What is Supply?

Supply is like a bag of candy…

Think about one of those big bags of candy with 100 assorted pieces of sweet treats. Say you give one of those bags to your son to share with his friends. The candy in the bag creates a mix of options for him to consider. That’s his stash, from which he decides which candy to eat and what to share with his friends. If someone is nice to him, or does something mean, it might change his decision on what to give them. But, that doesn’t change the options at his disposal. However, if you gave him a second bag of candy, his supply changes. Now he has a whole new set of choices.

When people talk about supply, they’re usually referring to the amount of something available on the market. However, economists try to be more specific about the difference between inventory and supply. Supply is not just what is available at a given price. It's what will be available at every price.

For instance, a refinery might cut back on the amount of gasoline it produces in response to falling demand. The media might report that as a change in supply. But, an economist would point out that the refinery is just reacting to the price change by decreasing the quantity it is supplying. Moving along the supply curve is not a change in supply. A change in supply only occurs if the conditions that create that price-quantity relationship gets disrupted.

The basics of supply boil down to the idea that entrepreneurs make profits by selling goods for more than the cost of production. So the marginal cost of production (the amount of money it costs to make one more unit of something) sets a floor for how much something would cost in the marketplace.

If it costs $10 to buy something wholesale, a retailer won’t stay in business very long if they put a $9 price tag on it. They might do that occasionally, to free up shelf space, or to get rid of an item that isn’t selling. But, they would not have paid $10 for something they expected to sell for less than that.

The fundamental idea behind supply is that the cost of making and selling something, including the opportunity cost (the value of the next best alternative) of doing so, sets the baseline for businesses to operate. Those incremental costs tend to increase as volume rises. That fact stems from the realization that companies are efficient and seek to maximize profits. Therefore, they exhaust the lowest cost options first. Consequently, increasing production requires using higher-cost options. If the cost increases, the price rises to cover those costs.

Supply can apply to individual firms or a larger market. Also, there are differences between supply in the short-term and the long-term.

Individual supply refers to the costs that apply to one person or firm, a microeconomic view of the market. For example, you supply your labor based on a set of personal choices. If you’re like most people, you provide 40 hours a week to your employer in exchange for a predetermined amount of money. That compensation must be more than your next best alternative for that time. However, working more than 40 hours a week might mean giving up more time with your friends and family than you would like. Therefore, your employer offers you more money (overtime pay) to compensate for the higher opportunity cost of the additional hours.

Market supply refers to the combination of factors that apply to several people or firms offering the same products. For instance, it might be cheaper for a company to give more hours to a part-time employee than to pay a full-time employee overtime. By looking across multiple suppliers (in this case, of labor), a buyer (in this case, an employer) can find the most affordable way to meet its needs. The result is that numerous suppliers tend to compete on price, generating a more gradually sloped supply curve.

Time is also relevant when talking about supply. That’s because some of a company’s costs occur on long-term contracts. Therefore, a company has less ability to adjust to changing circumstances while those contracts are in place. If the company is looking long-term, those contracts will expire and the business can pivot in a new direction. This issue means that supply considerations, for a person or a firm, might be different in the short-run versus the long-run.

When thinking about the aggregate supply of everyone in an economic system (aka a macroeconomic view) the reality of limited resources becomes relevant. Without changes to the population, state of technology, and other factors, there’s a limit to what an economy can produce. Therefore, the long-run aggregate supply isn’t sensitive to changes in price. However, an economy can flex up or down to deal with temporary changes in the market. That means the short-run aggregate supply curve has some elasticity (ability to react to higher or lower prices).

The determinants of supply are directly related to production costs. The general idea behind supply is that the cost of capital, labor, energy, and materials increase as production increases. That's what determines the supply function. However, the supply function assumes that those costs are stationary. But that's not always true. Those factors of production can fundamentally change from time to time. When they do, the whole relationship between price and quantity shifts. Some examples of determinants that affect supply are:

• Changes in labor costs (like a new union contract or minimum wage law)
• Changes in tax laws or regulations
• Improvements in technology or processes that enhance efficiency
• A change in the cost of the things required to make the product
• New competition or competitors leaving the market
• Any change in the availability of the product without changing its costs

Basically, anything that changes the volume of production, other than the market price of the product, is a determinant of supply. Whenever the cost of doing business goes up, the supply of goods goes down. And, whenever production becomes more efficient, supply increases — which results in a higher quantity demanded as the price falls.

The law of supply and demand is the combination of the law of supply and the law of demand. When viewed together, it shows how markets try to balance the number of buyers and sellers by changing prices and quantities until the market reaches an equilibrium (point of stability). If there is excess supply (more product than buyers willing to buy it), the price will fall. And, if there is excess demand (more buyers than available products), the price will rise.

The law of supply states that the quantity of a product on the market will increase if the price for that product goes up. While that definition might make it sound like businesses are greedy, there’s a more critical underlying reason that the law of supply works.

The law of supply is a consequence of increasing marginal costs of production — the realization that each unit of production tends to cost more than the previous one. Therefore, a company can’t increase output unless buyers are willing to cover the increased cost. That’s the other way to state the law of supply — Producers require higher prices to increase production because it costs more to do so.

A supply curve is a visual representation of a supply function, which represents the marginal cost of production (incremental cost of producing each unit of output). The cost of production is also the lowest price point a supplier expects to accept. It appears on the vertical axis while the quantity of output shows up on the horizontal axis.

Supply curves show the supply of a product, assuming no underlying determinants of supply are changing. If they are, then the supply of the products also changes, generating a new supply curve. For example, if minimum wage laws increase the cost of labor, it would result in a new supply curve.

A supply schedule is a table that lists various volumes of production and the incremental cost of making each one. It’s an alternative way to display a supply function. While a supply curve sketches the supply equation on a graph, a supply schedule lists points from that curve in a table.

A supply chain refers to the interlinking network of businesses that transform raw material into a finished product. Supply chains begin with the extraction of minerals from the ground, or the harvesting of crops. Those commodities move to the next stage of refining, smelting, or milling the material into something more useful. Manufacturers are the following link, turning those producer goods into higher-value products. Wholesalers then distribute the finished products to retailers, who connect the consumer goods to buyers. Each link in the supply chain acts as the supply for the following link.

Supply-side economics is a political theory that focuses a government’s actions on the supply-side of the economy. Most notably, it suggests that reducing corporate taxes and regulations would free entrepreneurs to generate more economic activity. As a result, the benefits would “trickle down” to the people they employ. The ideas became popular under President Ronald Reagan’s presidency and are sometimes called Reaganomics. Economists still disagree about the reliability and wisdom of using these ideas.

Alfred Marshall formalized the concepts of supply and demand in an 1890 book simply called Principles of Economics. He used graphs and formulas to demonstrate the concepts of supply and demand — and how they interact to create an equilibrium (or balancing point). But, Marshall built his ideas from philosophers that came before him.

The earliest known reference to what we now call supply might belong to John Locke in 1691. His work titled Some Considerations on the Consequences of the Lowering of Interest and Raising the Value of Money hints to an understanding of the market fundamentals we now call supply and demand.

Later, Adam Smith was instrumental in furthering the knowledge of how markets function. His work, called The Wealth of Nations (1776), is still considered the foundation from which all modern economic theory was built.

Supply, as a concept in economics, is closely related to the notion of demand. Together, supply and demand interact to form a market equilibrium (a balance of buyer and seller). The concept of equilibrium is crucial to the ideas of free enterprise, capitalism, and laissez-faire economic policies.

The concept of supply relies on the realization that producers face increasing marginal costs of production. That fact gives rise to the law of supply, and the supply curves that are drawn from it. Finally, the notion of supply rests on a presupposition that entrepreneurs seek to maximize profits. As rational, self-interested individuals, business owners use their best options first and don’t spend money without the expectation of receiving a return on investment.