Price Elasticity of Supply (PES)

Understanding Price Elasticity of Supply (PES)

• The law of supply states an increase in price (ceteris paribus) will cause producers to increase the quantity supplied
• Price elasticity of supply (PES) measures how responsive the change in quantity supplied is to a change in price
• Different products have different supply responsiveness

Calculation of PES

• PES can be calculated using the formula:
  PES = % change in quantity supplied / % change in price
  OR
  PES = % Δ in QS / % Δ in P
• To calculate a % change:
  % Change = (new value − old value) / old value × 100

Avocados Worked Example

• Initial price of avocados was AU$ 0.90, later raising to AU$ 1.45
• Bewdley Farm Shop in Margaret River sought to increase profits by increasing quantity supplied
• Sales increased from 110 units to 120 units per week
• To calculate the percentage change in quantity supplied (% ΔQS):
  % ΔQS = (120 − 110) / 110 × 100 = 9.1%
• To calculate the percentage change in price (%ΔP):
  %ΔP = (1.45 − 0.90) / 0.90 x 100 = 61%
• Insert values into PES formula:
  PES = 9.1% / 61% = 0.15
• A PES value of 0.15 indicates that avocados are very price inelastic in supply
• Suppliers are unable to significantly increase supply with a significant increase in price most likely because of the time it takes to grow additional avocados

PES Values

• Ranging from 0 to infinity, PES values are classified as follows:
  • 0 = Perfectly Inelastic: Quantity Supplied is completely unresponsive to a change in Price, an example being a fixed number of seats in a theatre
  • Between 0 and 1 = Relatively Inelastic: The % change in Quantity Supplied is less than proportional to the % change in Price, e.g. agricultural products
  • Between 1 and ∞ = Relatively Elastic: The % change in Quantity Supplied is more than proportional to the % change in Price, e.g. t-shirts
  • ∞ = Perfectly Elastic: Any % change in Price will cause the % change in Quantity Supplied to fall to zero, but, supply is unlimited at a particular price

Determinants of PES

• Some products respond to price changes more than others
• Factors that determine responsiveness:
  • Mobility of the factors of production: If producers can quickly switch resources between products, the PES will be more elastic
  • The rate at which costs of production increase: If it costs more to produce each additional unit of output (marginal cost). If the rate of the marginal cost increase is low, the quantity supplied will be more elastic, if marginal costs rise quickly, then the quantity supplied will be more inelastic
  • Ability to store goods: Products easily stored have a higher PES (elastic) as producers can quickly increase the supply; An inability to store products results in lower PES (inelastic)
  • Spare capacity: Products will be elastic if prices increase for a product and there is a capacity to produce more in the factories that make them, if there is no spare capacity to increase production, it will be inelastic
  • Time period: Producers may find it harder to respond to an increase in prices in the short run because it takes longer to produce

PES of Primary Commodities & Manufactured Products

• The price elasticity of supply (PES) of primary commodities (agricultural products or raw materials) tends to be lower than that of manufactured products (washing machines, phones, cars etc) for several reasons
• To explain the reasons for the differences, apply the factors that determine the price elasticity of supply
• Inelastic factors of primary commodities:
  • If the price of a specific agricultural commodity increases, farmers cannot quickly switch to producing a different crop
  • The PES for primary commodities is typically lower
  • The production of primary commodities is often subject to inherent constraints, (e.g. longer production cycles)
  • The cost to produce one more unit of output is relatively high
  • Perishable agricultural have limited storage capabilities
  • This reduces the short-term supply responsiveness and contributes to a lower PES for primary commodities
  • Output is relatively labor or land intensive which places limits on the amount of spare production capacity leading to a low PES
  • The time period to grow or extract primary commodities is much longer than that required to manufacture products
• Elastic factors of manufactured goods:
  • There is generally more flexibility to switch production to alternative goods in response to price changes, leading to a higher PES
  • For example, a car manufacturer may be able to adjust its factors of production from producing family cars to sports models relatively easily
  • The PES for manufactured products is typically higher
  • The additional costs of supplying mass-produced manufactured products is generally lower as it is easy to add on extra units to production output
  • Manufactured products can be stored for longer periods without significant deterioration or spoilage - This allows firms to respond to price changes by adjusting the quantity supplied from existing stock
  • Output is often generated using machinery and so there is more capacity when producing manufactured products leading to a higher PES
  • Many products are manufactured in a relatively short time period