Price elasticity of supply

What Is Price Elasticity of Supply?

Price elasticity of supply (PES) is a measure used in economics to show the responsiveness, or elasticity, of the quantity supplied of a good or service to a change in its price. It is a fundamental concept within microeconomics, which studies how individuals, households, and firms make decisions to allocate resources. A higher PES indicates that producers are more willing and able to increase their output when prices rise, while a lower PES suggests that supply is less sensitive to price changes. Understanding this elasticity is crucial for analyzing how changes in market conditions, such as shifts in the demand curve or supply curve, affect the market equilibrium of goods and services.

History and Origin

The concept of elasticity, including the elasticity of supply, was notably developed and formalized by the influential British economist Alfred Marshall in his seminal work, Principles of Economics, first published in 1890. Marshall is credited with transforming the idea of responsiveness into a useful analytical tool. He emphasized that the responsiveness of quantity supplied to price changes depends significantly on the time available for producers to adjust their production levels. Marshall's contributions were instrumental in establishing the analytical framework of supply and demand that forms the bedrock of modern economic theory.¹², ¹³

Key Takeaways

• Price elasticity of supply (PES) measures how sensitive the quantity of a good or service supplied is to changes in its price.
• A PES value greater than 1 indicates elastic supply, meaning quantity supplied changes proportionally more than price.
• A PES value less than 1 indicates inelastic supply, meaning quantity supplied changes proportionally less than price.
• Factors such as the availability of inputs, time horizon, and ability to store inventory significantly influence a product's PES.
• Understanding PES helps businesses and policymakers anticipate market responses to price changes.

Formula and Calculation

The formula for price elasticity of supply (PES) is calculated as the percentage change in quantity supplied divided by the percentage change in price:

Where:

• (% \Delta Q_s) represents the percentage change in the quantity supplied.
• (% \Delta P) represents the percentage change in the price of the good or service.

To calculate the percentage change for each, the following formulas are typically used:

• (% \Delta Q_s = \frac{Q_{\text{new}} - Q_{\text{old}}}{Q_{\text{old}}} \times 100%)
• (% \Delta P = \frac{P_{\text{new}} - P_{\text{old}}}{P_{\text{old}}} \times 100%)

This calculation helps producers understand how their production costs and potential revenue might be affected by price fluctuations, especially in relation to their marginal cost of production.

Interpreting the Price Elasticity of Supply

The numerical value of price elasticity of supply provides critical insights into how producers respond to price changes:

• Elastic Supply ((\text{PES} > 1)): If the PES is greater than 1, supply is considered elastic. This means that a small percentage change in price leads to a proportionally larger percentage change in the quantity supplied. Producers can significantly increase their output in response to higher prices, often because they have readily available factors of production or excess capacity.
• Inelastic Supply ((\text{PES} < 1)): If the PES is less than 1, supply is considered inelastic. This indicates that a given percentage change in price results in a proportionally smaller percentage change in the quantity supplied. Producers face constraints that limit their ability to quickly increase output, such as fixed capacity in the short run or difficulty in acquiring additional resources.
• Unitary Elastic Supply ((\text{PES} = 1)): When the PES equals 1, supply is unitary elastic. The percentage change in quantity supplied is exactly equal to the percentage change in price.
• Perfectly Inelastic Supply ((\text{PES} = 0)): In this extreme case, quantity supplied does not change at all, regardless of price changes. This is rare in practice but can apply to unique items or fixed resources in the very short term.
• Perfectly Elastic Supply ((\text{PES} = \infty)): Here, an infinite quantity can be supplied at a particular price, but nothing at a slightly lower price. This is also theoretical, implying producers can supply any amount demanded at a constant price.

The time horizon is a primary determinant of PES; supply tends to be more inelastic in the short run and more elastic in the long run, as producers have more time to adjust capacity, acquire inputs, and implement new technologies.

Hypothetical Example

Consider a small custom furniture manufacturer, "WoodCraft Wonders." Currently, WoodCraft Wonders produces 100 custom dining tables per quarter, selling each for $1,500. Due to a surge in demand, the market price for custom dining tables increases to $1,800, a 20% increase. In response to this higher price, WoodCraft Wonders decides to increase its output to 110 tables per quarter, a 10% increase.

Using the formula for price elasticity of supply:

1. Calculate the percentage change in quantity supplied:
   ( % \Delta Q_s = \frac{110 - 100}{100} \times 100% = 10% )

2. Calculate the percentage change in price:
   ( % \Delta P = \frac{$1,800 - $1,500}{$1,500} \times 100% = 20% )

3. Calculate the Price Elasticity of Supply (PES):
   ( \text{PES} = \frac{10%}{20%} = 0.5 )

In this hypothetical example, the PES for WoodCraft Wonders' dining tables is 0.5. This value, being less than 1, indicates that the supply of custom dining tables is inelastic in this scenario. Even with a significant price increase, WoodCraft Wonders' ability to increase production is limited, perhaps due to the specialized nature of its factors of production, the time required to source materials, or the availability of skilled labor.

Practical Applications

Price elasticity of supply is a vital concept with various practical applications for businesses, governments, and economists in market analysis:

• Business Strategy: Companies use PES to inform production planning. If a product has an elastic supply, a firm might aggressively increase production in anticipation of price rises, knowing they can capture more revenue. For products with inelastic supply, focus might shift to cost control or premium pricing strategies, as output cannot be easily scaled.
• Government Policy and Government Intervention: Policymakers consider PES when implementing taxes, subsidies, or regulations. For instance, a tax on a good with inelastic supply will likely be borne more by producers (or consumers through higher prices, with less impact on quantity), while a tax on a good with elastic supply will lead to a larger reduction in quantity supplied. During periods of economic disruption, understanding supply elasticity can help in formulating effective responses. For example, the Federal Reserve has noted how global supply chain disruptions during the COVID-19 pandemic significantly impacted inflation due to the inelastic nature of many critical goods, making it difficult for supply to quickly meet surging demand.¹⁰, ¹¹
• Commodity Markets: In markets for raw materials like oil or agricultural products, PES helps explain price volatility. For example, oil supply can be relatively inelastic in the short term due to the fixed nature of drilling infrastructure and exploration costs. Geopolitical events or sudden demand shifts can therefore lead to significant price swings. Analysis of global oil supply often highlights how factors like OPEC+ decisions and non-OPEC+ production affect the overall elasticity of the market.⁶, ⁷, ⁸, ⁹

Limitations and Criticisms

While price elasticity of supply is a powerful analytical tool, it has several limitations and faces criticisms:

• Static Measure: PES is a static measure, meaning it captures responsiveness at a specific point in time and under specific market conditions. Real-world supply is dynamic and can change over time due to technological advancements, changes in production techniques, or shifts in global trade patterns.
• Difficulty in Measurement: Accurately calculating PES can be challenging due to the need for precise data on quantity supplied and price changes, which may not always be readily available or consistent. Other economic indicators and complex interactions within supply chains can make isolating the direct impact of price difficult.
• Ceteris Paribus Assumption: The calculation assumes "ceteris paribus" (all other things being equal), meaning only price and quantity supplied are changing. In reality, many other factors, such as changes in input costs, technology, or even consumer behavior, can influence supply simultaneously, making a direct correlation challenging to isolate.
• Global Supply Chain Complexity: Modern global value chains are highly interconnected and complex, involving multiple stages of production across different countries. This complexity can make the supply of many goods appear more inelastic in the short term than traditional models might suggest, as adjustments require coordination across a vast network. The OECD has discussed how efforts to localize or reshore supply chains, intended to build resilience, could potentially reduce global trade and GDP without necessarily increasing supply chain flexibility in all cases, highlighting the intricate nature of modern supply networks.¹, ², ³, ⁴, ⁵

Price Elasticity of Supply vs. Price Elasticity of Demand

Price elasticity of supply (PES) and price elasticity of demand (PED) are both critical concepts in economics, but they measure responsiveness from different perspectives within a market. The key distinction lies in whose behavior is being analyzed:

While PES examines how producers alter their output in response to price signals, PED analyzes how consumers alter their purchasing habits when prices fluctuate. Both elasticities are crucial for understanding how markets react to various economic events and for predicting changes in price and quantity within a market.

FAQs

What does it mean if supply is perfectly inelastic?

If supply is perfectly inelastic, it means that the quantity supplied does not change at all, regardless of any change in price. The price elasticity of supply (PES) in this case is 0. This typically occurs in the very short run or for unique goods where production cannot be increased, such as original artwork or fixed plots of land.

How does time affect price elasticity of supply?

Time is one of the most significant determinants of price elasticity of supply. In the short run, producers often have fixed capacities and limited ability to adjust output, making supply more inelastic. In the long run, however, producers have more time to expand or contract production facilities, acquire new technology, train more labor, or exit the market, making supply more elastic.

Can price elasticity of supply be negative?

No, the price elasticity of supply is typically positive. This reflects the law of supply, which states that as the price of a good or service increases, the quantity supplied generally increases, and vice versa. A negative PES would imply that producers supply less when prices rise, which is contrary to rational economic behavior for most goods.

Why is price elasticity of supply important for businesses?

Understanding price elasticity of supply helps businesses make strategic decisions regarding production levels, pricing, and inventory management. If a business knows its product has an elastic supply, it might be more inclined to increase production significantly in response to expected price increases. Conversely, for products with inelastic supply, the focus might be on maximizing efficiency or adjusting pricing strategies, recognizing that output cannot be easily scaled up or down.

How does the availability of inputs influence PES?

The availability and mobility of factors of production (inputs) directly impact price elasticity of supply. If a producer can easily acquire more raw materials, labor, or machinery to increase output, the supply will be more elastic. If inputs are scarce, specialized, or difficult to obtain quickly, supply will tend to be more inelastic. This also applies to the ability to substitute between different inputs or produce complementary goods.