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Introduction to Fundamental Analysis

From XPRESSTRADE

Basic Description of The Law of Supply

Supply joins demand as one of the components of fundamental commodity market analysis. Supply characteristics relate to the behavior of firms in producing and selling a product or service. An understanding of the factors affecting supply in the past will help with the development of supply expectations in the future and the impact upon market price.

The law of supply can be approached from two different contexts. The first is that it represents the sum total of production plus carryover stocks. The other context for supply describes the behavior of producers -- total supply represents the quantities producers are willing to sell over a range of prices for any given time period. At the individual level, a supplier may be willing to produce a given product as long as the market price is equal to or greater than the cost of producing that product. The total supply is the sum of the individual quantities of product that each farmer brings to the market. Market supply is represented by an upward sloping curve with price on the vertical axis and quantity on the horizontal axis (see figure 2).

Figure 2

An increase in price in most instances will result in suppliers wanting to increase the quantity of a given product they will bring to the market, therefore the relationship between the price and supply is said to be "positive." Market supply will be affected by other variables in addition to the price. Factors that have been identified as important in determining supply behavior include the number of firms producing the product, technology, the price of inputs, the price of other commodities which could be produced, and the weather.

With higher prices, the producers of goods and services will receive greater profits. Greater profits will result in the means to expand production, thereby increasing the supply. This increased supply will ultimately satisfy the existing demand such that any additional production must be met with new demand in order for the price increases to be sustained. Suppliers are not free to set prices as they choose; they can raise prices only if consumers are willing and able to pay more. The law of supply, as was the case with demand, illustrates the discipline of the marketplace. The market doesn't care what it costs a supplier to produce something. Lower prices are the market's signal to suppliers that they have produced too much of something or that it is something consumers do not want. Successful suppliers accept the "discipline of the marketplace" and learn to produce for the market.

Next chapter: How Supply & Demand Determine Market Price

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