3.5 Other Determinants of Supply

It’s as Easy as Cake

In section 3.4 we looked at the impact of price on the supply curve, but there are many other factors that affect a company’s decision to produce. For example, new innovations are always coming out to make cake decorating and baking easier, whether it is machines like the one shown above, or faster and better mixers. These inventions save time and energy at different levels of production. External forces like these impact our supply curve. The four supply shocks we will examine in detail include:

1. Input Prices
2. Technology
3. Expectations
4. Number of Producers

Whereas changes in price change quantity supplied, these factors shift supply. This is distinctly different from changes in quantity supplied as these shocks affect the price-quantity interaction at every point on our curve.

Input Prices

Perhaps the most obvious shock to the supply curve is the cost of inputs. Also known as ‘Factors of Production’, these are the combination of labor, materials, and machinery used to produce goods and services. Our cupcake supply curve was based on the assumption of specific implicit and explicit costs which are prone to change. Any changes to these costs will affect our marginal costs at every point.

Changes in Explicit Costs

Changes in explicit costs are the easiest to conceptualize. We determined that the explicit cost of our cupcake supplies was around $0.50 each. What if icing sugar, an input to cupcakes, becomes more expensive? This will raise our marginal costs at all points of production, causing an upward shift in our supply curve.

Changes in Opportunity Costs

Opportunity cost is more of an abstract concept to think about in terms of input prices. Essentially, if cookies become more profitable to produce, our supply model considers the higher opportunity cost as an increase in our cost of making cupcakes. Suppose the market price for cookies increases from the original $0.50 to $1.00. Now, our MC will be as follows:

MC of 1st 5 cupcakes = $0.5 (explicit) + $0.8 (implicit) = $1.3 (increased from $0.9)

MC of 2nd 5 cupcakes = $0.5 (explicit) + $1.6 (implicit) = $2.1 (increased from $1.3)

MC of 3rd 5 cupcakes = $0.5 (explicit) + $2.4 (implicit) = $2.9 (increased from $1.7)

Notice this increase in marginal cost occurs at all levels, meaning the change will shift the entire supply, changing the quantity supplied at every point.

How does the supply curve actually change? In our discussion of demand, we explained that you could view a demand shift as vertical, as consumers’ willingness to pay changes at every quantity demanded; or as horizontal, as the amount consumers buy changes at every price level. There is a similar process for supply.

Vertical Shift – Figure 3.5a

The first way to view a shift in supply is as a vertical shift. Recall that supply represents the producer’s MC at each point of production. Assuming that in the original supply curve our MC of producing 15 units is $1.60, if costs increase by a dollar, we will see the marginal cost increase to $2.60. Since input prices increase by a dollar regardless of our production level, the entire curve will shift up by $1.00.

Horizontal Shift – Figure 3.5b

The next way to view a supply shift is slightly less intuitive. In Figure 3.5b, when the price of cupcakes is $1.80, our quantity supplied is equal to five cupcakes. Consider how this will change with a $1.00 decrease in input prices. Originally, we produced 5 cupcakes because our price was equal to marginal costs at that level When our costs fall, our price is still $1.80, but our costs are $0.90. Since P>MC, it is efficient to produce more than 5 units. Using marginal analysis, we find it is efficient to produce 17 units at this price.

Whereas before, it was only viable to produce 5 units at the price of $1.80, we can now produce up to 17 units efficiently. This causes the supply curve to shift right.

Most shocks will cause a uniform shift as can be explained vertically or horizontally. Technology, expectations, and the number of producers will all shift the supply curve in the same way as depicted.

Technology

As mentioned at the beginning of the section, changes in technology will also shift the supply curve. Why is that the case? Technology changes have a direct impact on the cost of production. If suddenly a new innovation allows you to cut your work time in half, you will cut down your costs of labor. If technology allows you to conserve wasted resources, then your input prices will decrease, These changes will increase supply, shifting the curve to the right. Technological Decay is a less common case where technological progress is reversed. What if the city banned the use of a certain cupcake icing machine because the noise was bothering other residents? This would cause you to go back to the less efficient practice of icing by hand, thereby increasing your costs. In summary:

• Improvements in technology will lower costs of production and increase supply
• Decay in technology will increase costs of production and decrease supply

Expectations

Like demand, expectations of the supply price affect production decisions. Production decisions are a lot like playing the stock market; if we are producing cupcakes and cookies to sell to the store tomorrow, we have to produce based on the current, incomplete knowledge we have about those prices. Normally, you will be confident that these prices will stay relatively stable, but if you have reason to believe the prices of cupcakes will drastically rise in the morning, you may devote more of your attention to producing them. Expectations are usually based on some form of evidence or signal and can cause supply shifts quite suddenly. In summary:

• If the firm expects prices to rise, supply will increase
• If the firm expects prices to fall, supply will decrease

Number of Producers

The final determinant of supply is the number of producers. So far, we have examined just one firm. Recall in section 3.3 we showed that the competitive market is characterized by many potential buyers, and added up individual demand curves to produce aggregate demand. Likewise, the market is made up of many other producers. By adding all the suppliers together, we get aggregate supply. This can affect total supply. If for example, four new firms enter the cupcake market, whereas Alaythia Cakes was producing just 5 cupcakes, now the firms each produce 5 cupcakes for a total of 25 (assuming that the individual supply curves are the same, which need not be the case). In summary:

• When more firms enter the market, supply will increase
• When firms leave the market, supply will decrease

Summary

The four supply shocks have been summarized in the table below. Once again, the best way to learn these shifts is not to memorize them, but to practice shifts on the diagram to view their effects.