Terms Beginning With 'l'

Law of Supply

  • January 25, 2021
  • Team Kalkine

What is the law of supply?

The law of supply states that keeping other parameters constant, as the prices of a commodity increase, the supply of that commodity also increases. This means that ceteris paribus, price changes move in the same direction as a commodity’s supplied quantity. 

Law of supply, along with the law of demand, helps explain how goods and prices are allocated in a market. Law of supply has been made from the producer’s standpoint while the law of demand has been made from the consumer's perspective. Together, both of these laws help determine the goods market equilibrium.

What is the supply curve?

A supply curve signifies the relationship between the price of a good and the quantity supplied. The slope of a supply curve is always positive because of the Law of Supply. This happens because as prices of a good increase, the firms focus more on producing that good to earn higher profits.

A graphical depiction of a supply schedule is called a supply curve. A supply schedule is a tabular representation of various price level and the quantities of the commodity supplied at those prices.

The variation in the slopes depends on the price elasticity of supply of a good. As the price elasticity of supply increases, the slope of the supply curve decreases.

In the diagram above, as the price of a commodity increases from P1 to P2, the quantity supplied also increases from Q1 to Q2. This positive relationship is explained through the law of supply.

Why is there a positive relationship between the price of a good and the quantity supplied?

The producers, like consumers, are rational beings and would like to save up on their costs. As the quantity demanded of a is good increased, the firms must produce more to satisfy the rising demand. This increase in production leads to business expansion, which means greater costs for the firm.

The business expansion involves costs like the addition of new labour force, new machinery, maybe setting up new factories etc. Thus, they start to charge more for each commodity, as the supply is increased in an economy. This relationship is explained under the assumption that all other factors affecting supply are kept constant.

Conversely, it can be argued that as the prices of goods rise in the economy, the demand falls because of the law of demand. Thus, some demand may still go unsatisfied if prices become too high.

How is equilibrium explained through the laws of demand and supply?

The price of a good adjusts according to the demand and supply in the economy. If there is excess demand for a good, it means that there is not enough production to meet the consumer’s demand. Consequently, producers could either increase the prices so that demand reduces, or improve their production, which could also lead to higher prices.

Alternatively, when there is a shortage of demand in the economy, firms would be compelled to lower prices and encourage consumers’ spending. They could also reduce supply by temporarily shutting down production; however, that seems like the costlier alternative.

Therefore, the conditions of excess supply and excess demand can both be brought to equilibrium by appropriate changes in the commodity’s price. Thus, the law of demand and supply collaboratively decide the market equilibrium and can influence the economy’s production levels.

How does the supply of a good change?

Keeping all other factors equal, the supply of goods may change because of prices or many other factors. When the supply changes because of a change in prices, the changes are observed along the curve.

However, the supply curve may shift when any factor, other than the price, is changed one at a time. These factors are income, technology, the cost of production, the scale of production, prices of related goods and government policies.

When either of these determinants is changed, keeping the others constant, the demand curve would change by shifting rather than through a movement along the curve.

The following diagram represents the movement along the curve:

Here the price and quantity allocations shift along the curve. However, when factors other than the price change, a shift in the demand curve is observed, which can be shown as:

Are there any exceptions to the law?

The backward bending supply curve of labour is one prominent example of an exception to the law of supply. The supply curve of labour follows the law of supply but only up to a certain extent. It starts bending backwards, defying the law of supply after a point.

The law of supply applies to labour as they offer a higher number of hours worked against higher wages. However, this only continues till the labour becomes wealthy enough not to find higher wages incentivising enough to work more. Therefore, beyond a point, the workforce may not offer as much labour as before and spend more time doing leisure than doing work.

Another important scenario is when the supply of a good is fixed. In such a case, even if there is excess demand in the economy, the producers cannot meet it due to limited supply. Therefore, they only have the option of waiting it out. This can be done by increasing prices. It is important to note, that even when supply is fixed, the prices rise and thus, the law of supply does not follow here.

What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others.  The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors.  For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel.  How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages.  Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage.  Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade.  Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries.  What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another.  The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services.  Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour.  Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television.  It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured.  Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power.  The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play.  It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability.  What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects.  The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers.  Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.

Difference between actual and an expected return. For example, if a stock increased by 7% because of some update, but the average market only increased by 3% and the stock has a beta of 1, then the abnormal return was 4% (7% - 3% = 4%)

Gain or loss as a percentage of the initial capital invested. For example – If we gain $10 on investing $100, our Absolute return would be 10% ($10/$100*100)

Calculating the cost of a product or an enterprise based on the direct and the indirect costs (overheads) involved. Multiple methods of absorption costing include Direct labour cost percentage rate, Direct material cost percentage rate, Labour hour rate , Prime cost percentage rate and Machine hour rate.    

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it. OK