AS Markets & Market Systems

Price Elasticity of Supply

In this chapter we consider elasticity of supply. Students should understand how to calculate elasticity of supply and understand some of the factors that influence the elasticity of supply for different products.

Definition of price elasticity of supply

Price elasticity of supply measures the relationship between change in quantity supplied and a change in price.
If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.

The formula for price elasticity of supply is:

Percentage change in quantity supplied divided by the percentage change in price

• When Pes > 1, then supply is price elastic
• When Pes < 1, then supply is price inelastic
• When Pes = 0, supply is perfectly inelastic
• When Pes = infinity, supply is perfectly elastic following a change in demand

Factors that Affect Price Elasticity of Supply

(1) Spare production capacity

If there is plenty of spare capacity then a business should be able to increase its output without a rise in costs and therefore supply will be elastic in response to a change in demand. The supply of goods and services is often most elastic in a recession, when there is plenty of spare labour and capital resources available to step up output as the economy recovers.

(2) Stocks of finished products and components

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 quickly by supplying these stocks onto the market - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be inelastic in response to a change in demand.

(3) The ease and cost of factor substitution

If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily and quickly be switched

(4) Time period involved in the production process

Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets for example, the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the overall production yield.

Supply curves with different price elasticity of supply

 The non-linear supply curve

A non linear supply curve has a changing price elasticity of supply throughout its length. This is illustrated in the diagram below.

Useful applications of price elasticity of demand and supply

Elasticity of demand and supply is tested in virtually every area of the AS economics syllabus. The key is to understand the various factors that determine the responsiveness of consumers and producers to changes in price. The elasticity will affect the ways in which price and output will change in a market. And elasticity is also significant in determining some of the effects of changes in government policy when the state chooses to intervene in the price mechanism.

Some relevant issues that directly use elasticity of demand and supply include:

• Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market e.g. the effectiveness of the congestion charge in reducing road congestion; or the impact of higher duties on cigarettes on the demand for tobacco and associated externality effects
• Changes in the exchange rate: The impact of changes in the exchange rate on the demand for exports and imports
• Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly power can raise prices in markets to extract consumer surplus and turn it into extra profit (producer surplus)
• Government intervention in the market: The effects of the government introducing a minimum price (price floor) or maximum price (price ceiling) into a market

Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing scarce goods and services among competing uses and in determining how producers respond to the incentive of a higher market price.