The law of supply and the idea of opportunity cost are two important concepts in economics that help us understand how producers make decisions about what and how much to produce. In this article, we will explain how these two concepts are related and why they matter for the efficient allocation of resources in a market economy.
What is the Law of Supply?
The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or service increases, the quantity of goods or services that suppliers offer will increase, and vice versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the number of items for sale.
The law of supply can be illustrated by a supply curve, which is an upward-sloping graph that shows the relationship between price and quantity supplied. The supply curve reflects the direct correlation between price and quantity supplied: at a higher price, suppliers are willing and able to produce more; at a lower price, they produce less.
Here is an example of a supply curve for gasoline:
What is Opportunity Cost?
Opportunity cost is the value of the next best alternative that is forgone as a result of making a decision. It is the benefit that could have been gained from choosing a different option. Opportunity cost measures the trade-off between two choices: what you give up versus what you gain.
For example, suppose you have $10 and you can either buy a pizza or a book. If you choose to buy the pizza, your opportunity cost is the value of the book that you could have bought instead. If you choose to buy the book, your opportunity cost is the value of the pizza that you could have enjoyed instead.
How are Supply and Opportunity Cost Related?
Supply and opportunity cost are related because when suppliers decide how much to produce, they face trade-offs between using their resources for different purposes. Producing more of one good means producing less of another good, or giving up some other valuable activity. The opportunity cost of producing more of one good is the value of the foregone production of another good.
For example, suppose a farmer can grow either wheat or corn on his land. If he chooses to grow more wheat, his opportunity cost is the amount of corn that he could have grown instead. If he chooses to grow more corn, his opportunity cost is the amount of wheat that he could have grown instead.
The law of supply states that as the price of a good increases, suppliers will produce more of it. This implies that suppliers will only produce more of a good if the price increase is enough to cover the opportunity cost of producing more. In other words, suppliers will only produce more if they can earn more profit from selling more.
The law of supply also states that as the price of a good decreases, suppliers will produce less of it. This implies that suppliers will reduce their production if the price decrease is enough to make them lose profit from selling less. In other words, suppliers will produce less if they can save more by producing less.
Therefore, we can see that supply and opportunity cost are related by the concept of profit: suppliers will adjust their production according to how much profit they can make or save by changing their output level.
Why Does it Matter?
Understanding how supply and opportunity cost are related helps us understand how market forces affect resource allocation in an economy. When prices change due to changes in demand or supply, suppliers respond by changing their production levels according to their opportunity costs. This leads to an equilibrium where supply equals demand, and resources are used efficiently.
For example, suppose there is an increase in demand for gasoline due to an increase in population or income. This will cause the price of gasoline to rise, which will induce suppliers to produce more gasoline by using more resources such as oil, labor, capital, etc. However, these resources have alternative uses: they could be used to produce other goods or services. Therefore, producing more gasoline means giving up some other production possibilities. The opportunity cost of producing more gasoline is the value of these foregone possibilities.
Suppliers will only produce more gasoline if the price increase is enough to compensate them for their opportunity cost. If the price increase is too low, suppliers will not produce more gasoline because they can make more profit by using their resources for other purposes. If the price increase is too high, suppliers will produce too much gasoline because they can make more profit by selling more than what consumers demand. In either case, there will be a disequilibrium in the market: either excess supply or excess demand.
The market mechanism will correct this disequilibrium by adjusting the price until supply equals demand. The equilibrium price will be the one that makes suppliers indifferent between producing more or less gasoline, or in other words, the one that equates their marginal revenue (the additional revenue from selling one more unit) and their marginal cost (the additional cost from producing one more unit). The marginal cost reflects the opportunity cost of producing more gasoline: the value of the next best alternative that is given up.
Therefore, we can see that the law of supply and the idea of opportunity cost work together to determine the optimal level of production and price in a market economy. By responding to price signals, suppliers allocate their resources efficiently and maximize their profits.