The Law of Supply: How Prices Affect Supply and Production Costs

1. Chapter 5 The Law of Supply

2. The Law of Supply • When prices go up, supply goes up • When prices go down, supply goes down

3. Why Does it Work That Way? • Let’s say you’re selling ska CDs… • Ska isn’t very popular, so you sell yours for $8 each

4. Why Does it Work That Way? • Suddenly, everyone who is cool is listening to ska and wearing ties to school • What happens next?

5. Why Does it Work That Way? • You are now free to charge $16.99 for a CD, and make a killing • What happens next?

6. Why Does it Work That Way? • All sorts of record labels start signing every ska band there is • Supply has gone up!

7. Why Does it Work That Way? • Every company has a certain amount of resources • Companies will use the resources they have to produce the most profitable goods and services • If the price goes up and people still buy it, businesses make more money!

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12. Supply Schedule • Works just like a demand schedule, with a column for price and a column for quantity supplied

13. Supply Curve • Graphs the supply schedule • The line is opposite the demand curve!

14. Supply Curve • You can make a supply curve for just your business or for the entire market – a market supply curve

15. Supply and Elasticity • Supply is elastic when a small price change leads to a big change in quantity supplied • Supply is inelastic when a big price change still has little effect on quantity supplied

16. Elasticity in the Short Run • Some business cannot respond to price changes quickly • Producers of goods (farmers, factories, etc.)

17. Elasticity in the Short Run • Other business respond very quickly to price changes • Service industry can hire more workers to produce more immediately

18. Elasticity in the Long Run • When businesses have a long time to respond to price changes, supply is even more elastic • Time is the most important factor in determining elasticity of supply

19. Costs of Production

20. Labor and Output • How do companies decide how many people to hire? • Marginal Product of Labor – the change in production output from hiring one more worker

21. Marginal Product of Labor • Let’s say you’re making delicious Sweet Onion Chicken Teriyaki sandwiches… • How many sandwiches can 1 Subway employee make in 5 minutes?

22. Marginal Product of Labor • Let’s say you’re making delicious Sweet Onion Chicken Teriyaki sandwiches… • How many sandwiches can 2 Subway employees make in 5 minutes?

23. Marginal Product of Labor • Increasing Marginal Returns – when adding workers increases production Keep Hiring!

24. Marginal Product of Labor • Diminishing Marginal Returns – when adding workers still increases production, but at a slower rate Watch Out!

25. Marginal Product of Labor • Negative Marginal Returns – when adding more workers decreases production Fire People!

26. Production Costs • Production costs are any expenses that go into making a product • Electricity, Worker’s Wages, Worker’s Benefits, Rent, Gas, Raw Materials, etc.

27. Production Costs • Fixed Cost – does not change, no matter how little or much is produced • For example: machinery repairs, rent, salaried employees

28. Production Costs • Variable Costs – costs that rise or fall based on how much is produced • For example: Raw Materials, Hourly Workers, Gas, Electricity

29. Calculating Total Cost • Total Cost = Fixed Cost + Variable Cost • TC = FC + VC

30. Calculating Average Total Cost • Average Total Cost = Total Cost Total Output • ATC = TC / Qs

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33. Production Costs • Marginal Cost – the additional total cost of producing one more unit • So if producing one Sweet Onion Chicken Teriyaki costs $1.50, and producing two costs $2.50, marginal cost is $1.00.

34. Production Costs • At first, the more you produce, the cheaper it is per item to produce them • Later on, increasing production will actually hurt the company’s profits Why?

35. That’s Right! • Because eventually, diminishing and negative marginal returns set in when you have too many workers!

36. Setting Output • Businesses, thus, base their hiring decisions on maximizing profit – they study marginal cost How can I line my pockets with more indescribable wealth?

37. Marginal Revenue and Marginal Cost • Marginal Revenue is the additional income from selling one more product • Typically, MR = Price • The best formula for a business to use is for their marginal revenue to = their marginal cost

38. How does this work? • If it will cost you $.30 to make another bag of Reese’s Pieces that you will sell for $.60…

39. How does this work? You Increase Production!

40. How does this work? • If it will cost you $.45 to make another bag of Reese’s Pieces that you will sell for $.60…

41. How does this work? You Increase Production!

42. How does this work? • If it will cost you $.60 to make another bag of Reese’s Pieces that you will sell for $.60…

43. How does this work? You Stop Producing More

44. Responding to Price Changes • When the price goes up for a good, how do businesses respond? • What if Reese’s Pieces suddenly cost $1.00?

45. Responding to Price Changes You Increase Production! Remember: Your marginal revenue is now way above marginal cost

46. When to Shutdown • If marginal revenue = marginal cost and you are still losing money… • You are in big trouble! • Profit is already maximized and you are still behind!

47. Changes in Supply Hey, class! What kinds of things do you think might affect supply?

48. 5 Factors that Shift Supply • 1. Input Costs – costs that go into producing your good • The business would naturally produce less if the product is less profitable • Higher input costs shift supply left, lower input costs shift it right

49. 5 Factors that Shift Supply • 2. Technology - can decrease input costs • Email has virtually eliminated many long distance phone bills and mail delivery charges for some businesses • Better technology shifts supply to the right

50. 5 Factors that Shift Supply • 3. Number of suppliers • New businesses entering the market shifts supply to the right • Businesses closing down and leaving the market shift supply to the left