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Chapter 12: Price elasticity of supply (1.2)
Key concepts:
 Definition of price elasticity of supply
 Formula
 Range of values
 Diagrammatical illustration
 Determinants of price elasticity of supply
 Applications of price elasticity of supply
This chapter addresses the issue of suppliers’ ability and willingness to put a good on the market. The price
elasticity of supply looks at the responsiveness of supply to a change in demand – e.g. how quickly firms
can adjust supply to meet a change in demand.The measurement of this is the price elasticity of supply.
 Definition of price elasticity of supply
Compare the three goods in figure 12.1. Why would a supply curve be ‘steep’ or ‘shallow’? Try to fit the
correct good to each diagram; blank DVDs, the Olympic boxing finals and the supply of IB economics
hours in a public school (answer in footnote). 1 It is rather self-evident that the supply curves indicate the
willingness/ability of firms to increase output of a good within a given period of time.
Fig. 12.1 Supply curves for three goods
Good a
Good b
Pb($)
Good c
P ($)
P ($)
Sc
Sb
Sa
150
100
50
0
1
100
200
Q/t
100 150
Q/t
100
Q/t
The answers are: Figure a = blank DVDs, figure b = supply of IB economics, figure c = supply of
tickets to the Olympic boxing finals. You may still send me $5.
The diagram series above pretty much says it all. The price has increased by 50% in all three cases (from
$100 to $150) but the percentage increase in quantity supplied varies from 100% to zero. We have just
defined price elasticity of supply (PES); it is the relative increase in quantity supplied due to a relative
increase in price. The price elasticity of supply (PES) for Good a is 100/50; PES = 2: Good b is 50/50;
PES = 1.0. Good c is 0/50; PES = 0.
Definition: Price elasticity of supply (PES) The price elasticity of supply (PES) is a
measure of the responsiveness of firms in increasing the quantity supplied on the market due
to a change in price. The supply curve is upward sloping, i.e. PES will be positively
correlated to price, with few exceptions.
 Formula
By now you should recognise the formula methodology. The only difference between the formula for PES
and PED is that we replace Qd (quantity demanded) with Qs (quantity supplied).
(Rory; could you make this neat…somehow.)
PES =
Q1 – Q0
-------------------  100
Q0
% in Qs
-----------------------------  ----------------------------------% in price
P1 – P0
------------------  100
P0
 Range of values
Just as demand elasticity will have an endless range, so will supply elasticities. The main difference is that
elasticity of supply will not have a range of infinity to zero along a single curve. Yet the definition of what
is elastic remains the same.
Definition: range of PES values
A price elasticity of supply of less than 1 is called inelastic supply; PES that is equal to one is
unit elastic; PES that is higher than 1 is elastic.
PES < 1; inelastic
PES = 1; unit elastic
PES > 1; elastic
 Diagrammatical illustration
Supply curves Sa, Sb and Sc in figure 12.2 show the differences in price elasticities of supply for the three
goods. As in PED, the values of PES will vary along the curves, yet depending on whether the curve
intercepts the P-axis, Q-axis, or origin, there is a boundary to the values.
Fig. 12.2 PES for three goods
P(€)
PESa: 200%/50% = 4
Sa
Sb
Sc
PESb: 50%/50% = 1
60
+50%
40
PESc: 28.6%/50% = 0.57
10
30 40
+200%
60 70
+50%
90
Q/t
+28.6%
Any linear supply curve which starts on the P-axis will have a PES of more than one. A linear curve
starting at the origin will have a PES equal to 1 and in full logical consequence; a straight-line supply curve
originating from the Q-axis will have a PES of less than 1. Note that this rule is valid no matter what the
slope of a (linear) supply curve is. This is illustrated in figure 12.3, where the changes in quantity and price
have been marked out along the axis for comparison.
Fig. 12.3 PES for different axis-intercepts
P ($)
P ($)
S0
S1
P ($)
S2
S3
S4
S5
150
100
10 20 30
60
Q/t
20 30
50
75
Q/t
PES > 1; supply is elastic
%∆P = 50;
%∆QS = 100
PES = 1; supply is unitary
%∆P = 50;
%∆QS = 50
A straight-line supply
curve originating from
the P-axis will always
have a PES > 1, since
the percentage change in
quantity supplied will
always be larger than
the percentage change in
price.
A straight-line supply
curve originating
from the origin will
always have a PES =
1, since the
percentage change in
quantity supplied will
always be the same
as the percentage
change in price.
40 50
72
90
Q/t
PES < 1; supply is inelastic
%∆P = 50;
%∆QS = 25
A straight-line supply
curve originating from
the P-axis will always
have a PES < 1, since
the percentage change
in quantity supplied
will always be less
than the percentage
change in price.
(Smaller heading) A few extreme cases of PES
There are two extreme cases of price elasticity of supply. One is where the quantity supplied remains the
same no matter what the price, i.e. perfectly inelastic supply. The other case is when quantity supplied is
infinite at one specific price, i.e. perfectly elastic supply. In both cases, there is actually no correlation
between price and quantity supplied. Figure 12. 4 illustrates this.
Fig. 12.4 Extreme cases of PES
Perfectly elastic supply
Perfectly inelastic supply
P ($)
P ($)
8
8
PES = ∞
6
6
Sinfinite PES
PES = 0
4
4
2
2
0
0
2
Szero PES
4
6
8
Q/t
0
Q/t
0
2
4
6
8
Memory trick:
When supply is perfectly elastic, suppliers are able/willing to supply any amount at a price of $4, while a
change in price will have no effect on a good which has a perfectly inelastic supply curve. It bears
mentioning that while equivalent extreme forms of PED are most difficult to find in the real world, there
are several examples of both perfectly inelastic and perfectly elastic supply. A valid example of perfectly
inelastic supply would be concert tickets (***Chapter 15, “Born again in the USA”) and of perfectly elastic
supply the world supply curve for a good in an importing country (***Chapter 65, tariff diagram).
Outside the box: A special S-curve
I have taken care to use the term ‘straight-line’ or ‘linear’ supply curve in explaining
how the value of PES depending on where the curve originates. The reason is
illustrated in figure 12.4, where a curve with an increasing slope shows that point
values of PES along the curve change. Following section S1 through the tangential
points S2, S3, S4 to section S5, PES goes from infinity to zero. This shape of the supplycurve has relevance for the total output curve (= aggregate supply curve) in Section 2,
macro.
Figure 12.4 Changing PES values along a supply curve
P ($)
S4; PES <1
S5; PES = 0
S1;
S3;
PES =1
S2;
PES > 1
PES = ∞
Q/t
 Determinants of price elasticity of supply
The ability for producers to increase output is intimately hinged on the time span in question; the shorter
the time period, the lower the price elasticity of supply. The quantity supplied of fresh tomatoes is difficult
to increase in a two week period while a period of six months gives entirely different supply elasticity. So
would canned tomatoes – part of the time issue is whether a good is storable or not. (Recall that supply is
defined as the amount suppliers are willing and able to put to market, not the ‘quantity in existence ’.) It is
far quicker to furnish the market from a warehouse. Non-storable goods will render an inelastic supplycurve, an example of which would be frozen oysters. Fresh oysters are an excellent example of a good
which cannot be stored for any length of time. 2
This makes sense when one thinks about how the difficulties in increasing the supply would be alleviated
over time. Increasing the quantity of beef supplied per month is far more difficult that increasing the supply
over a two year period. The producers will have time to come up with better cross-breeding methods and
expand herds. All this would increase producers’/suppliers’ ability to increase the quantity supplied within
the time period. Figure 12.5 shows how supply would differ over time; immediate supply (Simmediate) would
be perfectly inelastic, supply in the short run (SSR) would be inelastic, supply in the long run (SLR) would
be elastic and supply in the very long run (SVLR) completely elastic. The diagram also serves as a reminder
of how the short run supply inelasticity of primary goods such as agricultural produce, iron ore, and oil
causes large price fluctuations.
2
I have observed some very strange market effects for goods which, when stored, increase in quality and
therfore price – such as Cuban cigars and Rioja wines. Somebody needs to do an extended essay on this.
Fig. 12.5 Time as a determinant of PES - supply of beef
P ($)
Simmediate
SSR
SLR
SVLR
Q/SR to VLR
Simmediate: The PES of beef in the immediate
term would be perfectly inelastic in a given
market.
SSR: Over longer time spans however,
increases in demand can more easily be met by
increased stocks of frozen meat.
SLR: In the long run, larger herds and
increased land use for cattle (another reallocation issue!) increases the PES.
SVLR: In the very long run, improved genetic
cattle strains resulting from crossbreeding and
genetic modification increase PES further.
In a similar vein, time is an issue for producers who are at the limits of output capacity. The availability of
excess capacity, say available machines, labour and factory space, will have a major impact on the ability
to increase supply within a given time frame. In the short run it can be difficult to get hold of scarce factors
and to expand the size of production plants. Over longer time-periods it is easier to plan and target output
by increasing bulk-buying of material and increasing the amount of capital used.
Closely related to the issue of the time involved in increasing quantity supplied within a given period, is the
ability (and cost!) incurred by producers in switching from the production of one good to another. A
producer substitute is a good which suppliers can switch to as an alternative – not to be confused with
consumer substitutes. The ease or difficulty any given supplier experiences in moving productive resources
from one good to another will be a major factor in determining supply elasticity. A common classroom
example is whiteboard pens and permanent markers being very close producer substitutes. Switching from
whiteboard pens to permanent markers3 would involve very little in the way of tool readjustment, machine
modifications, new material and knowledge and so forth. Supply would be very elastic. Switching from
compact cars to mid-sized cars is also fairly supply elastic.
Many primary goods such as iron ore, teak wood and agricultural goods will be highly inelastic, as the
ability to switch to such goods in the short run is very limited. The basic premise here is that once suppliers
have a large amount of resources sunk in a certain sector, the re-applicability of these resources is the key
to increasing supply of other goods. Just consider commodities such as iron and copper; if you have a
copper mine and demand for iron increases it’s going to be a bit difficult to switch production to iron. I
mean, you have a copper mine…
<Start: Applied economics>
APPLIED ECONOMICS; WE’RE ON A HIGHWAY TO HELL!4
One day Joe the math teacher came down to my office to ask me ‘what the heck I was doing’ in my IB1
class ‘and would I please stop doing it’. Apparently, I had made the claim that we would never run out of
oil. Ever. Joe wanted to take issue with this statement. I explained that I was not making any claim that oil
was ‘infinite’ as a resource but that market forces would make sure that as long as there was a need for oil,
there would be a supply. The stone-age did not end because we ran out of stones.
3
A favourite classroom prank known to all my people, incidentally.
Classic song by AC-DC.
4
What happened in November of 1973, was that OPEC – for political reasons – decreased supply. As
demand was highly inelastic in the short run the price of oil went from USD3 per barrel to short run
equilibrium of USD11 during 1974, a 260% increase in price. The next ‘oil crisis ’ in 1979/’80 was caused
primarily by the ripple-effects of negative expectations as the Iran-Iraq war broke out. The price rose even
further, but not the shock level of ‘73/’74 as the PED of oil had increased.
We have been running out of oil since my grandfather drove buses in St. Louis during the depression. We
have been running out of oil since the 2nd World War; since the 1960s; since the first and second oil crises
in ‘73/74 and ‘79/80…you get the picture. In 1940 there was an estimated 10 years of consumption left, in
1980 over 25 years, and in 2000 40 years! The real price of a barrel of oil in 2000 was the same as in 1920.
The Bronze Age did not end because we ran out of copper and tin.
This is a classic example of the ‘horse-shit theorem’. I read somewhere that had computers existed in the
mid 19th century, they would have predicted that by the end of the 21st century the world would be
covered in six feet of horse-shit. This is the danger of extrapolation; basing a prediction on past and current
facts/happenings. What has happened, of course, is that we have moved on to other forms of transportation.
Just like stones, horses, and the original Donkey Kong games, we have moved on. Yes, we are running out
of oil. We would run out of oil ultimately even if we only used 10 litres per year – that is the definition of
‘finite resource’. Yet the fact remains: Oil supply is not a question of physics but of economics. The
Iron Age did not end for a lack of iron.
We are not running out of oil for three reasons:
1.
The price and incentives function of supply and demand has made sure that when oil prices have
skyrocketed, there has been a major incentive to find new fields and to use the old fields more
efficiently by developing technology. The simple fact is that previously costly oil resources became
economically viable when the oil price rose. Enormous fields were found in the 1980s and 1990s;
As price increases, there is an incentive to find new fields and get oil out of previously noneconomically viable well/fields. These include the North Sea, Russia, Indonesia, Mexico, Canada,
Alaska, to name a few.
The high price of oil has also led to previously unprofitable shale oil deposits (oil locked in sand)
becoming increasingly interesting. Estimates of the amount of oil held in shale deposits in Canada
alone could increase total known reserves by 50% - the problem being that it is more expensive to
extract, about 30 USD per barrel rather than 8 – 15 in Alaska and Saudi Arabia. If the price of oil
increases enough, then it becomes economically viable to extract the shale oil. Estimates of total
reserves of shale oil would take care of the world’s TOTAL energy needs (at present rate of
consumption) for the next 5,000 years.
2.
‘Oil crisis’ never meant that there wasn’t enough oil, but that supply had fallen. Scarcity does not
mean ‘not enough oil’ but ‘dear oil’. As oil became expensive during the ‘70s and ‘80s oil crises, the
rationing function and substitution effects kicked in. The rationing effect meant that quantity
demanded fell and the substitution effect meant that people started to find substitutes and ways to
become less dependent on oil.
3.
The reasons outlined above have led to far greater efficiency in both the extraction and use of oil.
We are simply getting better in production and use. In 1973, 38% of the world’s oil came from the
Middle East – now it’s below 30%, in spite of a 25% increase in demand. Technology in oil
production means that when previously 20% of the oil in a field could be withdrawn we can now
withdraw over 30%. Estimates show that America’s 10 largest oil fields held over 60% of their oil
when the fields were closed down. These ‘known reserves’ increase by the year – the increase in
known reserves is about 900% since 1950 and by close to 50% since the mid ‘70s. The cost of
extracting the aforementioned shale oil in Canada has dropped from USD30 a barrel in the ‘70s to
less than USD12 a barrel in 2002. On the users side; cars have increased efficiency by over 50%
since mid-1970s, houses are better insulated and we have become much better at recycling plastics
and other materials which use oil in their production.
In summary; the supply of oil has been increasing monumentally while our demand, although increasing,
has become more elastic as we have started to seriously look at substitutes, such as natural gas and also
renewable resources such as geo-thermal energy, wind and solar power etc. Again, we started to look for
substitutes as soon as renewable energy options became competitive with oil. 35 years after the first oil
crisis, the price of oil was marginally higher in 2000 than it was in 1973. The present Information Age will
not end because we run out of information.
Oil is not going to become scarce. It is going to become uninteresting.
During the 1980s and 1990s, demand for oil continued to rise and supply was able to not only keep up but
outstrip demand increases to the extent that the price of a barrel of oil dropped to the historic low of USD10
a barrel during 1997/98, when the real price of oil was the lowest ever.
Addendum to this edition: During the writing of this edition, a couple of colleagues were again sniggering
over the fact that this “Applied economics” box would have to be scrapped – or severely re-done. The
underlying reasoning was a mixture of “…we’ve passed ‘peak oil production’…oil prices are at a
permanently high level…”…etc. I continued to argue that there will always be enough oil – or in fact, too
much oil, given environmental issues – and that this ‘Applied economics’ box would be kept in all coming
editions until I was proven wrong. In February 2011, I looked at the diagram below. You tell me; is it time
to scrap this box?
Source:
http://tonto.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=EER_EPD2DC_PF4_Y05LA_DPG&f=
D
(Sources: Most of the figures and statistical data have been taken from a truly astounding book, The
Skeptical Environmentalist, Björn Lomborg, pages 118 – 138. Additional figures on shale deposits have
been taken from The Economist, There's oil in them thar sands! Jun 26th 2003.)
Highly theoretical question to keep you awake at night: Assume that we have 100 years’ consumption
of oil left – at the present consumption rate. Now, if we increase our consumption by 1% per year yet
manage to increase our efficiency in oil usage by 2% each year; how long before we run out of oil? Send
me some oil futures for the answer…no, it’s in the footnote below. 5
<End; Applied economics>
5
The answer is: Never! (But I’m still bribable. It’s the only thing I have in common with Mexican cops.)
 Applications of price elasticity of supply
Many primary goods such as iron ore, teak wood and agricultural goods will be highly inelastic, as the
ability to switch to such goods in the short run is very limited. The basic premise here is that once suppliers
have a large amount of resources sunk in a certain sector, the re-applicability of these resources is the key
to increasing supply of other goods. Just consider commodities such as iron and copper; if you have a
copper mine and demand for iron increases it’s going to be a bit difficult to switch production to iron. 6
Secondary goods tend to have higher price elasticity of supply than primary goods. The reasons are simply
that secondary goods can be stored, are often produced in industries with a degree of excess capacity, are
subject to technological advances in production and are increasingly global in span so that production is
close to relevant markets.
6
I mean, you have a copper mine…
Summary and revision (need a cool pic here….maybe a pic of someone doing push-ups!)
1.
Price elasticity of supply (PES) shows the responsiveness of producers to a change in price.
2.
The value of PES is given by the relative change in quantity supplied over the relative change in
price. The formula for PES is (Marcia; please cut in again.)
3.
The range of values for PES is
a. PES > 1; supply is elastic
b. PES < 1; supply is inelastic
c. PES = 1; supply is unit elastic
4.
Any linear supply curve with a P-axis intercept has a PES greater that 1; any linear curve
intercepting the origin is unit elastic; any linear supply curve intercepting the Q-axis will have a
PES value of less than 1 (inelastic).
P(€)
PESa: %∆P < %∆Qs – elastic supply
Sa
Sb
Sc
P1
PESb: %∆P = %∆Qs – unit elastic supply
+50%
P0
PESc: %∆P > %∆Qs – inelastic supply
Q/t
+200%
5.
+50%
+28.6%
Determinants of PES are the time span, the storability of the good, excess capacity of producers,
closeness of producer substitutes and the ease of attaining more factors of production within the
given time period.
S0: Immediate supply: non-storable, no excess capacity, no close
producer substitutes, no factor mobility.
P ($)
S1: SR, degree of storability, some excess capacity, some
producer substitutes, degree of factor mobility.
S0
S1
S2
S3
Q/SR to VLR
6.
S2: LR, storable good, considerable excess capacity, very close
producer substitutes, high factor mobility.
S3: VLR, perfectly storable, unlimited capacity, perfect producer
substitutes, perfect factor mobility.
Primary goods tend to have relatively low PES while secondary (and tertiary) goods tend to be
more elastic in supply.