Price Elasticity of Supply
Introduction
Price elasticity of supply (Pes) measures the relationship between change in quantity supplied and a change in price.
If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.
Formula:
The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price
When Pes > 1, then supply is price elastic
When Pes < 1, then supply is price inelastic
When Pes = 0, supply is perfectly inelastic
When Pes = infinity, supply is perfectly elastic following a change in demand
Factors Determining Elasticity of Supply
1. Spare Production Capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources.
2. Stocks of Finished Products and Components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in the market.
3. The Ease and Cost of Factor Substitution: If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched. A good example might be a printing press which can switch easily between printing magazines and greetings cards.
4. Time Period Involved in the Production Process: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield. In contrast the supply of milk is price elastic because of a short time span from cows producing milk and products reaching the market place.
Areas of the AS and the A2 economics syllabus where price elasticity of supply is important
• Housing Supply: Inelastic supply of new housing in response to rising demand – pushes up property prices with consequences for housing wealth, affordability etc
• Oil Industry: Can OPEC and non-OPEC countries step up crude oil output as global demand expands?
• Trade: I.e. the ability of a nation’s export industries to respond to depreciation in the exchange rate if export demand grows – important for countries using the exchange rate as an instrument of macro policy
• Commodity Prices: Inelastic supply of many hard and soft commodities – making prices more volatile – especially in markets where there is strong speculative activity - link to global food price inflation
• Labour Market: Elasticity of supply of labour is a factor explaining wage differentials – i.e. migrant workers can help to relieve shortages of labour and improve the elasticity of supply
• Macroeconomics and the Output Gap: The changing elasticity of SRAS at different points of the economic cycle
• Elasticity of supply of renewable sources of energy as demand increases e.g. bio-fuels, solar power
• Quasi Public Goods: i.e. public goods such as the airwaves, motorways, beaches etc which become crowded and congested – causing the marginal cost of supplying to an extra user to rise
• Government Intervention in a Market: if you are answering questions on maximum and minimum prices or indirect taxes and subsidies, you can always make a useful analytical point about the importance of price elasticity of supply in affecting the results of any such market intervention.
Here is a mnemonic is for factors affecting price elasticity of supply (courtesy of Innes Robinson)
BRITS
1. Barriers to entry – e.g. Patents or high cost of advertising could make it hard for new firms to enter the market
2. Raw materials – If raw materials are readily available, it will be relatively easy to expand production
3. Inventory – Businesses with plenty of stock can increase supply easily.
4. Time – Many agricultural products take time to make so supply is fixed in the short term.
5. Spare Capacity – If businesses are not running to full capacity they are more able to increase supply. The supply of goods and services is often most elastic in a recession when there is plenty of spare labour and capital resource
Elasticity of demand and supply and price changes – a quick summary
Elasticity determines how much a shift changes quantity versus price.
• If D increases and S is perfectly inelastic, then price rises and quantity doesn’t change.
• If S increases and D is perfectly inelastic, then price falls and quantity doesn’t change.
• If D increases and S is perfectly elastic, then price stays the same and quantity rises.
• If S increases and D is perfectly elastic, then price stays the same and quantity rises.
