Price elasticity of supply measures the responsiveness to the 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.
There’s also price elasticity of demand. This measures how responsive the quantity demanded is affected by a price change. Overall, price elasticity measures how much the supply or demand of a product changes based on a given change in price. Elastic means the product is considered sensitive to price changes. Inelastic means the product is not sensitive to price movements.
Price elasticity of supply = % Change in Supply / % Change in Price
- 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 in order to sell more at higher prices.
- If producers cannot cope with increasing demand, prices may continue to rise as quantity cannot keep up.
The Law of Supply
In a free market, producers compete with each other for profits. Since profits are never constant across time or across different goods, entrepreneurs shift resources and labor efforts towards those goods that are more profitable and away from goods that are less profitable. This causes an increase in the supply of highly valued goods and a decrease in supply for less-valued goods.
Economists refer to the tendency for price and quantity supplied to be related to the law of supply. To illustrate, suppose that consumers begin demanding more oranges and fewer apples. There are more dollars bidding for oranges and fewer for apples, which causes orange prices to rise and apple prices to drop. Producers of fruit, seeing the shift in demand, decide to grow more oranges and fewer apples because it can result in higher profits.
There are five types of price elasticity of supply, including perfectly and relatively inelastic, unit elastic, and perfectly, and relatively elastic. Here’s an example of each of the five price elasticity of supply curves:
Perfect Inelastic Supply
Perfect 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 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.
Relatively 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. Inelastic goods include nuclear power, which has a long lead time given the construction, technical know-how, and long ramp-up process for plants.
Unit Elastic Supply
Unit Elastic Supply has a PES of one, where quantity supplied changes by the same percentage as the price change.
Relatively 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.
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.
Price Elasticity and Its Determinants
How much will the supply of oranges increase or the supply of apples decrease? These answers depend on each fruit's price elasticity of supply. If oranges have a very high price elasticity of supply, then their supply increases dramatically. Apples, on the other hand, might have a lower price elasticity of demand, which means their supply won't drop as dramatically.
What exactly affects price elasticity. There are a number of factors, among them, the amount of capacity to increase or reduce the production of a product that the industry has. As well, the amount of current stock, inventory, or raw materials that the industry holds plays a part in elasticity. Beyond that, the amount of time it takes to produce a good and the labor and capital available affect the quantity supplied.
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 is often a signal that demand is outpacing supply for a given product, meaning that more supply could be absorbed by the market. 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 an elasticity of zero it is called "perfectly" inelastic. This means that the supply and/or demand of the product will not change at all 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 a number of 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. Making sure products can last long while stored also increases PES.