3.1 Individual Supply: What You Sell, at Each Price
Shannon has been working hard for the past few weeks, preparing for her company’s annual planning summit. She joined BP’s management training program straight out of college and has spent the past few years working as a business analyst in the strategy division. BP is a major producer and seller of gasoline, and the planning summit brings together the heads of every major business unit to formulate production and sales plans for the next year. Shannon impressed her boss enough that she’s been picked to present the division’s analysis.
A refinery transforms crude oil into gasoline.
Understandably, she’s nervous, as the decisions that are made at the planning summit will ripple throughout the company. The head of the retail division will use these plans to coordinate sales targets across thousands of gas stations. The engineers who lead the refinery division—the large plants that transform crude oil into gasoline—will use the decisions as the basis for setting their production schedules. And the logistics division—which buys the crude oil needed by the refineries—will start making purchasing plans. Shannon also knows that impressing the company’s senior executives will be critical to her own career prospects.
The question on the planning summit’s agenda is one that is central to all businesses: Given the price of our product, what quantity should we supply? The stakes are high, because the right decision can be the difference between a healthy profit and a big loss.
At the summit, Shannon gives a presentation outlining how the company should respond if next year’s gas price is high. Because a high gas price would make selling more gas profitable, she recommends that the company ramp up production. Her presentation is quite specific, outlining exactly how much BP should increase production, depending on how much prices rise.
She then turns to more pessimistic scenarios, assessing how the company should respond to low gas prices. If the price of gas is low, she recommends cutting back the quantity of gas it produces and sells. Her presentation makes clear that the lower the gas price falls, the greater the cutbacks required, and hence the lower the quantity they would supply. Finally, she concludes that if the gas price is sufficiently low, the best way to minimize losses would be to halt production entirely and produce no gas. While this would be a hard decision to make, it would help BP survive until gas prices rose again.
Shannon’s presentation details how the ideal quantity to produce and sell varies, depending on the price. Indeed, because price is a critical factor determining any company’s profitability, businesses often find it useful to plan for a variety of different scenarios. Figure 1 shows the memo that Shannon distributed after the meeting, describing her company’s supply plans for next year. Each bullet point in Shannon’s memo shows the quantity of gasoline she recommends that BP supply, at each price.
Figure 1 | BP’s Supply Plan
An Individual Supply Curve
While Shannon has written the plan up as a memo, economists find it more convenient to represent these plans in a simple graph, called an individual supply curve. An individual supply curve is a graph of the quantity that a business plans to sell at each price; it summarizes a business’s selling plans. You can graph an individual supply curve for anything that you might sell—goods, services, your time, anything!—you just need to think about the quantity you’d sell at each price.
An individual supply curve graphs your selling plans.
Figure 2 graphs the individual supply curve for Shannon’s company, plotting the supply plans she outlined point by point in her memo. The graphing conventions for supply curves are the same as for demand curves: Price goes on the vertical axis, and quantity is on the horizontal axis. (Remember: “P’s before Q’s.”)
Figure 2 | An Individual Supply Curve
Each bullet point in Shannon’s memo represents a separate point on her company’s individual supply curve. The first bullet point says that at a price of $1 per gallon, BP plans to produce 10 million gallons of gas per week. This point is plotted at the lower left of Figure 2—simply look across from the price of $1 (on the vertical axis) to the quantity of 10 million gallons of gas (on the horizontal axis), and you’ll find it graphed as the first point. The next bullet point in the memo is plotted as the next point to the right: When the price rises to $2 per gallon, BP plans to increase the quantity supplied to 15 million gallons of gas per week. Each subsequent point shows that as the price rises, the quantity BP plans to supply also rises, all the way up to the final point, where a price of $5 per gallon leads Shannon to recommend that BP supply 30 million gallons of gas per week. Finally, we connect these dots in order to estimate the quantity supplied at prices in between those mentioned in Shannon’s memo. This line is BP’s individual supply curve, and it illustrates the quantity the company will supply, at each price.
Notice the last bullet point in Shannon’s memo: It says that when the price falls below $1, the company should supply zero gas. Why? For any company, there’s a point where the price is sufficiently low that your best choice is to minimize your losses by temporarily shutting down operations until the price rises again. This is illustrated by the vertical red line on the far left of Figure 2, which shows that if the price is between $0 and $0.99, BP plans to supply zero gallons of gas.
An individual supply curve holds other things constant.
The supply curve shown in Figure 2 plots the amount of gas BP will supply at different prices, given current economic conditions. But if something important were to change—say, the price of crude oil rose, or the wages of refinery workers fell—BP would change its plans, and those new plans would result in a new supply curve. This is why we say that an individual supply curve shows the quantity of gas that her company is willing to sell at each price, holding other things constant. Of course, the interdependence principle reminds us that things other than price can influence supply. But for now, we’re “holding other things constant,” so that we can focus on what happens when the price—and only the price—changes. Stay tuned, though, because later in this chapter we’ll analyze how shifts in these other factors can cause the supply curve to shift.
The individual supply curve is upward-sloping.
Which should you keep, and which should you sell?
Notice that the individual supply curve in Figure 2 rises upward as you look from left to right. It is upward-sloping because at higher gas prices, BP plans to supply a larger quantity. This makes sense—if each gallon brings a higher price, selling extra gallons of gas will be more profitable, and so BP should do more of it. (I’ll call this supply curve “upward-sloping” even though it’s vertical for prices below $1, because eventually higher prices led to a larger quantity supplied.)
Not all businesses go through the careful planning process that BP does. But even so, each of them still has an individual supply curve. After all, every business must choose what quantity to supply when the price changes. When you graph these choices, the resulting individual supply curve illustrates the extent to which a higher price leads to a larger quantity supplied.
Do the Economics
Just as BP is making supply decisions, you are also making important supply decisions in your everyday life. Let’s work through an example, and discover the shape of your individual supply curve.
At the end of this year, you’ll probably have several used college textbooks. And once you’ve passed your exams, you’ll have to choose which books to keep and which to sell to next year’s students. As such, you are a supplier in the market for college textbooks. For each book, you’ll have to decide whether it is worth selling, given the price. If the book is uninteresting or if it is for a class that’s not relevant for your future work, you are likely to sell it, even if you can only get a few dollars for it. But if it’s a book that you’ll need to refer to for next year’s classes or later in your career, then you will be more reluctant to sell it. In fact, you may be happy to keep many of your books. But if you can get a high enough price, you’ll go ahead and sell them. So the quantity of used textbooks you supply depends on the price.
Amazon launched a textbook buyback scheme, and their senior executives are trying to figure out what price they will need to offer sellers like you. One way for them to assess market conditions is to run a simple survey, like the one shown on the left in Panel A of Figure 3.
Figure 3 | Discover Your Individual Supply Curve
Go ahead and fill in your answers, describing your supply plans: How many second-hand textbooks will you re-sell at the end of the year, if you’re offered a price of $5 per book? What if the price is $10, $20, $30, $40, or even higher? Now, take the data from Panel A and plot your responses in the figure in Panel B. You have discovered your individual supply curve for textbooks. When Amazon’s executives analyze your individual supply curve, they will notice that the higher the price they offer, the larger the quantity that you will supply. That is, they’ll discover that individual supply curves for used textbooks are upward-sloping.
The Law of Supply
You’ve now seen that BP will supply more gas when the price of gas is high. Likewise, you will supply more used textbooks when their price is high. In fact, economists have studied supply decisions in thousands of different markets and they have found that there’s a general tendency for the quantity supplied to be higher when the price is higher. It’s an intuitive idea: If you can sell something for a higher price, you’ll sell more of it (holding other things constant). This is such a general principle that economists call it the law of supply. This law means that supply curves are upward-sloping, because higher prices are associated with larger quantities.
You are a supplier.
Let’s continue thinking about the supply decisions of our favorite business, Y.O.U., Incorporated. It turns out that YOU are making supply decisions every day. You are a supplier whenever you offer something in exchange for something else. And so figuring out your role as a supplier means answering two simple questions: What are you supplying? And in exchange for what?
If you are selling your old cell phone, then you are a supplier of cell phones. Or if you are selling concert tickets you can’t use, you are a supplier of concert tickets. You are also a supplier when you offer services, instead of “stuff.” If you have a job, you are a supplier of labor to your employer. Your economics professor is a supplier of educational services.
Your tutor is a supplier—of academic help.
Asking, “In exchange for what?” tells us about the price. Sometimes the price is some amount of cash—say, if you listed your cell phone for $100 on Craigslist, or your on-campus job pays $10 per hour. But the price isn’t always measured in dollars. For instance, you might offer to help your friend with her economics homework, on the understanding that she will help you with your Spanish. Here, you are supplying your services as an economics tutor. And there is a price attached to your help, even though it’s not measured in dollars: You are hoping for a certain amount of Spanish tutoring in return. When you start to think like this, you’ll see that you are making important supply decisions every day of your life. Even though many of these don’t look like standard business decisions, you can learn to make better decisions by following the same logic that managers use when figuring out how to make good supply choices. Let’s now turn to exploring that logic, working through Shannon’s thoughts as she analyzed the best supply decisions for BP.