Introduction

In the previous article we discussed the price elasticity of demand; what it is, what factors determine the price elasticity of demand for a good, and why it is important for firms to understand to price elasticities of the demand curve for their goods.

In this article, we will discuss the price elasticity of supply. In this article, where we refer to a good we also mean a service.

What is price elasticity of supply and how is it measured?

The price elasticity of supply is the responsiveness of quantity supplied to a change in price.

When price goes up, quantity supplied also goes up. However, the amount by which quantity supplied rises when prices rise depends on the individual supply curve for each good and for each firm; this is known as its price elasticity.

Price elasticity of supply is measured between two pricing points on a supply curve, and differences in elasticities are shown on the two supply curves below - S1 and S2.

On the supply curve with a steeper incline (S1) a change in price has a smaller effect on the quantity supplied than the curve with a shallow incline (S2). We say that, in relative terms, S1 is more price inelastic and S2 is more price elastic.

The way we determine whether demand for a good is price elastic or price inelastic in absolute terms between two points is as follows:

1. Elastic - the supply for a good is price elastic if the quantity supplied moves proportionately more to a change in price in percentage terms. For example, if the price for a good increases by 1%, but the quantity supplied increase by 5%, we say it is price elastic;
2. Inelastic - the supply for a good is price inelastic if the quantity supplied moves proportionately less to a change in price in percentage terms. For example, if the price for a good increases by 1%, but the quantity supplied decreases by 0.5%, we say it is price inelastic;
3. Unit elasticity - the supply for a good is unit elastic if the quantity supplied moves proportionately the same to a change in price in percentage terms.

Determinants of Price Elasticity of Supply

We discussed the determinants of supply in our article on suppy. These determine the position of the supply curve, as well as its shape (steep, shallow, curved, straight etc).

Certain determinants of supply have a greater impact on price elasticity than others:

1. Costs of supply - if the costs of supply increase exponentially as quantity supplied increases, there is less incentive to supply more, even at higher prices. As such, the supply curve will be steeper, and less price elastic.
2. Barriers to supply / entry - there may be certain barriers to supply / entry, such as regulation. For example, planning permission is needed to build houses. The more barriers to supply that there are, the less price elastic it will be; firms may not be able to increase supply significantly even if there is an increase in demand (and therefore prices);
3. Spare capacity - are all resources being used to produce goods/services, or do firms have additional resources (factors of production) that they could use to increase production? The more spare capacity the firms producing a good have, the more price elastic the supply curve for that good will be – firms will be able to produce more in response to an increase in demand (and therefore increase in price);
4. Time - time plays a large factor in the elasticity of supply. It may be hard to produce more in the short-run, even if demand and prices increase, due to limited production capability. In the longer run, the ability to produce more may increase as firms respond to the increased demand and opportunities.

Have a look at the other determinants of supply and think about how they could affect the price elasticity of supply: whether supply will increase a lot or a little due to an increase in price.

Why is price elasticity of supply important?

For an economy

For an economy, understanding the price elasticity of supply of certain goods can be important from a macroeconomic standpoint. For example, understanding the price elasticity of supply for residential housing or other essential goods, such as fuel.

If the supply of such goods is inelastic but there is forecast to be an ever increasing demand, this could result in disproportionate increases in price versus amount supplied over time, resulting in high inflation. We discuss inflation in later articles, but for now it suffices to say that too high inflation is bad because it erodes the purchasing power of participants within an economy, making them less well off.

Governments may therefore try to take steps to increase the supply of particular goods (pushing the supply curve outwards) and increase their elasticity overall.

For a firm

Up to now we have drawn supply curves as straight. However, in reality, they are likely to be curved. A supply curve’s steepness or shallowness (i.e. their price elasticity) will vary at different price points. Further, supply curves for each firm, even for the same good, will differ from the market average and from other firms.

This is because, in reality, the perfect market assumption does not apply and different factors affect different firms. For example, a larger factory that produces bread may have more spare capacity than a smaller bakery due to the types of machine in use.

It is important for a firm to understand what its own supply curve looks like - including where it sits on the Price and Quantity axes and whether it is price elastic or inelastic between certain points - and how this compares to the market average and direct competitors. This will impact how well a firm can respond to an increase in demand, and whether it might win or lose market share. A firm can take appropriate strategic decisions based on whether it forecasts an increase or decrease in demand.

We demonstrate this on figures 2 and 3 below. These show the supply curve for a firm, versus a market average firm supply curve. On the diagrams, we also plot a market average firm demand curve (however, in reality, the demand curve for each firm will differ as discussed).

In figures 2 and 3, the supply curves are elastic between P1 and P2 - quantity supplied increases proportionately more than the increase in price (caused by the increase in demand). The supply curves are inelastic between P2 and P3 - quantity supplied increases proportionately less than an increase in price.

In figure 2, the supply curve for the firm shown is less price elastic than the market average. If demand moves from D1 to D2 and D3, the market average prices move to P2 and P3 and quantity supplied to Q2 and Q3.

However, at P2 and P3, the firm shown can only supply less than market average. It also may not be able to increase prices to where the demand curve intersects that firm’s supply curve, because the market would undercut it. The firm may therefore lose market share.

In figure 3, the firm has a more price elastic supply curve than the market average. Accordingly, if demand moves from D1 to D2 and D3, the market average prices move to P2 and P3 and quantity supplied to Q2 and Q3.

At these prices, the firm shown could supply more than the market average. Alternatively, it could supply at the lower price point at which the demand curve intersects its own supply curve, thereby undercutting the market. By taking either of these options, the firm could increase its market share.

Noting the above, if a firm is forecasting an overall increase in demand, it may want to take steps to push its own supply curve out and make it more elastic so it can take advantage of future opportunities.

A practical example

The price elasticity of supply can be a difficult concept to understand, so it might be useful to discuss an example.

Assume that a law firm has made significant cuts during a recession, more so than the market average. This would shift its supply curve inwards and could make it less elastic (because the firm would have less spare capacity). If there is later an increase in demand during an upturn, it may not be able to respond to that increased demand as well as other firms. If this is the case, it may lose market share.

Alternatively, if a firm takes steps to ensure it has appropriate spare capacity and ensure its supply curve remains elastic (such as by cutting other costs and keeping key staff, or developing strong partnerships with temp firms), it may be able to respond better to an increase in demand during a market upturn and increase its market share.

A word of warning, however. Firms may not always be able to ensure they have a large amount of spare capacity in the long run, since this could drain profits. For example, wages of staff will still need to be paid. However, if staff are under utilised because they are surplus to requirements, they may not generate sufficient revenue to cover costs.

The above is a simplistic example, assuming that everything apart from the supply curve is the same for each firm. A firm’s demand curve may be different to the market, even for the same or a very similar good. Further, the specific factors affecting firms may differ.

However, even in this simplistic example, it is clear to see that a firm must understand what its own supply curve looks like (including its position on the Price and Quantity axes and its elasticity) and how this compares to the market average and its direct competitors. This will allow it to take strategic decisions based on forecasted changes in demand to ensure it remains competitive within the market. These strategic decisions can be complex and nuanced.

Conclusion

We now understand the concept of price elasticity of supply including how it is measured, the factors that affect it, and why it may be important for economies and firms to understand.

In summary:

• Price elasticity of supply is the responsiveness of quantity supplied to a change in price (which will increase or decreased due to changes in demand);
• If supply is price inelastic, a change in price will result in a proportionately smaller change in quantity supplied. If supply is price elastic, a change in price will result in a proportionately larger change in quality supplied. If supply is unit elastic, a change in price will have proportionately the same impact on quantity supplied;
• The determinants of supply impact price elasticity, including 1) costs of supply; 2) barriers to entry / supply; 3) spare capacity; and 4) time (amongst others);
• A firm with greater elasticity of supply compared to market average could increase its market share in the event of an increase in demand. Firms will make nuanced decisions based on what they forecast for demand.

Think about the goods that you use every day and assess their price elasticity of supply by reference to the determinants of supply.

Also think about how the supply curve for the same good may differ between firms, including where the supply curve may sit relative to other firms on the Price and Quantity axes, and whether the supply curve is likely to be more elastic and inelastic in one firm over another.

Think about the reasons for your conclusions.