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IB Diploma Economics:
Price elasticity of Supply
Price elasticity of supply (PES)
Firms make a profit by selling goods and services at higher prices than their cost to produce. How much of a profit firms make is determined by the cost of the factors of production to produce the product and on firms' efficiencies in producing the product. Since higher prices make it easier to earn a profit, and since the amount of profit is also dependent on the quantity sold, if increased demand raises prices, then suppliers will respond by increasing their supply, since that will allow them to earn a higher profit. Of course, this is the law of supply, but it does not state how much supply will change when prices change. Elasticity of supply measures the percentage change in the quantity of supply compared to the percentage change in a supply determinant. Although the elasticity of supply can be measured against several supply determinants, the most important is the price. The price elasticity of supply measures the percentage change in supply quantity compared to the percentage change in the price, which, in turn, determines the change in total revenue.
Change in price, change in QS
The law of supply
Price elasticity of supply
Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes.
There is a positive relationship between price and quantity supplied – following the law of supply.
The law of supply states that, ceteris paribus, as the price of a good increases, so too does the quantity supplied, and as the price of a good decreases the quantity supplied will decrease.
Price elasticity of supply provides useful information as to how much the quantity supplied of a good will change in response to a change in price. For some goods a small price change can result in a relatively large change in the quantity supplied of a good – elastic supply. For other goods, a relatively large price change will not change the quantity supplied by that much – inelastic supply.
Price elasticity of supply is measured along the slope of the supply curve.
Calculating Price elasticity of supply
When changes in price and quantity supplied are given in percentages, then price elasticity of supply is calculated using the following formula:
If the price of good A decreases by 10%, the quantity supplied decreases by 8%.
PES = 8÷10 = 0.8
Essential statement: For the PES calculation we take absolute values. A price decrease of 10% should technically be -10, a negative number, because it is a decrease in price. However, because we assume that the law of supply holds true we can ignore the negative value. A price increase will lead to an increase (positive value) in quantity supplied; and a price decrease (negative value) will lead to a decrease (negative value) in quantity supplied.
Calculating Price elasticity from a supply curve
→ % change in price = [($6 - $4) ÷ $6] x 100 = 33.3%
→ % change in Qs= [(100 - 60) ÷ 100] x 100 = 40.0%
→ PES = 40.0 ÷ 33.3 = 1.2
If price and quantity supplied information is given in numeric terms, it is our strong recommendation that you convert this information into percentage terms and then do your PES calculation. There is another formula you can use, but, it is reasonably complex and remember that in the IB Economics exams you will not be provided with formulas. Do not waste mental energy memorising a complex formula! Here is how to calculate a percentage change:
The price of good A decreases from $10 to $9, and the quantity supplied decreases from 1000 units to 875.
→ % change in price = [($10 - $9) ÷ $10] x 100 = 10%
→ % change in Qs = [(1000 - 875) ÷ 1000] x 100 = 12.5%
→ PES = 12.5 ÷ 10 = 1.25
Interpreting the value of PES:
The range of values for price elasticity of supply is from zero (0) to infinity (∞), and the law of supply dictates that the PES value is always positive.
→ +/+ = positive
→ –/– = positive
The PES value provides us with information as to how much quantity supplied of a good will change relative to a price change. For example, if PES = 1.2, then the percentage change in quantity supplied is larger than the percentage change in price; and if PES = 0.8, then the percentage change in QS is less than the percentage change in price.
Inelastic supply (PES<1)
The supply curve cuts the horizontal quantity axis. With price inelastic supply, the change in quantity supplied is proportionally smaller than the change in price – supply is relatively unresponsive to price. For example, a price increase of 10% will only increase the quantity supplied by 5%, or a price decrease of 15% will only decrease the quantity supplied by 10%.
For example it takes approximately three months to build the world’s largest passenger aeroplane – the Airbus A380. For the company to increase the supply of this plane, they would need to build new factory space or entire new factories, employ and train new employees, purchase new robotics and other capital equipment, etc. The quantity of Airbus 380s supplied cannot be increased by much in response to price changes, no matter how large the price increase is and profitable this may be to the company. It would take years for the company to significantly ramp up production and increase the supply of this plane.
Unit elastic supply (PES = 1)
The supply curve cuts the origin (where price and quantity equal zero). With unit price elastic supply, the change in quantity supplied is equal to the change in price – supply is responsive to price. For example, a price increase of 10% will increase the quantity supplied by 10%, or a price decrease of 15% will decrease the quantity supplied by 15%.
An example would be a bakery where related products are easily substituted in the production process. Thus, if the price of apple pies increase and become relatively more profitable, the supply of apple pies can easily be increased by baking more apple pies and fewer of the now relatively less profitable blueberry pies.
Perfectly inelastic supply (PES=0)
The supply curve is vertical. With perfectly inelastic supply, the change in quantity supplied is zero (0) when there is a change in price – supply is completely unresponsive to price. For example, a price increase of 10% will not affect the quantity supplied to the market, neither too would a price decrease of 15% which would result in a 0% change in the quantity supplied.
Perfectly inelastic supply is a short-term phenomenon. For example, the supply of quickly perishable goods such as a seasonal fruit. Watermelons are too heavy to import and too large to store in refrigerated warehouses. It takes growers time to increase the size of the watermelon crop in response to price changes, and it does not make financial sense to dump the crop once it is ready for market – receiving $1.00 a kg is better than receiving $0.00 a kg for the existing watermelon crop. Supply of watermelons is unchanged in the short-term.
Elastic supply (PES>1)
The supply curve cuts the vertical price axis. With price elastic supply, the change in quantity supplied is proportionally larger than the change in price – supply is relatively responsive to price. For example, a price increase of 10% will increase the quantity supplied by 20%, or a price decrease of 15% will decrease the quantity supplied by 25%.
For example, supply would be price elastic where a firm had stockpiles. Oil, which is typically has price inelastic supply because it usually take a long time to find new oil reserves and then develop them, has become increasingly price elastic. In 2017 the world was producing an extra one million barrels of oil a day than it was consuming. Many of the world’s largest oil producers were building up large reserves of oil which they could then bring quickly to market – i.e., increase the quantity of supply relatively quickly to increases in the price of oil.
Perfectly elastic supply (PES = ∞)
The supply curve is horizontal. With perfectly inelastic supply, the change in quantity supplied is infinite when there is a change in price – supply is infinitely responsive to price. For example, a very small price increase will lead to a very large increase in the quantity supplied.
The key for perfectly elastic supply is that the good has a large number of very, very, very close (as in perfect) substitutes-in-production readily available. Any quantity of the good can be produced at the same production cost and price because the productive resources can be easily (as in perfectly) switched back and forth between other goods. A hypothetical example of perfectly elastic supply comes with a generic cheese sandwich, such as that sold by Manny Mustard and thousands of others. The production cost of combining labour, kitchen utensils, mayonnaise, cheese, and bread are one dollar per sandwich. This cost is the same for one sandwich or one billion sandwiches. There is no increasing opportunity cost. There are no economies of scale.
As such, the supply of generic cheese sandwiches is perfectly elastic. If buyers pay a buck each, one dollar, they get as many generic cheese sandwiches as they want. If buyers should lower the price they offer for generic cheese sandwiches by an infinitesimally small amount, then sellers do not supply any generic cheese sandwiches. If buyers should raise the price they offer for generic cheese sandwiches by an infinitesimally small amount, then sellers supply an infinitely large amount. Of course, buyers have no reason to offer a lower price because they can buy all that they want at the existing price.
PES varies along the supply curve
The PES value varies along the length of the supply curve, just like PED varied along the length of the demand curve. Thus, it is only possible to make PES comparisons at the point where two or more supply curves intersect (see figure, above). At the point of intersection, it is the ‘flatter’ supply curve that is more price elastic at that particular price.
The determinants of price elasticity of supply
Length of time
This is probably the most important factor in determining the responsiveness of supply to changes in price. In the short-term, firms may be unable to change the factor inputs it uses in the production process to change the quantity of the good that it produces.
Watermelons are too heavy to import and too large to store in refrigerated warehouses. It takes growers time to increase the size of the watermelon crop in response to price changes, and it does not make financial sense to dump the crop once it is ready for market – receiving $1.00 a kg is better than receiving $0.00 a kg for the existing watermelon crop. Supply of watermelons is relatively unchanged in the short-term.
However, in the long-term the supply of watermelons can be increased relatively easily. In response to price increases farmers will convert more farmland into watermelon production (perhaps replacing a planned sweetcorn crop with an additional watermelon crop), purchase new farmland to grow watermelons, hire and train extra labour, and invest in new capital goods and machinery to help produce the increased crop. Over time, the watermelon supply curve will move from S1 to S2 and then to S3.
The key point is that over time, the ability of firms to respond to price changes becomes much greater, because they have time to adjust their factor inputs.
Spare capacity of firms
Excess capacity: exists when the current levels of demand are less than the full capacity output of a business – also known as spare capacity.
Full capacity: when a business produces at maximum output.
Capacity shortage: when the demand for a business’s products exceeds production capacity.
A firm will be operating at full capacity when all of the firm’s capital and labour are being used – i.e., there is no idle plant or equipment, and all staff are fully employed. When firms are operating at full capacity then it will have relatively price inelastic supply. To increase production additional capital investment is required and additional labour must be recruited, and trained for new and/or expanded production lines. This takes time and costs money. It will take a relatively large price to substantially increase output.
However, firms operating with excess capacity will have relatively price elastic demand. Output can be increased using the same factors of production and the firm will be more responsive to increases in the price of a good it produces. Relatively small increases in price can be met quickly with additional output up to the point where the firm then is operating at full capacity.
If there is a capacity shortage, then firms will need significant time to invest in the capital expansion of the business and the additional human capital that will be required.
Mobility of factors of production
To be able to increase output, firms must obtain more resources to use in the production of that good. The more easily and quickly resources can be shifted from the production of one good to the production of the other, the faster firms can increase or decrease supply. For example, when unemployment in an economy is high there is an excess of skilled labour which firms can immediately utilise in their production processes. Whereas when unemployment is low, skilled workers are hard to come by and firms must invest time and money in recruiting, training and developing the extra employees required to increased production. Labour laws can be an important variable in determining how price elastic the supply of a good may be. If it is quick, easy and relatively inexpensive for firms to terminate employment contracts (e.g., the United States) then firms can reduce output more easily than when labour laws make sacking workers a lengthy and costly process (e.g., Italy).
Often firms will run multiple production lines to produce a range of different goods. It may be relatively easy to quickly shift resources (e.g., labour) out of one line of production and into another if the price of that good increases. For example, Proctor & Gamble the world’s largest consumer goods company (by sales) produces different brands of shampoo (e.g., Herbal Essences® and Pantene®), and will use the same factories to do so. If the price of a premium brand shampoo increases, resources from other lines of less profitable shampoos can be used to meet the additional output required to maximise the firm’s total revenues and/or profitable.
Ability to store stocks
Stocks are goods and components that are held in storage. 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.
Supply will be the most price elastic when:
Low PES for primary commodities than Manufactured products
Regarding supply, primary commodity products are more price inelastic and manufactured goods are more price elastic. This is due, in large part, because of the time required for primary producers to respond to price changes. For example, agricultural goods such as corn and soybeans require at least a growing season to increase the supply of a particular crop. Thus, if the price of corn increases as demand increases, it takes at least a year before farmers can produce the extra output needed to meet that increased demand and eliminate the temporary shortage in the market.
Often there is limited land available for increased agricultural use and a limited supply of labour with increasing urbanisation around the world. Many countries are now highly aware of the environmental degradation that often occurs with the expansion of farmland. Rainforest being cleared in Indonesia to increase the production of palm oil and rivers in New Zealand being polluted through dairy farm runoff. Many countries will have
increasingly strict rules and regulations around agricultural production.
It takes time and money to develop the irrigation infrastructure (canals and piping) and capital investment in the machinery and software required to deliver efficient irrigation.
If land availability is increasingly scarce, new technologies are required to increase crop yields. And the development of new agricultural technologies, such as the genetic modification of rice strains, takes time.
Other primary commodities such as oil, gas and minerals (e.g., copper and iron ore) requires much time to explore and develop new fields and mines. And, because of the huge costs involved, firms in these industries will not respond quickly to price increases and it will take a sustained increase in prices for new investments that increase output to take place.
PROGRESS CHECK - TEST YOUR UNDERSTANDING BY COMPLETING THE ACTIVITIES BELOW
You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Economics requirements for the Microeconomics: 1.8 Price Elasticity of Supply topic.