Economics Terms A-Z
Price Elasticity of Supply
The price elasticity of supply for an item A ηA measures how the quantity of the item supplied qA changes in response to a change in the item’s price pA
Price elasticity of supply is generally positive because firms are attracted to supply more (less) of an item as its price rises (falls). Precisely how sensitive supply is to changes in price depends on several factors, the most important of which is how long it takes sellers to adjust the amount of the item they can offer for sale. This is not just about the ability to ramp up production when more of the item is demanded, but also how feasible or costly it is for the seller to store items when demand falls. The more complex the production process, the greater the dependence of sellers (and hence their responsiveness to price changes) on other markets. In markets for physical goods and the local provision of services, public infrastructure is also a significant factor in the price elasticity of supply.
The supply curves for five standard theoretical cases are shown in the graph below. In the first case, the supply curve S1 starts at the origin (0,0), is linear and upward-sloping. This implies that any change in price is met with a proportional change in quantity supplied; the price elasticity of supply is unitary η1 = 1. If the item’s price increases by 10%, so too does its quantity supplied.
As with the price elasticity of demand there are two extreme cases for the price elasticity of supply: perfect elasticity and perfect inelasticity. The horizontal supply curve S2 represents perfectly price-elastic supply: the elasticity tends towards (positive) infinity η2 → ∞. In theory, this means that if its price increases above p2 an infinite amount of the item will be supplied; but if its price drops below p2 then none will be supplied. Clearly, this is unlikely to happen in practice, however in industries with flexible production and factor markets with spare capacity, the price elasticity of supply can be very high, one example being the market for coffee-to-go, where new entrants are very quick to take advantage of increased consumer willingness to pay and leave the market quickly when conditions deteriorate.
At the other extreme, the vertical supply curve S3 indicates that supply of the item is fixed at a quantity of q3, whatever its price: supply is perfectly price-inelastic η3 = 0. This is indeed the case, at least in the short-term, for items with longer, less flexible production processes because producers of such items are unable to react quickly to price changes. The remaining two cases are the supply curves S4 and S5, the former representing relatively price-inelastic supply 0 < η4 < 1 and the latter a price elasticity of supply greater than unity η5 > 1.
Economists distinguish between short-run and long-run supply curves due to the difference in their price elasticities. Supply is often assumed to be price-inelastic in the short run because the short run is defined by there being at least one fixed factor of production. In the long run all inputs are variable and therefore supply tends to be more price-elastic, reflected in a flatter supply curve.
The market for housing is a good example to gain an understanding of what can influence the price elasticity of supply. Using urban variation across the United States, Green, Malpezzi and Mayo uncover some key determinants of supply price elasticity in their article, “Metropolitan-specific estimates of the price elasticity of supply of housing, and their sources” (American Economic Review, 2005).
Good to know
The combination of price elasticity of demand and price elasticity of supply is what determines the respective sizes of consumer surplus and producer surplus in a market. In general, the less price-elastic demand (supply) is, the greater the consumer (producer) surplus. This is particularly relevant information when it comes to market interventions because it allows one to calculate which side of the market stands to gain most (or, more commonly, lose least) through a tax or other regulation on supply.
Consumer Surplus and Producer Surplus
Consumer surplus is the gain made by consumers when they purchase an item at the competitive market price rather than the (highest) price that they would have been willing to pay for it. Analogously, producer surplus is the gain made by producers when they sell an item at the market price rather than the (lowest) price that they would also have accepted for it.
A monopoly describes a market in which there is only one firm and it does not face any competition. A monopolist is a firm that offers a unique product or service without close substitutes and therefore does not have any competitors. This means that the monopolist faces the entire market demand and each customer interested in buying the product can choose whether to buy from the monopolist at the respective price or not to buy at all.
Price Elasticity of Demand
The price elasticity of demand for an item A ϵA measures how the quantity of the item demanded qA changes in response to a change in the item’s price pA