants to produce 5 units of good B, 4 units of good A will be forgo. In this case, the producer will face the 3 simple concepts of economics which is scarcity, choice and opportunity costs. When the several assumption is set in the PPF it occur the scarcity of resources. For example, the resources is only enough to produce 20 units of good A. But, if the producer wants to produce 5 units of good B as well, the scare of resources will happened in order to produce both goods. At this time, the producer will have to choose what is the most important and profitable good instead of both goods also selected to maximize the producer's satisfaction. When one of the good selected, another choice must be sacrificed. The good that has been sacrificed is called opportunity costs. According to these, the three basic economics concepts are being explained using the PPF.
- Principles of Economics 7th edition, Karl E. Case & Ray C.Fair
- Economics Mc Connell/Brue/Flynn (18th Edition), Mc Graw Hill/Irwin
- Microeconomics theory and applications, G.S Maddala & Ellen Miller