Price elasticity of supply

Imagine you have a firm that produces computers. Whenever there is a price increase for computers, you would increase the total quantity produced. Conversely, whenever there’s a price decrease, you would also decrease the supply. How quickly would you be able to increase or decrease the supply? What if you needed some more workers to help you produce more computers? By how much would the supply change and how would you measure it?

Price elasticity of supply helps answer all these questions. It enables you to understand how firms respond to a change in the price of a good or service.

What is price elasticity of supply?

To understand the meaning of price elasticity of supply, you have to understand the dynamics of the supply curve in a free market. In a free market, the quantity that a firm chooses to supply is determined by the price of its goods or services.

What happens to the quantity supplied when you have a price increase? A movement along the supply curve occurs where the firm increases the total output due to the incentive provided by the price increase. The law of supply states that firms will always choose to increase the total quantity supplied whenever there is a price increase and vice versa. How much will a firm decide to increase its production when there’s a price increase?

Price elasticity of supply measures how much the total quantity produced changes whenever there is a price change. That is to say, when there’s a price increase, the price elasticity of supply would measure by how much the firm increases its production. You also have the price elasticity of demand, which measures how much the quantity demanded changes in response to a price change.

You have different types of elasticity of supply, all of which measure how much quantity supplied is sensitive to the price change. For instance, you could have a relatively inelastic supply where there’s little to no change to the quantity supplied whenever there is a price change.

The price elasticity of supply formula

Price elasticity of supply is calculated as a percentage change in the quantity supplied divided by a percentage change in the price of a good.

The formula for the price elasticity of supply (PES) is:

$PES=\frac{\%\Delta Quantitysupplied}{\%\Delta Price}$

You can find a percentage change in a variable by using the following formula:

$\%\Delta =\frac{Newvalue-Oldvalue}{Oldvalue}*100\%$

This means that the quantity supplied is very sensitive to price changes. In this case, the price elasticity of supply is equal to 2, which means that a 1% change in price leads to a 2% change in quantity supplied.

Types of price elasticity of supply

There are factors that influence the elasticity of the supply curve, and because of these factors, we have different types of price elasticity of supply.

Perfectly elastic supply

Fig 1. - Perfectly elastic supply

Figure 1 shows the perfectly elastic supply curve. The price elasticity of a perfectly elastic supply curve is infinite. Firms supply an endless amount of products when there is a perfectly elastic supply. However, the slightest change in price would lead to no quantity being supplied. There are no real-life examples of perfectly elastic supplies.

Elastic supply

Fig 2. - Elastic supply

Figure 2 shows what an elastic supply curve looks like. An elastic supply occurs when the price elasticity of supply is greater than one. The quantity supplied changes by a greater proportion than the price change. This is very common in the real world, especially for products that are easily produced and don’t require much input.

Unit elastic supply

Fig 3. - Unit elastic supply

Figure 3 shows what a unit elastic supply curve looks like. A unit elastic supply occurs when the price elasticity of supply is equal to one. When there’s a unit elastic supply, you have proportional changes in output and prices. In other words, the quantity supplied changes by the same proportion as the price change.

Fig 4. - Inelastic supply

Figure 4 shows what the inelastic supply curve looks like. The inelastic supply curve occurs when the price elasticity of supply is smaller than one. The quantity supplied changes by a smaller proportion than the price change. This often occurs in industries where changes in production processes are hard to make in the short run as firms have difficulties adjusting to the price level quickly.

Fig 5. - Perfectly inelastic supply

Figure 5 shows the perfectly inelastic supply curve. Perfectly inelastic supply occurs when the price elasticity of supply equals zero. Regardless of how much the price changes, the quantity supplied will remain static. This happens in the real world. Think about a Picasso painting: no matter how much the price goes up, how many paintings from Picasso are out there?

Elasticity of supply and market equilibrium

The elasticity of supply is very important when it comes to demand shifts in the market. That is because it determines by how much the price and quantity of the good will change.

Fig 6. - Elasticity of supply and market equilibrium

Figure 6 shows two shifts in the demand curve. Diagram one shows a shift when the supply is price elastic. In this case, the quantity of goods has increased by a larger proportion than the price increase. That is because the supply was elastic, and it was easier for the firm to increase their total output produced quickly.

On the other hand, diagram 2 shows what happens when there’s a shift in the demand curve and the supply is inelastic. In this case, the price increases by a larger proportion than the quantity supplied. Think about it. The supply is inelastic, therefore, the firm has more limits in increasing its quantity supplied. Although the demand has increased, the firm could only increase its production by little to match the demand. Therefore, you have a proportionally smaller increase in the quantity supplied.

Determinants of price elasticity of supply

The price elasticity of supply measures the response of a firm in terms of quantity supplied whenever there is a price change. But what affects the degree to which the firm can respond to the change in price? There are factors that influence the degree and pace at which firms can adjust their quantity in response to a price change. Determinants of price elasticity of supply refer to factors that either make the supply curve more elastic or inelastic. The main determinants of price elasticity of supply are the following.

The length of the production period

This refers to how quick the production process is for producing a certain good. If the firm can quickly adjust its production process and produce output more quickly, it has a relatively more elastic supply curve. However, if the production process takes a lot of time and effort to change the quantity, the firm has then a relatively inelastic supply.

The availability of spare capacity

When the firm has spare capacity that it could use to produce output more quickly, the firm can easily adjust its quantity supplied to the price change. On the other hand, if a firm doesn’t have much spare capacity, it is harder to adjust output to the price change. This way, the availability of spare capacity can influence the elasticity of the supply curve.

The ease of accumulating stocks

When firms can store and keep their unsold goods, they can adjust to the price change quicker. Imagine there’s a sudden price drop; the capacity to store their unsold goods would make their supply more responsive to changes, as the firm could wait to sell its stock at the higher price later. However, if the firm doesn’t have such capacity as it might face high cost or other reasons, it has a more inelastic supply curve.

Ease of switching production

If firms are flexible in their production process, this will help them have a more elastic supply, meaning they can adjust much quicker to price changes.

Market entry barriers

If there are many barriers to entering the market, it causes the supply curve to become more inelastic. On the other hand, if the market entry barriers are low, the supply curve is more elastic.

Time scale

Time scale is the period that the firms need to adjust their production inputs. The elasticity of supply tends to be more elastic in the long run rather than the short run. The reason for that is firms have more time to change their inputs, such as buying new capital or hiring and training new labour.

In the short run, firms are faced with fixed inputs such as capital, which is hard to change in a short period of time. Firms then rely on variable inputs such as labour in the short run, which causes the supply curve to be more inelastic. All these contribute to the elasticity of the supply curve.