Suppliers make a profit by selling goods and services at higher prices than their cost to produce. How much of a profit suppliers make is determined by the cost of the factors of production to produce the product and on the suppliers' efficiency in producing the product. Since higher prices make it easier to earn a profit, and since the amount of profit is also dependent on the quantity sold, if increased demand raises prices, then suppliers will respond by increasing their supply, since that will allow them to earn a higher profit. Of course, this is merely the law of supply, but it does not state how much supply will change when prices change. The elasticity of supply measures the percentage change in the quantity of supply compared to the percentage change in a supply determinant. Although the elasticity of supply can be measured against several supply determinants, the most important is the price. The price elasticity of supply measures the percentage change in supply quantity compared to the percentage change in the price, which, in turn, determines the change in total revenue.
|Price Elasticity of Supply||=||Quantity Change Percentage|
Price Change Percentage
There is a wide variation in the price elasticity of supply, which depends not only on the product or service, but also whether the price change occurs in a short time or over a long time. If the supply changes little with a change in price, then supplies are considered inelastic. Supply is elastic if there are large changes in supply for a small change in price. If the percentage change in price is equal, though opposite, to the percentage change in quantity, then the supplies considered unit elastic.
For instance, the supply of land is generally inelastic, because, as Will Rogers once quipped, they're not making any more of the stuff. By contrast, the supply of software is almost perfectly elastic since it costs very little to make and distribute copies of software.
Graphs of Perfectly Elastic and Perfectly Inelastic Supply
Perfectly Elastic Supply (Graph #1):
Perfectly Inelastic Supply (Graph #2):
|If supply elasticity||< 1||then supply is||inelastic|
|= 1||unit elastic|
The price elasticity of supply varies over the supply curve for most goods or services, because production often involves several different methods of increasing the supply. For instance, when the price increases, suppliers can increase the use of their available resources and they can hire more labor over the short term. Suppliers may also be able to shift resources from the less profitable to the more profitable products. However, if the price continues to rise, then suppliers would have to make major investments to greatly increase supply, so the price elasticity of supply is elastic at first, when suppliers can put idled resources to work, then becomes inelastic over the short term as prices continue to rise, not only because suppliers would have to make major investments, but it would take time for new suppliers to enter the market. Likewise, if prices fall, suppliers can idle resources and lay off their workers, but suppliers will tend to maintain a certain amount of supply to cover fixed costs. However, as prices continue to drop, then eventually suppliers will sell their factors of production, or suppliers will leave the industry to find better opportunities elsewhere.
For example, if a farmer brings a truckload of watermelons to the farmers market, then he will try to sell all the watermelons, regardless of the price; otherwise, the watermelons will perish. On the other hand, even if the price is very high, the farmer has no way of supplying more watermelons right away.
Over the short run, supply tends to be in inelastic, because of the limited options available to increase supply. Over the long-run, supply becomes more elastic, because suppliers can take actions that take more time to increase the supply, such as building new factories, or growing more of a certain crop on farmland.
How Prices Change With Demand Under Inelastic and Elastic Supply
Inelastic Supply (Graph #1):
Elastic Supply (Graph #2):