Price elasticity of supply
Key terms
Define each term.
Multiple choice
Circle the correct answer.
Which good is most likely to have the lowest price elasticity of supply in the short run?
Price rises by 20% and quantity supplied rises by 30%. PES is:
Housing supply in a major city is highly inelastic. A rise in demand from population growth will most likely:
Worked problems
Show your working.
Calculating and interpreting PES. The price of tomatoes rises from $2.00 to $2.50 per kilo. Quantity supplied rises from 8,000 to 9,200 kilos per week. Calculate PES, classify it, and state what would happen to the value if the same price rise were sustained for two years.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
Why inelastic supply concentrates the effect of a demand shock on price
- A Demand for a good rises, shifting the demand curve right.
- B Price begins to rise, rationing the available quantity among buyers.
- C The equilibrium price ends up substantially higher while equilibrium quantity is little changed, so producers of the existing output enjoy a windfall gain.
- D But supply is inelastic: capacity is fixed, stocks are exhausted and new production takes time, so quantity supplied rises only slightly.
- E Because quantity cannot adjust, the shortage is eliminated almost entirely by price rising rather than by output expanding.
- F At the original price, quantity demanded now exceeds quantity supplied, so a shortage appears.
- G Producers would like to supply more at the higher price, since it is more profitable.
Diagrams
Draw three supply curves on separate diagrams: one perfectly inelastic (vertical), one perfectly elastic (horizontal) and one relatively inelastic (steep). On each, show a rise in demand and mark the resulting change in price and quantity.
Draw two markets with the same rightward shift of demand: one with a steep, inelastic supply curve and one with a shallow, elastic supply curve. Mark the change in price and quantity in each. Then, on a third diagram, show a specific tax shifting supply upwards where supply is inelastic and demand elastic, and shade the producer and consumer shares of the tax.
Answers
Price elasticity of supply: A measure of the responsiveness of the quantity supplied of a good to a change in its price.
B. Increasing milk output requires expanding the herd, which takes years of breeding, so output cannot respond to a price rise in the short run. The other three can all raise output quickly, through spare capacity, released stock or additional labour respectively.
B. PES = 30 / 20 = 1.5, which exceeds 1 and is therefore elastic. The sign is positive because price and quantity supplied move in the same direction, unlike PED. Dividing the wrong way round gives 0.67 and is the commonest error.
B. Inelastic supply means quantity cannot respond much, since building takes years and land is constrained by planning rules and physical space. The demand increase is therefore absorbed almost entirely by price. This is why supply-side reforms to planning are argued to matter more for housing affordability than demand-side subsidies, which shift demand further right against the same inelastic supply.
Step 1. Calculate the percentage change in quantity supplied. Change = 9,200 - 8,000 = 1,200. Percentage change = (1,200 / 8,000) x 100 = 15%.
Step 2. Calculate the percentage change in price. Change = 2.50 - 2.00 = 0.50. Percentage change = (0.50 / 2.00) x 100 = 25%.
Step 3. Apply the formula. PES = 15 / 25 = 0.6.
Step 4. Classify the result. 0.6 lies between 0 and 1, so supply is price inelastic. Quantity supplied rose proportionately less than price, so growers could not fully exploit the higher price in the short run.
Step 5. Consider the longer period. Over two years growers can plant more, expand glasshouses and bring new land into production, so quantity would respond far more. PES would rise above 0.6 and probably above 1. Elasticity of supply is not a fixed property of a good; it depends on the time allowed for adjustment.
Always divide by the original value when computing percentage changes, and always state the classification rather than leaving a bare number. A calculation ending at 0.6 without the word inelastic usually loses the interpretation mark.
A, F, B, G, D, E, C
- Demand for a good rises, shifting the demand curve right.
- At the original price, quantity demanded now exceeds quantity supplied, so a shortage appears.
- Price begins to rise, rationing the available quantity among buyers.
- Producers would like to supply more at the higher price, since it is more profitable.
- But supply is inelastic: capacity is fixed, stocks are exhausted and new production takes time, so quantity supplied rises only slightly.
- Because quantity cannot adjust, the shortage is eliminated almost entirely by price rising rather than by output expanding.
- The equilibrium price ends up substantially higher while equilibrium quantity is little changed, so producers of the existing output enjoy a windfall gain.
Step 7 explains the distributional consequence, which is where evaluation marks sit. In markets with inelastic supply, such as urban land and housing, a demand increase transfers income to existing owners rather than generating additional output, which is the analytical basis for land value taxation.
The comparison is the point. With perfectly inelastic supply the entire increase in demand goes into price and none into quantity. With perfectly elastic supply it goes entirely into quantity and none into price. Real markets fall between, and where they fall determines whether a demand shock raises prices or output. This is the same reasoning used for tax incidence.
Keep the size of the demand shift identical across the first two diagrams so the comparison isolates the elasticity. On the tax diagram, the consumer share is the vertical distance from the old price up to the new price, and the producer share is the distance from the old price down to what the seller now receives after tax. Candidates routinely shade one and forget the other.