Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
Price elasticity of supply is similar to elasticity of demand, but there are differences too. Let's explore them by looking at some real-life examples of elastic and inelastic supply.
Calculating Price Elasticity
Elasticity is simply a measure of how responsive the quantity demanded or supplied is to changes in price. The elasticity of demand is just common sense. When the price of normal products go down, we will buy more, and vice versa when the price goes up. The simple mathematical calculation is elasticity = % change in quantity demanded or supplied / % change in price. When the price drops by 5% and we buy 10% more, then demand is elastic, since 10% / 5% = 2.0. The key number here is 1.0. If the elasticity calculation is greater than 1.0, demand or supply is elastic. Below 1.0 and it is inelastic.
Let's meet Joan. She's the manager of a large bottling plant for one of the big cola companies. We are very flexible at this plant, she tells us. When people started living healthier lifestyles, there was a big change in demand for our products. Everyone wanted the no-cal version cola instead of regular. We were able to meet the change in demand quickly and easily by going to 75% no-cal cola here, instead of 50%. It was just a matter of switching to the no-cal syrup during our second shift. Our costs didn't go up at all. Soon the trucks full of no-cal were rumbling out to all of the grocery stores and vending machines in our region of the country. The corporate people raised the price a little, but they know it's a war selling cola in grocery stores with all of the competition, so they kept our price hike small. She then showed us a few numbers. When the quantity of no-cal we supplied went up by 25% and the price only went up 5%, that meant our supply elasticity was 25% / 5%, or 5.0. That is quite a bit more than 1.0, so the company economist said we have very elastic demand. We like to think we have healthier customers too.
Now let's pay a visit to Gus. Gus runs a chain of gas stations in a northern state. He goes on to tell us how supply works in his business. He says that the demand for gas at the pump is very seasonal. People love to travel in the summer. The road trip with the vehicle on the open highway, with the driver's elbow hanging out of one window and the dog's head hanging out another, is a common sight in the summer. We love the freedom of the open road. The demand curve for gas shifts outward every summer and, unless the supply curve shifts along with it, the price goes up. The problem is that we can't shift the supply curve very much. The refineries that we buy our gas from are already running at close to capacity anyway, so they can't supply us with much more gas, and the oil companies won't spend the millions to build new ones if it's just for seasonal demand, since the new refining capacity won't be needed in the winter months when people are snug in their homes instead of driving somewhere. So what happens in the summer is my supply of gas only goes up about 10%, while the demand shift raised the price 20%. So my elasticity of supply is 10% / 20% = 0.5, and since that is below 1.0, it's inelastic.
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So we see that elasticity of supply works a little differently than demand. The quantity change comes first, usually from a change in customer demand for the product. If the change is an increase, that will force the price to rise, unless the supply can increase enough to keep up and bring the price back down. If supply is elastic, like at Joan's bottling plant, it does. If supply is inelastic, like at the gas stations, the supply doesn't catch up quickly and the price of gas rises. So let's generalize as to why that happens. What are some key factors that determine the elasticity of supply?
Spare capacity: We saw that Joan can easily increase capacity at the bottling plant by switching products. The more of this that's available, the more elastic supply is.
High stock levels are available: Storing gasoline is a risky proposition. It can blow up on you, so there isn't a large amount of gasoline stored up, which contributes to supply inelasticity.
Short time frames for production and getting to market: This happens pretty quickly for Joan. Her plant produces thousands of bottles and cans per day. The cola trucks are always rolling. Short time frames make a product more elastic.
Our examples were focused on elasticity in the short run. Over the long run, as things change, the supply for all products becomes more elastic. If the big oil companies believe the demand for gas has increased permanently, they will do more fracking and drilling for oil. They will build out refinery capacity to turn the oil into gasoline and meet the demand. This process may take years, but it will happen as long as selling gasoline is profitable.
The price elasticity of supply is simply a measure of how responsive the quantity supplied is to changes in price. The calculation is elasticity = % change in quantity demanded or supplied / % change in price. When the change in quantity is greater than the change in price, the elasticity calculation is greater than 1.0 and supply is elastic; when it's less than 1.0, inelastic. Supply is more elastic when there is spare capacity, when high levels of stock are available, and when there are short time frames to produce and deliver the product. Supply will just about always be more elastic in the long run, as there is more time to increase production.
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