Price elasticity of supply (PES) measures the responsiveness of the supply of a good or service to changes in its price.
It refers to the responsiveness of suppliers to adjust the quantity of a good when its price changes.
- High elasticity means that supply is sensitive to changes in price.
- Low elasticity is the exact opposite.
An elastic supply means that suppliers are able to increase their output without constraints as to cost and time.
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On the other hand, an inelastic supply means that suppliers experience difficulty in changing production and output in a given time.
Given a longer period of time, suppliers can adjust their output in response to price change.
Therefore, we can say that elasticity of supply is said to be higher over longer periods of time than over short periods of time.
A supplier must ideally have a high degree of responsiveness to market conditions in general and fluctuations in prices in particular.
The higher the PES of a supplier the more competitive and profitable it becomes compared to its rivals.
Price Elasticity of Supply's Factors
Firms resort to different methods to increase their supply elasticity and responsiveness to market conditions.
These include:
- Adopting the latest technology
- Maintaining sufficient inventory
- Improving distribution channels
- Enhancing productivity of workers
- Ensuring spare capacity
- Improving storage systems
These factors significantly influence the price of the consumer goods and services, therefore the supply elasticity is affected.
PES Formula
Economists use a price elasticity of supply formula to determine the price elasticity of supply.
The basic equation used is:
To arrive at the percentage changes in both quantity and price, the difference of the new price (or quantity) is divided by the difference of the old price (or quantity), as follows:
Unfortunately, this PES formula may cause a potential bias when determining the price elasticity.
That's because an upward shift in price (or quantity) by a particular unit produces a different result from a downward shift in price (or quantity) by the same unit.
For example, a change in price from $20 to $25 creates a percentage change in price of $5/$25 = 20%.
However, a drop in price from $25 to $20 will give a percentage change of $5/$20 = 25%.
Midpoint Formula of Price Elasticity
To address this issue, economists use a revised formula called the midpoint formula of price elasticity.
As you may notice, this formula is very similar to the midpoint formula that we use to find the income elasticity of demand.
- Old QS represents the initial value of the quantity supplied
- New QS represents the final value of the quantity supplied
- Old Price represents the initial price
- New Price represents the final price
The price elasticity of supply is always positive when this modified formula is used, similar to the slope of a supply curve.
This eliminates the problem that we faced when used the first formula.
Price Elasticity of Supply
- If Supply Elasticity < 1, supply is considered inelastic
- If Supply Elasticity = 1, supply is considered unit elastic
- If Supply Elasticity > 1, supply is considered elastic
Example #1 - Using the PES Formula
Now let's take a look at an example so you can see how easy it is to calculate the price elasticity of supply.
For example, a particular product was selling at a price of $10 per unit. Because of some changes in the business environment, the manufacturer decides to increase the price to $12 per unit.
Assume that when the product price is $10, the quantity supplied is 200, and when the price is $12, the quantity supplied is reduced to 175.
- Question: Calculate the price elasticity of supply.
First of all, we need to calculate the percentage change in price and quantity supplied of this product.
After having the percentage change in price and quantity supplied, we simply plug these figures into the PES formula to calculate the supply elasticity of this product:
So in this example, the price elasticity of supply when the price increase from $10 to $12 is 0.625 (62.5%).
Example #2 - Using the Midpoint Formula
Now let's take a look at another example.
In this example, we will use the modified midpoint formula to calculate the supply price elasticity when the price change from $10 to $12.
We also assume that the quantity supplied decreased from 200 units to 175 units.
- Question: Calculate the price elasticity of supply.
For calculating the price elasticity, we simply use the midpoint formula given above:
Because the price elasticity of supply is 0.182 (18.2%), which is under 1.0 (or 100%), supplies in this case are considered inelastic.
