Price elasticity of supply

The price elasticity of supply (PES or E_s) 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.

Price elasticity of supply using the midpoint method.

The elasticity is represented in numerical form, and is defined as the percentage change in the quantity supplied divided by the percentage change in price.

When the elasticity is less than one, the supply of the good can be described as inelastic; when it is greater than one, the supply can be described as elastic.[1] An elasticity of zero indicates that quantity supplied does not respond to a price change: the good is "fixed" in supply. Such goods often have no labor component or are not produced, limiting the short run prospects of expansion. If the elasticity is exactly one, the good is said to be unit-elastic.

The quantity of goods supplied can, in the short term, be different from the amount produced, as manufacturers will have stocks which they can build up or run down.

Factors

Availability of raw materials

For example, availability may cap the amount of gold that can be produced in a country regardless of price. Likewise, the price of Van Gogh paintings is unlikely to affect their supply.[2]

Length and complexity of production

Much depends on the complexity of the production process. Textile production is relatively simple. The labour is largely unskilled and production facilities are little more than buildings – no special structures are needed. Thus the PES for textiles is elastic. On the other hand, the PES for specific types of motor vehicles is relatively inelastic. Auto manufacture is a multi-stage process that requires specialized equipment, skilled labour, a large suppliers network and large R&D costs.[3]

Mobility of factors

If the factors of production are easily available and if a producer producing one good can switch their resources and put it towards the creation of a product in demand, then it can be said that the PES is relatively elastic. The inverse applies to this, to make it relatively inelastic.

Time to respond

The more time a producer has to respond to price changes the more elastic the supply.[2][3] Supply is normally more elastic in the long run than in the short run for produced goods, since it is generally assumed that in the long run all factors of production can be utilised to increase supply, whereas in the short run only labor can be increased, and even then, changes may be prohibitively costly.[1] For example, a cotton farmer cannot immediately (i.e. in the short run) respond to an increase in the price of soybeans because of the time it would take to procure the necessary land.

Inventories

A producer who has a supply of goods or available storage capacity can quickly increase supply to market.

Spare or excess production capacity

A producer who has unused capacity can (and will) quickly respond to price changes in his market assuming that variable factors are readily available.[1] The existence of spare capacity within a firm, would be indicative of more proportionate response in quantity supplied to changes in price (hence suggesting price elasticity). It indicates that the producer would be able to utilise spare factor markets (factors of production) at its disposal and hence respond to changes in demand to match with supply. The greater the extent of spare production capacity, the quicker suppliers can respond to price changes and hence the more price elastic the good/service would be.

Various research methods are used to calculate price elasticities in real life, including analysis of historic sales data, both public and private, and use of present-day surveys of customers' preferences to build up test markets capable of modelling elasticity such changes. Alternatively, conjoint analysis (a ranking of users' preferences which can then be statistically analysed) may be used.[4]

Elasticity versus slope

The elasticity of supply will generally vary along the curve, even if supply is linear so the slope is constant.[1] This is because the slope measures the absolute increase in quantity for an absolute increase in price, but the elasticity measures the percentage change. This also means that the slope depends on the units of measurement and will change if the units change (e.g., dollars per pound versus dollars per ounce) while the elasticity is a simple number, independent of the units (e.g., 1.2). This is a major advantage of elasticities.

The slope of the supply curve is dP/dQ, while the elasticity is (dQ/dP)(P/Q). Thus, a supply curve with steeper slope (bigger dP/dQ and thus smaller dQ/dP) is less elastic, for given P and Q. Along a linear supply curve such as Q = a + b P the slope is constant (at 1/b) but the elasticity is b(P/Q), so the elasticity rises with greater P both from the direct effect and the increase in Q(P).

Another special feature of the linear supply curve arises because its elasticity can also be written as bP/(a + bP), which is less than 1 if a < 0 and greater than 1 if a > 0. Linear supply curves which cut through the positive part of the price axis and have zero quantity supplied if the price is too low (P < -a/b) have a < 0 and hence they always have elastic supply.[5] Curves which cut through the positive part of the quantity axis and have positive quantity supplied (Q = a) even if the price is zero have a > 0 and hence always have inelastic supply. Curves which go through the origin have a = 0 and hence have an elasticity of 1.

Short run and long run

Since firms typically have a limited capacity for production, the elasticity of supply tends to be high at low levels of quantity supplied and low at high levels of quantity supplied. At low levels of quantity supplied, firms typically have substantial capacity available for use, so small increases in price make it profitable for firms to begin to use this idle capacity. Thus, the responsiveness of quantity supplied to changes in price is high in this region of the supply curve. However, as capacity becomes fully utilized, increasing production requires additional investment in capital (for example, plant and equipment). Since the price must rise substantially to cover this additional expense, supply becomes less elastic at high levels of output.

Selected supply elasticities

• Heating Oil: 1.58 (Short run) [6]
• Gasoline: 1.61 (Short run) [6]
• Tobacco: 7.0 (Long run) [6]
• Housing: 1.6–3.7 (Long run) [6]
• Cotton
  • 0.3 (Short run) [7]
  • 1.0 (Long run) [7]
• Steel: 1.2 (Long run, from Minimills) [8]
• Land: 0, except when land reclamation is taking place

See also

• Price elasticity of demand
• Cross elasticity of demand

Notes

1. Png, Ivan (1999). pp. 129–32.
2. Parkin; Powell; Matthews (2002). p.84.
3. Samuelson; Nordhaus (2001).
4. Png, Ivan (1999). pp. 79–80.
5. Research and Education Association (1995). pp. 595–97.
6. Png (1999), p.110
7. Suits, Daniel B. in Adams (1990), p. 19, 23. Based on 1966 USDA estimates of cotton production costs among US growers.
8. Barnett and Crandall in Duetsch (1993), p.152

References

• Adams, Walter (1990). The Structure of Indian Industry (8th ed.). MacMillan Publishing Company. ISBN 0-02-300771-0.
• Case, K; Fair, R (1999). Principles of Economics (5th ed.).
• Duetsch, Larry L. (1993). Industry Studies. Englewood Cliffs, NJ: Prentice Hall. ISBN 0-13-454778-0.
• Parkin, Michal; Powell, Melanie; Matthews, Kent (2002). Economics. Harlow: Addison–Wesley. ISBN 0-273-65813-1.
• Png, Ivan (1999). Managerial Economics. Blackwell. ISBN 978-0-631-22516-4. Retrieved 28 February 2010.
• Research and Education Association, The Economics Problem Solver. REA 1995.
• Samuelson; Nordhaus (2001). Microeconomics (17th ed.). McGraw–Hill.
• O'Sullivan, Arthur; Sheffrin, Steven M. (2004). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 104. ISBN 0-13-063085-3.CS1 maint: location (link)