LAW OF SUPPLY

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ECON100 CONCEPT OF THE DAY: LAW OF SUPPLY

As part of our dual mandate to rebrand the dismal science’s moniker into the ‘decision’ making science as well as to lower the barrier to understand and access economic concepts without a formal economics degree, we’re rolling out a definition of the day (or week) to further these goals. Today’s concept of the day (or week) is: the law of supply.

WHAT EXACTLY IS THE LAW OF SUPPLY?

The law of supply is the relationship between the price of an item or good and the quantity demanded of that item or good. The relationship is a positive relationship meaning the price and quantity demanded for that item or good move in the same direction. If the price is high, or increasing then the quantity supplied is moving in the opposite direction: increasing. The quantity supplied represents the amount a supplier is willing and able to supply the market at a particular price point.

WHY SHOULD WE CARE ABOUT THE LAW OF SUPPLY?

Because the law of supply is immediately recognizable once you take a look at a typical supply curve, a concept we’ll discuss in a later post. The law of supply is what’s behind the typical upward (or positive) slope of the typical supply curve. We say typical because most, but not all supply curves slope upward but in general and for purposes of standardized tests (like AP economics) they do.

The characteristic upward slope is explained by the way the market supply curve is compiled. We’ll spend more time in detail when we talk about supply in general, but we’ll give a quick explanation. At a specific price point (let’s say £ 25), a specific amount of the good is supplied (called quantity supplied). The market sellers respond to the  price point of £ 25 by producing 500 units. If all 500 units are purchased, then the relative shortage (at that price) will not be resolved until the price increases. Why? Two reasons: (1) for both the firm and the market, additional production implies additional expenses associated with increased production (more labor, capital, shipping costs, ect) and (2) some firms in the market may have high up-front costs and therefore won’t produce in the market until the price reaches a certain price point. Above that threshold, they will provide goods to the market. Below that market price and the firm will stay offline, produce goods for another industry, or exit the market.

Figure 1. Graph showing law of supply. At a price of 25 pounds, only 500 units are produced.

For an example, we’ll look at the Canadian Oil Sands, a vast area (54,000+ square miles)  in the province of Alberta, which by projections of the Canadian Association of Petroleum Producers (CAPP), contains a recoverable 167 billion barrels, making it second in line only to Saudi Arabia in terms of reserves. Since the first mining operations and wells were drilled in the late 1960’s, Oil Sands production has increased steadily and is projected to hit 3.4 million barrels/day by 2050, according to the Canada Energy Regulator (AER)¹.

While the Oil Sands may rival the crude oil endowments of Saudi Arabia, Iran and Venezuela, it lags far behind in cost because of its composition, a mix of a heavier crude oil deposit (bitumen), sand, clay, depth and water. 20% of recoverable reserves consist of surface mining, which is costly because 2-3 tons of soil are filtered for each barrel of oil. Furthermore, the AER estimates the remaining 80% of the reserves must be mined in-situ, and cannot be accessed via surface mining, the lower cost extraction method. The two in-situ recovery methods require expensive extraction techniques such as drilling wells into pockets of bitumen, most 200 meters deep or more, using thermal energy (steam) to capture the heavy, highly viscous bitumen (also known as solid hydrocarbon) trapped deep in the ground. Using in-situ methods, it takes almost 3 barrels of water to recover one barrel of oil (steam to oil ratio).

As an industry, Oil Sands expenses eclipsed CAN $29.7 billion and Oil Sands expenditures reached CAN $9 billion². Because of these expenses, oil prices must remain high for the Oil Sands to remain economically feasible. A WSJ article in 2012 highlighted how benchmark prices for oil, the West Texas Intermediate (WTI), must exceed $50 per barrel for a firm to green light any new investment in the Oil Sands. Specialized firms, called upgraders, further refining bitumen into synthetic crude often experience break-even thresholds in excess of $100 per barrel, due to costly refining process, rising capital and labor costs³. A 2015 press release from Canada Energy Regulator highlighted how low benchmark oil prices were negatively affecting industry capital spending in the Oils Sands, deferring or canceling 11 projects in the Oil Sands, which reduced production output by 770 Mbd/d (million barrels per day)4. While improvements in operational and technological efficiencies are responsible for some of the falling expenditure industry-wide, those are.

OK, so what does the law of supply  mean for you?

Once you understand the law of supply side of a market, you can observe and take note of its role in how some prices in your local, regional, and national economy function.  Suppliers on the demand side of the market participate in it because the market price exceeds the individual producer’s cost of producing that particular good sold in the market. Many economics students struggle with distinguishing movement along the curve from a curve shift. Movement along the curve is in direct response to a change in the price (all else holding constant) and allows us to find equilibrium on a graph (when we need to find it). Now once we have covered both sides of the market we can use our understanding of supply and demand to make sense of prices we see throughout the economy.

REFERENCES

  1. Canada Energy Regulator. “CER – Canada’s Energy Future 2021 Fact Sheet : Oil Sands.” Régie de l’énergie du Canada, 24 May 2022, https://www.cer-rec.gc.ca/en/data-analysis/canada-energy-future/2021oilsands/index.html. Accessed 13 November 2022.
  2. Statistics Canada. “Oil and gas extraction capital expenditures and expenses (x 1000000).” Statistique Canada, Statistics Canada, 27 September 2022, https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=2510006401. Accessed 13 November 2022.
  3. Cummins, Chip. “Mining Canada’s Oil Sands: Suddenly Not a Sure Thing.” The Wall Street Journal, Dow Jones Inc, 2 November 2012, https://www.wsj.com/articles/SB10001424052970204005004578080733669452700. Accessed 13 November 2022.
  4. Canada Energy Regulator. “CER – Market Snapshot: Oil Sands Production to Increase, but Effects of Low Oil Prices are Evident.” Régie de l’énergie du Canada, 29 January 2021, https://www.cer-rec.gc.ca/en/data-analysis/energy-markets/market-snapshots/2015/market-snapshot-oil-sands-production-increase-but-effects-low-oil-prices-are-evident.html. Accessed 13 November 2022.

Check out the video below to see how after several years of difficult economic conditions, drought, and low milk prices, some Michigan farmers have decided to leave the industry.