PRICE ELASTICITY OF SUPPLY |
Definition: Law of supply tells us that producers will respond to a price drop by producing less, but it does not tell us how much less. The degree of sensitivity of producers to a change in price is measured by the concept of price elasticity of supply. Price elasticity formula: Es = percentage change in Qs / percentage change in Price. If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qs = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qs, and Q2 = new Qs. Percentage change in P = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price, and P2 = New Price. Putting the two above equations together: Es = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} Because of the direct relationship between Qs and Price, the Es coefficient will always be a positive number. Examples: 1. If the price of Product A increased by 10%, the quantity supplied increases by 5%. Then the coefficient for price elasticity of the supply of Product A is: Es = percentage change in Qs / percentage change in Price = (5%) / (10%) = 0.5 2. If the quantity supplied of Product B has decreased from 1000 units to 200 units as price decreases from $4 to $2 per unit, the coefficient for Es is: Es = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} = {(1000 - 200) / 1/2(1000 + 200)} / {(4-2) / 1/2 (4+2)} = 2
Characteristics: Es approaches infinity, supply is perfectly elastic. Producers are very sensitive to price change. Es > 1, supply is elastic. Producers are relatively responsive to price changes. Es = 1, supply is unit elastic. Producers’ response and price change are in same proportion. Es < 1, supply is inelastic. Producers are relatively unresponsive to price changes. Es approaches 0, supply is perfectly inelastic. Producers are very insensitive to price change. It is impossible to judge elasticity of a supply curve by its flatness or steepness. Along a linear supply curve, its elasticity changes.
Determinant: 1. Time lag: How soon the cost of increasing production rises and the time elapsed since the price change influence the Es. The more rapidly the production cost rises and the less time elapses since a price change, the more inelastic the supply. The longer the time elapses, more adjustments can be made to the production process, the more elastic the supply. 2. Storage possibilities: Products that cannot be stored will have a less elastic supply. For example, produces usually have inelastic supply due to the limited shelf life of the vegetables and fruits. |