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Price Elasticity of Supply

19 January, 2016 - 17:17

LEARNING OBJECTIVES

  1. Explain the concept of elasticity of supply and its calculation.
  2. Explain what it means for supply to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic.
  3. Explain why time is an important determinant of price elasticity of supply.
  4. Apply the concept of price elasticity of supply to the labor supply curve.

The elasticity measures encountered so far in this chapter all relate to the demand side of the market. It is also useful to know how responsive quantity supplied is to a change in price.

Suppose the demand for apartments rises. There will be a shortage of apartments at the old level of apartment rents and pressure on rents to rise. All other things unchanged, the more responsive the quantity of apartments supplied is to changes in monthly rents, the lower the increase in rent required to eliminate the shortage and to bring the market back to equilibrium. Conversely, if quantity supplied is less responsive to price changes, price will have to rise more to eliminate a shortage caused by an increase in demand.

This is illustrated in Figure 5.8. Suppose the rent for a typical apartment had been R0 and the quantity Q0 when the demand curve wasD1 and the supply curve was either S1 (a supply curve in which quantity supplied is less responsive to price changes) or S2 (a supply curve in which quantity supplied is more responsive to price changes). Note that with either supply curve, equilibrium price and quantity are initially the same. Now suppose that demand increases to D2, perhaps due to population growth. With supply curve S1, the price (rent in this case) will rise to R1 and the quantity of apartments will rise to Q1. If, however, the supply curve had been S2, the rent would only have to rise to R2 to bring the market back to equilibrium. In addition, the new equilibrium number of apartments would be higher at Q2. Supply curve S2 shows greater responsiveness of quantity supplied to price change than does supply curve S1.

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Figure 5.8 Increase in Apartment Rents Depends on How Responsive Supply Is 
 

The more responsive the supply of apartments is to changes in price (rent in this case), the less rents rise when the demand for apartments increases.

We measure the price elasticity of supply (eS) as the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged:

Table 5.7
eS = % change in quantity supplied% change in price
 

Because price and quantity supplied usually move in the same direction, the price elasticity of supply is usually positive. The larger the price elasticity of supply, the more responsive the firms that supply the good or service are to a price change.

Supply is price elastic if the price elasticity of supply is greater than 1, unit price elastic if it is equal to 1, and price inelastic if it is less than 1. A vertical supply curve, as shown in Panel (a) of Figure 5.9, is perfectly inelastic; its price elasticity of supply is zero. The supply of Beatles’ songs is perfectly inelastic because the band no longer exists. A horizontal supply curve, as shown in Panel (b) of Figure 5.9, is perfectly elastic; its price elasticity of supply is infinite. It means that suppliers are willing to supply any amount at a certain price.

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Figure 5.9 Supply Curves and Their Price Elasticities 
 

The supply curve in Panel (a) is perfectly inelastic. In Panel (b), the supply curve is perfectly elastic.