The law of supply is an economic theory that predicts how the price of goods and servicesaffects their supply. It says that as prices rise, businesses will increase the amount ofgoods and services that they make available. Though the law of supply can be useful whenmaking business decisions, it doesn't take into account other factors that can affectsupply, such as changes in production costs and the competitive environment. Still,understanding the law of supply, as well the exceptions to the law and other relevantfactors, can help companies determine how to price their products and services and adjusttheir supply to maximizeprofits.
What Is the Law of Supply?
The law of supply is a basic economic concept. It states that an increase in the price ofgoods or services results in an increase in their supply. Supply is defined as the quantityof goods or services that suppliers are willing and able to provide to customers. The lawworks like this: Rising prices mean that products become more profitable, assuming otherfactors such as production costs remain constant. The prospect of higher profits thereforemotivates businesses to supply more of these products. Existing suppliers may increase thesupply of more profitable products at the expense of less profitable ones. In addition, newsuppliers may enter the market, further increasing the overall supply.
Key Takeaways
- The law of supply states that an increase in the price of goods or services results inan increase in the quantity that suppliers make available to the market.
- Existing suppliers increase production of higher-priced goods to maximize profits, whilenew suppliers may also enter the market.
- The law of supply assumes that all other factors remain constant. In practice, manyother factors can play into supply decisions, including rising production costs andmarket competition.
Law of Supply Explained
Consider the example of a pizzeria that sells pasta dishes as well as pizzas. If the price ofpizza rises, and with it the profit per pie, the business may focus its resources onincreasing the production of pizza — while decreasing the production of pastaofferings. As the price keeps rising, the pizzeria continues to increase the pizza supplybecause it can increase its profits by doing so. This relationship can be representedgraphically as a supply curve, which shows the number of pizzas produced at differentprices.
As prices and output continue to increase, the supplier eventually reaches the maximumquantity that it can provide with its existing equipment — it can't make any morepizzas because its ovens are already full at all times. The pizzeria may then decide toinvest in an additional pizza oven to increase its supply. Meanwhile, other entrepreneursestablish new pizzerias because the higher prices justify the startup costs. This furtherincreases the market supply.
How Does the Law of Supply Work?
The law of supply applies to services and labor as well as goods — a higher price canincrease the supply. For example, employees may be more likely to work overtime ifthey're paid at a higher hourly rate. Professions that offer relatively high salaries,such as software engineering, may attract more people to educational programs thatultimately increase the supply of qualified job applicants.
In practice, prices are often determined by the relationship between supply and demand. Arelated economic theory, the law of supply and demand, describes how this works. Risingdemand for products and services tends to drive up prices. This provides an incentive forproviders to increase the supply. However, as the price of those products and servicescontinues to rise, fewer customers will buy them. The law of supply and demand predicts thatas a result, free markets move toward an equilibrium point where the price and quantity ofthe supply exactly matches customer demand.
Factors That Affect Supply
The law of supply predicts that rising prices result in increases in the supply of goods orservices — but that's assuming all other factors remain constant. In reality,many other factors can affect supply, and those factors can change frequently. Here are 10of the most common.
Price and demand forecasts.
Many businesses base their production plans on forecasts of future demand andpricing, not just on what customers are currently buying. Enterprise resource planning software can helpbusinesses improve demand forecasts by considering factors such as economic growthand seasonality. Furthermore, if a product's price is expected to increase,businesses may hold back stock so they can make a larger profit in the future.
Production costs.
The law of supply assumes that companies can increase profits by selling more goodsor services when prices rise, which provides them with an incentive to increase thesupply. But if the price rises reflect increased production costs, that may not betrue. If a pizzeria raises the price of a slice by 50 cents because the cost of thetomatoes used in the sauce went up by 50 cents, its profit is unchanged — sothe price increase doesn't represent an incentive to make more pizzas. On theother hand, if production costs fall and prices remain stable, profits increase andso does the incentive to supply more pizzas.
Competition.
New suppliers may enter the market even if prices are not increasing and demand isstable. Often, these new suppliers aim to offer products at lower prices thanexisting providers.
Technology.
Technology can enable companies to make and sell more products at a lower cost, thusincreasing the available supply.
Transportation.
Transportation delays or rising shipping costs can affect a company's ability toincrease its supply of goods. If goods can't move from warehouses to retailshelves, they can't be purchased by customers and don't count toward themarket supply.
Availability of raw materials and labor.
A business may want to increase the supply of a product but unable to do so becauseit can't purchase the raw materials or hire the people required to produce it.
Government regulations and subsidies influence supply in some industries.
Companies must meet strict regulatory requirements when introducing certainhealthcare products, for example, which can limit the supply of these productsregardless of the demand. On the other hand, government subsidies support the supplyof some local transportation services.
Weather and natural disasters.
For many agricultural goods, the weather has a major impact on supply. A dry seasonor flooding can greatly reduce crop yields.
Comparable goods.
A change in the supply of one good can affect the supply of other goods. Forexample, if the market price of corn increases, farmers may dedicate more land togrowing corn. As a result, they use less land for growing squash, so the supply ofsquash decreases.
Business objectives.
Companies may adjust the supply of products to achieve specific objectives. Forexample, some businesses introduce limited-edition collectibles in small quantitiesto increase their desirability and value. At the other extreme, companies sometimessupply products in large quantities to build market presence and brand awareness,even if increasing the supply doesn't generate higher profits.
Types of Law of Supply
There are five types of supply — market supply, joint supply, composite supply,short-run supply and long-run supply. Here's how to distinguish them.
Market supply.
The market supply is the total supply from all producers. If a town has threepizzerias that produce 30, 40, and 25 pies a day, respectively, at $20 apiece, themarket supply at the $20 price level is 95 pies a day.
Joint supply.
Joint supply occurs when multiple goods are produced from a single source. Forexample, cows can be used to produce milk as well as leather.
Composite supply.
Composite supply occurs when goods are intrinsically linked and sold only as abundle. For example, a car manufacturer typically offers air conditioning and audiosystems only as part of a bundled package with the purchase of a new vehicle.
Short-run supply.
Short-run supply is the total supply that companies can provide without additionalinvestment in business expansion. It's also known as short-term supply.
Long-run supply.
Long-run supply, also known as long-term supply, includes factors such assuppliers' investment in new production capacity. It also considers that newsuppliers may enter the market while older firms exit.
Exceptions to Law of Supply
Not every business scenario is determined by the law of supply. There are many exceptions— situations where the supply of goods and services isn't determined by thepricing. Here are some of the most common.
Economies of scale.
When a producer becomes large enough, it may be able to apply economies of scale toreduce the cost of producing goods and services. As a result, it may be able toincrease its supply while keeping prices stable or even reducing them.
Shift in business plan.
If a business is shifting its market focus and plans to cease production of someproducts, it may temporarily increase the supply of those products at a low price toeliminate any remaining stock and raw materials. A business may also use thisapproach as an emergency measure if it needs cash in a hurry.
Monopoly.
When there's only a single supplier of a good or service, the company may beable to increase or decrease its supply or pricing irrespective of external factors.
Competitive pricing.
In a highly competitive market, businesses may increase the supply of their productswhile reducing the price to capture market share.
Expiring or dated goods.
If perishable goods near their expiration date, a business may increase their supplyearly to try to recoup some of the production costs before the goods becomeunsellable.
One-of-a-kind goods.
Handmade art or other rare goods cannot be easily reproduced, so the supply cannotexpand even if the price rises.
Inelastic supply.
For many goods, including agricultural products, it is difficult to quickly adjustthe supply even if the price rises. It can take months or even years for crops toreach maturity and become available to customers. For example, an apple farmer whoadds trees to their orchard won't be able to harvest the fruit for severalyears.
Law of Supply Examples
The law of supply operates across almost every industry. Here are some common examples.
- The owner of a coffee shop notices that sandwich prices are rising. To boost profits,the owner starts making more sandwiches for sale.
- A movie studio sees that major theaters are charging higher prices for blockbusterfilms, so it begins greenlighting more projects to develop star-studded action movies.
- Noticing that the price of organic vegetables is increasing faster than the price ofconventionally produced crops, a farmer starts the process of gaining organiccertification.
Conclusion
The law of supply describes a simple relationship between pricing and supply — thehigher the price of an item, the more suppliers will make. In practice, many other factorscan affect both supply and pricing, including production costs, the availability of rawmaterials and the competitive environment. So while it's useful to consider the law ofsupply when making business decisions, it's equally important to take into accountother factors that may apply to your situation.
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Law of Supply FAQs
What is the basic law of supply?
The law of supply states that as prices increase, overall supply will increase. Existingsuppliers increase their production to maximize profits. New sellers may also enter themarket.
What is law of supply and law of demand?
The law of supply and the law of demand are two sides of the supply equation. The law ofsupply states that as prices increase, so does the amount produced by sellers. The law ofdemand states that as prices increase, customer demand declines. Theoretically, a freemarket will move toward an equilibrium point where the price and quantity of the supplyexactly matches the demand.
