How Does Price Elasticity Affect Supply?

What Is Price Elasticity of Supply?

Price elasticity of supply is the responsiveness of a supply of a good or service after a change in its market price. According to basic economic theory, the supply of a good will increase when its price rises. Conversely, the supply of a good will decrease when its price decreases. This happens because producers want to take advantage of a rise in price, so they increase production of their goods and services until demand is exceeded—at which time prices begin to fall. Producers then decrease output to match the price decline.

Goods and services can be either elastic or inelastic. Elastic means the product is considered sensitive to price changes—luxury goods and non-necessary items fall into this category. Inelastic means the product is not sensitive to price movements—food and gas are examples of inelastic supply goods.

Key Takeaways

  • Price elasticity of supply indicates how quickly producers shift production levels in response to price changes.
  • Economic theory predicts that when prices rise, producers will want to increase the quantity supplied to sell more at higher prices.
  • If producers cannot cope with increasing demand, prices may continue to rise as quantity cannot keep up.

Formula and Calculating Price Elasticity of Supply

To find an item's PES, you need to know the percent change in quantity supplied and the percent change in its price.

PES = % CS ÷ % CP where: PES = Price elasticity of supply CS = Change in supply CP = Change in price \begin{aligned}&\text{PES} = \% \text{CS} \div \% \text{CP}\\&\textbf{where:}\\&\text{PES}=\text{Price elasticity of supply}\\&\text{CS}=\text{Change in supply}\\&\text{CP}=\text{Change in price}\end{aligned} ?PES=%CS÷%CPwhere:PES=Price elasticity of supplyCS=Change in supplyCP=Change in price?

So, imagine you have a farm that can produce and deliver 500 bushels of corn per quarter. The price for one bushel in the first quarter was $157.56. In the second quarter, one bushel was $159.25, and your farm produced and delivered 505 bushels.

First, determine the percent change in price:

  • $159.25 - $157.56 = 1.69
  • 1.69 ÷ $157.56 = 0.0107
  • 0.0107 x 100 = 1.07%

Then, the percent change in supply:

  • 505 - 500 = 5
  • 5 ÷ 500 = 0.01
  • 0.01 x 100 = 1.0%

Use the formula to calculate price elasticity:

1.0% ÷ 1.07% = 0.000107

A result of 0.0001 shows that your farm's corn price elasticity of supply is very low or inelastic. But if your farm produced 525 bushels in the second quarter, the elasticity would change:

  • 525 - 500 = 25
  • 25 ÷ 500 = 0.05, or 5%
  • 1.0% ÷ 5% = 0.2
  • Elasticity of Supply Possibilities

    Price elasticity of supply has five possibilities:

    • Perfectly elastic: The result is an infinite number
    • Elastic: The result is less than one
    • Unitary: The result equals one
    • Inelastic: The result is greater than one
    • Perfectly inelastic: The result is equal to zero.

    So, if the corn from your farm has a price elasticity of supply equal to 0.2, it is elastic.

    Perfectly Elastic Supply

    The PES for perfectly elastic supply is infinite, where the quantity supplied is unlimited at a given price, but no quantity can be supplied at any other price. There are virtually no real-life examples of this, where even a small change in price would dissuade or disallow product makers from supplying even a single product.

    Image by Sabrina Jiang ? Investopedia?2020

    Elastic Supply

    A price elasticity supply greater than one means supply is relatively elastic, where the quantity supplied changes by a larger percentage than the price change. An example would be a product that’s easy to make and distribute, such as a fidget spinner. The resources to make additional spinners are readily available, and the total cost would be minimal to ramp production up or down.

    Image by Sabrina Jiang ? Investopedia?2020

    Unitary Elastic Supply

    Unitary Elasticity Supply has a PES of one, where the quantity supplied changes by the same percentage as the price change.

    Image by Sabrina Jiang ? Investopedia?2020

    Inelastic Supply

    The PES for relatively inelastic supply is between zero and one. That means the percentage change in quantity supplied changes by a lower percentage than the percentage of price change. An inelastic example is nuclear power, which has a long lead time given the construction, technical know-how, and long ramp-up process for plants.

    Image by Sabrina Jiang ? Investopedia?2020

    Perfectly Inelastic Supply

    Perfectly inelastic supply is when the PES formula equals zero. That is, there is no change in quantity supplied when the price changes. Examples include products that have limited quantities, such as land or a painting from deceased artists. The amount of gold on earth, for instance, is finite, as is the number of bitcoins ever to be mined. As a result, at some point, there cannot be an increase in supply regardless of price.

    Image by Sabrina Jiang ? Investopedia?2020

    Price Elasticity of Supply vs. Demand

    Price elasticity of supply refers to how responsive supply is to price changes—price elasticity of demand (PED) refers to how responsive demand is to price changes.

    While price elasticity of supply is related to producer behavior, where producers increase and decrease supply due to price, price elasticity of demand is related to consumer behavior. The theory behind PED is that the higher prices rise, the less demand there will be from consumers.

    What Does Elasticity of Prices Mean?

    Elasticity of prices refers to how much supply and/or demand for a good changes as its price changes. Highly elastic goods see their supply or demand change rapidly with relatively small price changes.

    Why Do Suppliers Increase Production When Prices Rise?

    Rising prices often signal that demand is outpacing supply for a given product, meaning that the market could absorb more supply. Moreover, firms can profit by selling more goods at relatively higher prices, at least until the newly available supply leads prices to fall back down.

    What Does Perfectly Inelastic Mean?

    When a good has zero elasticity, it is called "perfectly" inelastic. This means the product's supply and/or demand will not change, even as its price changes. Raw materials that are scarce or consumer staples that are needed for basic survival are often cited as examples of near-perfectly inelastic goods.

    The Bottom Line

    Companies hope to keep their price elasticity of supply high to remain nimble should the price of their products shift. That is, they want to be able to capture more profit should prices rise or trim production should prices fall. To help boost PES, companies can do several things.

    These include improving the technology used, such as upgrading equipment and software to improve efficiency. Improved capacity and capacity on hand also boost PES, including boosting the stock on hand and expanding storage space and systems. Beyond that, improving how products are shipped and distributed can help. PES can also be increased by ensuring products can last long while stored.

Article Sources
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  1. Burke, Paul J., and Ashani Abayasekara. "The Price Elasticity of Electricity Demand in the United States: A Three-Dimensional Analysis."?The Energy Journal, vol. 39, no. 2, 2018, pp. 123-146.

  2. Grimes, Arthur, and Andrew Aitken. "Housing Supply, Land Costs and Price Adjustment."?Real Estate Economics, vol. 38, no. 2, 2010, pp. 325-353.

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