Supply is to producer as demand is to consumer. Supply is what producers do. Supply reflects producers' changing willingness and ability to make or sell at the various prices that occur in the market. If you were selling cookies or crude oil, which would entice you to produce more, a low price or a high price? If you said low price, you would quickly find yourself broke. However, if you said high price, you just might have a chance to make a profit. The law of supply states that producers are able and willing to sell more as the price increases. The reason for the law of supply is the simple fact that as production increases, so do the marginal costs. As rational, self-interested individuals, suppliers are only willing to produce if they are able to cover their cost.
Elasticity of Supply
Elasticity of supply is the producers' sensitivity to changes in price on the quantity they are willing to produce. The key factor in supply elasticity is the amount of time it takes to produce the good or service. If producers can respond to price changes rapidly, supply is relatively elastic. However, if producers need considerable time to respond to changes in the market price of their product, supply is relatively inelastic. Compare corn tortillas and wine. Corn tortillas are easily produced with readily available materials. If the market price of corn tortillas were to suddenly increase, producers would have little difficulty in producing more tortillas in response to the price change. Now, if the market price of pinot noir were to suddenly increase, wine makers would have much more difficulty responding to the price change. Vines take years to develop, grapes take time to ripen, and wine needs time to age. All of these factors give wine a relatively inelastic supply.
Elasticity of supply and demand is important in determining the incidence of taxation, or who bears the burden of a tax on goods and services. Even though the legal incidence of a tax might fall on a producer, the economic incidence of the same tax might fall on the consumer.
Changes in Supply
As price changes, producers are willing to produce more or less. Price affects the quantity producers supply, but it does not affect supply. For example, the supply of coffee is influenced by weather, land prices, other coffee producers, coffee futures, cocoa profits, and subsidies to coffee producers. The one thing that does not influence the supply of coffee is the current price of coffee. This often causes confusion, but it need not. Understand that supply refers to producers' willingness to produce various amounts at various prices, and not to some fixed quantity. Supply is influenced by nature, the price of inputs, competition, expected prices, related profits, and government.
Nature plays a big part in determining the supply of coffee. Rain, sunshine, temperature, and disease are obvious examples of variables in nature that will affect the coffee harvest. Excellent weather conditions often lead to large increases in supply, and poor weather leads to the opposite.
Economists recognize that expectations of the future play a large role in determining the economy of today. As time has progressed and policymakers have become more sophisticated, much effort has been placed in setting expectations for the markets. Instead of reacting, policymakers must now contend with setting future expectations when they make policy decisions about the economy.
Input or resource prices have a direct influence on producers' supply decisions. Land, seed, fertilizer, pesticide, harvesting equipment, labor, and storage are just a few of the costs that coffee producers face. Supply decreases as those costs rise, making growers less able to produce at each and every market price. Supply increases when the cost of production falls.
The presence of more or less competition causes increases or decreases in supply. As the popularity of coffee has risen, more and more producers have entered the market. The introduction of more competition increased the quantity of coffee supplied at each market price.
Expectations of future price increases tend to decrease supply, but expectations of future price decreases have the opposite effect. If producers expect higher prices in the future, they will be less willing to supply in the present. Coffee producers might withhold production in order to sell when prices are higher. If prices are expected to move lower in the future, producers have an incentive to sell more in the present.
The profitability of related goods and services also affects the supply of a good like coffee. For example, coffee-growing land is also favorable for growing cocoa. If the profits are greater in the cocoa market than in the coffee market, over time more land will be pulled from coffee production and put into cocoa production. Likewise, if profits in the coffee market are greater, eventually, more land will be put into coffee production at the expense of cocoa production.
Government policies can also affect supply. Government can tax, subsidize, or regulate production, and this will affect supply. If Brazil wants to reduce the local production of coffee in order to restore forests, the Brazilian government can tax coffee production. This would increase the cost of production and reduce the supply. If government wants to encourage production and increase supply, it can subsidize producers, that is, pay them to produce. Vietnam might subsidize coffee production in its highlands in order to increase the supply of this valuable export commodity. Regulation often has the effect of limiting supply. If Vietnam wanted to preserve its highland rainforests, it might make rules or regulations that effectively limit the ability of coffee growers to produce.
Technology and the availability of physical capital are key determinants of supply. Technological innovation has allowed producers in many different industries to increase the quantity of goods that they are willing and able to produce at each and every price. Increases in the amount of physical capital available relative to labor also help firms to increase output. Economists refer to this phenomenon as capital deepening. As capital deepening increases for a firm, so does supply.