4.3: Price Elasticity of Supply

Learning Objective

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 4.8. Suppose the rent for a typical apartment had been R₀ and the quantity Q₀ when the demand curve was D₁ 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.

 

Figure 4.8 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 (e_S) 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:

Equation 4.3

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 4.9, 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 4.9, is perfectly elastic; its price elasticity of supply is infinite. It means that suppliers are willing to supply any amount at a certain price.

 

Figure 4.9 Supply Curves and Their Price Elasticities The supply curve in Panel (a) is perfectly inelastic. In Panel (b), the supply curve is perfectly elastic.

 

Time: An Important Determinant of the Elasticity of Supply

Time plays a very important role in the determination of the price elasticity of supply. Look again at the effect of rent increases on the supply of apartments. Suppose apartment rents in a city rise. If we are looking at a supply curve of apartments over a period of a few months, the rent increase is likely to induce apartment owners to rent out a relatively small number of additional apartments. With the higher rents, apartment owners may be more vigorous in reducing their vacancy rates, and, indeed, with more people looking for apartments to rent, this should be fairly easy to accomplish. Attics and basements are easy to renovate and rent out as additional units. In a short period of time, however, the supply response is likely to be fairly modest, implying that the price elasticity of supply is fairly low. A supply curve corresponding to a short period of time would look like S₁ in Figure 5.10. It is during such periods that there may be calls for rent controls.

If the period of time under consideration is a few years rather than a few months, the supply curve is likely to be much more price elastic. Over time, buildings can be converted from other uses and new apartment complexes can be built. A supply curve corresponding to a longer period of time would look like S₂ in Figure 4.8.

Elasticity of Labor Supply: A Special Application

The concept of price elasticity of supply can be applied to labor to show how the quantity of labor supplied responds to changes in wages or salaries. What makes this case interesting is that it has sometimes been found that the measured elasticity is negative, that is, that an increase in the wage rate is associated with a reduction in the quantity of labor supplied.

In most cases, labor supply curves have their normal upward slope: higher wages induce people to work more. For them, having the additional income from working more is preferable to having more leisure time. However, wage increases may lead some people in very highly paid jobs to cut back on the number of hours they work because their incomes are already high and they would rather have more time for leisure activities. In this case, the labor supply curve would have a negative slope.