Producer Choice And The Law Of Supply

Now let's shift our focus to producers and the supply side of the market. How does the market process determine the amount of each good that will be produced? To figure this out, we first have to understand what influences the choices of producers. Producers convert resources into goods and services by doing the following:

1. organizing productive inputs and resources, like land, labor, capital, natural resources, and intermediate goods;

2. transforming and combining these inputs into goods and services; and

3. selling the final products to consumers.

Producers have to purchase the resources at prices determined by market forces. Predictably, the owners of these resources will supply the resources only at prices at least equal to what they could earn elsewhere. Put another way, each resource the producers buy to make their product has to be bid away from all other potential uses. Its owner has to be paid its opportunity cost. The sum of the producer's cost of each resource used to produce a good wall equal the opportunity cost of production.

There is an important difference between the opportunity cost of production and standard accounting measures of cost. Accountants generally do not count the cost of the firm's assets, such as its buildings, equipment, and financial resources, when they calculate a product's cost. But economists do. Economists consider the fact that these assets could be used some other way—in other words, that they have an opportunity cost. Unless these opportunity costs are covered, the resources will eventually be used in other ways.

The opportunity cost of these assets to the firm is the amount of money the firm could earn from the assets if they were used another way. Consider a manufacturer that invests $10 million in buildings and equipment to produce shirts. Instead of buying buildings and equipment, the manufacturer could simply put the $10 million in the bank and let it draw interest. If the $10 million were earning, say, 10 percent interest, the firm would make $1 million on that money in a year's time. This $1 million in forgone interest is part of the firm's opportunity cost of producing shirts. Unlike an accountant, an economist will take

Opportunity cost of production

The total economic cost of producing a good or service. The cost component includes the opportunity cost of all resources, including those owned by the firm. The opportunity cost is equal to the value of the production of other goods sacrificed as the result of producing the good.

that $ 1 million opportunity cost into account. If the firm plans to invest the money in shirt-making equipment, it had better earn more from making the shirts than the $1 million it could earn by simply putting the money in the bank. If the firm can't generate enough to cover all of its costs, including the opportunity cost of assets owned by the firm, it will not continue in business.

Profits and Losses

Profits direct producers toward activities that increase the value of resources; losses impose a penalty on those who reduce the value of resources.


An excess of sales revenue relative to the opportunity cost of production. The cost component includes the opportunity cost of all resources, including those owned by the firm. Therefore, profit accrues only when the value of the good produced IS greater than the value of the resources used for its production.


A deficit of sales revenue relative to the opportunity cost of production. Losses are a penalty imposed on those who produce goods even though they are valued less than the resources required for their production.

Firms earn a profit when the revenues from the goods and services that they supply exceed the opportunity cost of the resources used to make them. Consumers will not buy goods and services unless they value them at least as much as their purchase price. For example, Susan would not be willing to pay $40 for a pair of jeans unless she valued them by at least that amount. At the same time, the seller's opportunity cost of supplying a good will reflect the value consumers place on other goods that could have been produced with those same resources. This is true precisely because the seller has to bid those resources away from other producers wanting to use them.

Think about what it means when, for example, a firm is able to produce jeans at a cost of $30 per pair and sell them for $40, thereby reaping a profit of $10 per pair. The $30 opportunity cost of the jeans indicates that the resources used to produce the jeans could have been used to produce other items worth $30 to consumers (perhaps a denim backpack). In turn, the profit indicates that consumers value the jeans more than other goods that might have been produced with the resources used to supply the jeans.

The willingness of consumers to pay a price greater than a good's opportunity cost indicates that they value the good more than other things that could have been produced with the same resources. Viewed from this perspective, profit is a reward earned by entrepreneurs who use resources to produce goods consumers value more highly than the other goods those resources could have produced. In essence, this profit is a signal that an entrepreneur has increased the value of the resources under his or her control.

Business decision makers will seek to undertake production of goods and services that will generate profit. However, things do not always turn out as expected. Sometimes business firms are unable to cover their costs. I osses occur when the revenue derived from sales is insufficient to cover the opportunity cost of the resources used to produce a good or service. Losses indicate that the firm has reduced the value of the resources it has used. In other words, consumers would have been better off if those resources had been used to produce something else. In a market economy, losses will eventually cause firms to go out of business, and the resources they previously utilized will be directed toward other things valued more highly.

Profits and losses play a very important role in a market economy. They determine which products (and firms) will expand and survive, and which will contract and be driven from the market. Clearly, there is a positive side to business failures. As our preceding discussion highlights, losses and business failures free up resources being used unwisely so they can be put to a use producing other things that people value more highly.

Entrepreneurs organize the production of new products. In doing so, they take on significant risk in deciding what to produce and how to produce it. Their success or failure depends upon how much consumers eventually value the products they develop relative to other products that could have been produced with the resources. Entrepreneurs figure out which projects are likely to be profitable and then try to persuade a corporation, individual investors to invest the resources needed to give their new idea a

Producer Choice and the Law cf Supply 63

chance. Studies indicate, however, that only about 55 to 65 percent of the new products introduced are still on the market five years later. Being an entrepreneur means you have to risk failing.

Toprosper, entrepreneurs must convert and rearrange resources in a manner that will increase their value. A person who purchases 100 acres of raw land, puts in a street and a sewage-disposal system, divides the plot into 1-acre lots, and sells them for 50 percent more than the opportunity cost of all resources used is clearly an entrepreneur. This entrepreneur profits because the value of the resources has increased. Sometimes entrepreneurial activity is less complex, though. For example, a 15-year-old who purchases a power mower and sells lawn services to his neighbors is also an entrepreneur seeking to profit by increasing the value of his resources-time and equipment.

Market Supply Schedule *-

How will producer-entrepreneurs respond to a change in product price? Other things constant, a higher price will increase the producer's incentive to supply the good. Established producers will expand the scale of their operations, and over time new entrepreneurs, seeking personal gain, will enter the market and begin supplying the product, too. The law of supply states that there is a direct (orpositive) relationship between the price f a good or service and the amount cf it that suppliers are willing to produce. This direct relationship means that price and the quantity producers wish to supply move in the same direction. As the price increases, producers will supply more—and as the price decreases, they will supply less.

Like the law of demand, the law of supply reflects the basic economic principle that incentives matter. Higher prices increase the reward entrepreneurs get from selling their products. The more profitable producing a product becomes, the more of it they will be willing to supply. Conversely, as the price of a product falls, so does its profitability and the incentive to supply it. Just think about how many hours of tutoring services you would be willing to supply for different prices. Would you be willing to spend more time tutoring students if instead of $5 per hour, tutoring paid $50 per hour? The law of supply suggests you would, and producers of other goods and services are no different.

Exhibit 6 illustrates the law of supply. The curve shown in the exhibit is called a supply curve. Because there is a direct relationship between a good's price and the amount offered for sale by suppliers, the supply curve has a positive slope. It slopes upward to the right. Read horizontally, the supply curve shows how much of a particular good producers are willing to produce and sell at a given price. Read vertically, the supply curve reveals important information about the cost of production. The height cf the supply curve indicates both (I) the minimum price necessary to induce producers to supply that

Law of supply

A principle that states there is a direct relationship between the price of a good and the quantity of it producers are willing to supply. As the price of a good increases, producers will wish to supply more of it. As the price decreases, producers will wish to supply less.


EXHIBIT 6 Supply Curve

As the price of a product increases, other things constant, producers will increase the amount of the product supplied to the market.

Quantity/time r

68 CHAPTER 3 Supply, Demand, and the Market Process

EXHIBIT 7 Producer Surplus

Producer surplus is the area above the supply curve but below the actual sales price. This area represents the net gains to producers and resource suppliers from production and exchange.

Producer surplus


Quantity/time additional unit ana (2) the opportunity cost O producing that additional unit. These are both measured by the height of the supply curve because the minimum price required to induce a supplier to sell a unit is precisely the marginal cost of producing it.

Producer surplus The difference between the minimum price suppliers are willing to accept and the price they actually receive. It measures the net gains to producers and resource suppliers from market exchange. It is not the same as profit.

We previously used the demand curve to illustrate consumer surplus, the net gains of buyers from market exchanges. The supply curve can be used in a similar manner to illustrate the net gains of producers and resource suppliers. Suppose that you are an aspiring musician and are willing to perform a two-hour concert for $500. If a promoter offers to pay you $750 to perform the concert, you will accept, and receive $250 more than your minimum price. This $250 net gain represents your producer surplus. In effect, producer surplus is the difference between the amount a supplier actually receives (based on the market price) and the minimum price required to induce the supplier to produce the given units (their marginal cost). The measurement of producer surplus for an entire market is illustrated by the shaded area of Exhibit 7.

It's important to note that producer surplus represents the gains received by all parties contributing resources to the production of a good. In this respect, producer surplus is fundamentally different from profit. Profit accrues to the owners of the business firm producing the good, whereas producer surplus encompasses the net gains derived by all people who help produce the good, including those employed by or selling resources to the firm.

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