The law of supply or supply hypothesis gives us the relationship between price and quantity supply of the commodity. It states that other things remaining the same, the quantity of any commodity that a firm will produce and offer for sale rises with a rise in its price and falls with a fall in its price. It means the law of supply shows that higher the price, the larger is the quantity supply; and lowers the price; the smaller is the quantity supply. Therefore, as per the law of supply, the quantity supply is positively related to the price of the product.
The law of supply is also based on the assumption of ceteris paribus i.e., other things remaining the same assumptions. Here other things include the determinants of supply except for own price of the commodity-like price of related goods, government policy, input prices, the goal of the firm, nature of the industry, and so on. The law of supply to operate these other factors except its price should hold constant or unchanged.
Assumptions of the Law of Supply
The major assumptions used in the law of supply are;
- No change in the number of firms,
- There is no change in production technology
- No change in government taxation and subsidy policy
- Price of factors of production remains constant
- No change in price expectations of sellers
- There is no change in the objective of the firms
Based on the above assumption the law of supply can be explained with help the help supply schedule and supply curve.
A supply schedule is a table that shows how much a firm is willing to supply at a particular price under the existing situations.
|Combinations||Price (Rs. Per Unit)||Supply in Unit|
The above table shows the positive relationship between the price of the commodity and quaintly supply by the seller. When per unit price is Rs. 2, the quantity supply is 5 units. When price increase to Rs.4 per unit, quantity supply will also increase to 10 units, and a maximum price of Rs. 10 per unit motivates the seller to supply 25 units of product.
A supply curve is a diagrammatic presentation of the combinations of price and quantity supply showing a positive relationship between them. It conveys the information as a supply schedule does.
In the above figure, the upward sloping line represents the supply line or supply curve of the firm. Different five combinations of price-quantity in the figure show price in the market and corresponding quantity supply of the product. The positively sloping curve depicts the direct relationship between price and supply.
Reasons behind Direct Relationship between Price and Supply
The law of supply shows the positive relationship between the price of the commodity and the quantity supply of a commodity. It is indicated by the upward-sloping supply curve. The upward slope of the supply curve is supported by the following factors.
Price determines the level of profit
The profitability of the business firm is based on the price of the product in the market. The higher the price of a commodity, the higher is the profit, ceteris paribus. Therefore the increase in price gives incentives to producers to produce and offer for sale a large amount of the goods. Thus, the price of the commodity serves as an incentive to produce more and more units of the commodity. The degree of encouragement depends on the level of price. Higher the price higher will be an incentive for the producer to produce and supply more.
Increasing marginal cost
The marginal cost of the product will increase with an increase in output due to the operation of diminishing returns. It is believed that with an increase in production the marginal cost also is increased. Thus, producers are ready to produce larger quaintly and offer them to sell in the market only at higher prices to cover the higher cost of production.
The new entry in the market
The increase in the price of the commodity motivates not only the existing producers but also many new prospective or potential producers in the market. For example, the rise in the price of onion will motivate the farmers to produce more quantity of onion in place of potato and other vegetables. The farmer would withdraw the resources from the production of potato and devote the same to the production of onion. Therefore, at increasing prices, more firms are willing to enter the market to produce goods. This will lead to a rise in supply in the market.
Exceptions or Limitations of Law of Supply
The law of supply states that an increase in prices raises the supply and vice-versa under ceteris paribus. But, there are different situations in which such a condition or rule may not be true. These conditions are known as exceptions or limitations of the law of supply. The major exceptions of the law of supply are below;
Expectations of fall in the prices
In the case of the price of the product is decreasing and if the seller feels that the price will further decrease in the future then he or she may increase the supply even at decreasing price.
In the case of the auction sale, the law of supply is not applicable. An action sale may occur at the situation when the seller is in a financial crisis and needs money at any cost. The seller in such case will ready to sell his goods or products at any offered price. Thus, the auction sale does not follow the law of supply.
In the case of agricultural goods, the law of supply may not apply. The supply of such goods is based on seasonal factors rather than price. So, the farmers could not wait for the applications of the law of supply.
Some of the goods are perishable which cannot be kept as a stock for a long time. Such types of goods are sold even if the price is decreasing where the law of supply does not apply.
If the business firm has to close its old business to start the new one, it has to clear all the stocks of goods. For this, the firm can sell all the goods by lowering the price which is just the opposite of the law of supply.
Necessity of liquidity
If the business firm needs a large amount of liquidity or cash, it may sell a large amount of the product lowering the price. In this case, the law of supply will not apply.
It is the situation in the economy in which all the economic activities like production, employment, consumption, investment, etc. decrease sharply. So, the suppliers supply more even at a low price due to fear of further fall in the price due to the worse condition in the economy.