The Law of Supply in Action

by Don Boudreaux on March 3, 2005

in Energy

Teaching the law of demand to principles-of-economics students is a bit easier than teaching the law of supply. The reason is that everyone understands that consumers want to buy greater quantities of a good as its price falls and fewer quantities of that good as its price rises.

Teaching the law of supply is a tad bit trickier because of the widespread knowledge of economies of scale. Each semester, several thoughtful students always ask "Doesnt producing more of something reduce the cost per unit and, hence, enable producers to sell it at a lower price? So dont lower prices, rather than higher prices, correspond to higher quantities supplied? I dont understand why price must rise in order to inspire a firm to offer greater quantities for sale." Good point.

I respond first by asking the students to wait a few lectures until we explore the law of diminishing returns; they’ll see then that no firm can expand output indefinitely without eventually seeing its costs of production per-unit rise.

Second, I advise that they now not think of the decisions of an individual firm but, rather, of the decisions of many firms. I ask them: What will a rise in prices do to the number of suppliers in the market? Will it increase the number of suppliers? Lower this number? Leave it the same?" The correct answer, of course, is "increase the number of suppliers."

When I next teach the law of supply to principles students, I’ll use this example that I found in today’s New York Times, which explains that

Oil drilling has long been a more common sight on the arid plains of West Texas, but oil prices topping $50 a barrel are now luring wildcatters to urban areas written off until recently as uneconomical by the energy industry.

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