Elasticity of supply

Elasticity of supply

Elasticity of Supply – Is the measure of the ease with which an industry can be expanded and of the behaviour of the marginal costs.

Price elasticity of supply

Price elasticity of supply is the measure of degree of responsiveness of supply due to change in price of commodity

$PES = \frac{\text{proportional change in amount supplied}}{\text{proportional change in price}}$

Interpretation of PES

1. PES = 0 (perfectly inelastic) This means there is no change in quantity supplied due to change in price

2. PES < 1 (inelastic) This means that the change in price is greater than the change in quantity supplied

3. PES = 1 (unitary) This means the amount of change in price is equal to the amount of change in quantity supplied

4. PES > 1 (elastic) This means that change in quantity supplied is more than change in price.

5. PES = ∞ (perfectly elastic) This means that there is no change in price but there is change in quantity supplied

Factors that influence P.E.S

1. Gestation Period If a commodity has a short gestation period its supply will be price elastic as supply can easily be increased in a shorter period of time. E.g. industrial goods, however if a commodity has a longer gestation period its supply will be price inelastic eg. Agricultural goods.

2. Degree of entry of new firms in the market If there is free entry of firms in the market eg. Under perfect competition supply would be price elastic. However if there are barriers to entry of new firms in the market. E.g. under monopoly supply would be price inelastic.

3. Ability to store stock For those commodities which can easily be stored their supply is price elastic, as supply can easily be increased from the existing stock. However for those goods that cannot easily be stored e.g. vegetables, their supply is price inelastic.

4. The existence of spare capacity If a firm is operating at full capacity, further increase in output will be more difficult and hence inelastic supply. However if a firm is operating below full capacity supply will be price elastic as more output can be produced by further utilizing the underutilized factor inputs.

5. Time In the short run supply would be price inelastic as some factor inputs will be fixed e.g. land, capital, and technology. However in the long run supply will be elastic as all factor inputs will be variable.

6. The level of technology With the use of advanced technology, supply will be price elastic as such technology is more efficient. However with the case of poor technology supply will be inelastic as such technology is less efficient.

7. Cost and availability of factors of production When the cost of production is low and there is adequate supply of factors of productions, supply will be price elastic. On the other hand when the cost of production is high and there is limited supply of factors of production, supply will be inelastic.

Cross elasticity of supply

It is the proportional (percentage) change in the supply for good x divided by the proportional (percentage) change in the price of good y

$CES = \frac{\text{percentage change in supply of good } x}{\text{percentage change in price of good } y}$

Where:

• $Q_X$ = Quantity supplied of good X
• $P_Y$ = Price of good Y
• $\Delta Q_X$ = Change in quantity supplied of X
• $\Delta P_Y$ = Change in price of Y

1. CES = +ve This means that the commodities in consideration are complements (jointly supplied) e.g., meat & hides. When the price of one increases, quantity supplied of the other also increases and vice versa

2. CES = -ve This means that the commodities in consideration are substitutes e.g. beans & peas, when the price of one increases, quantity of the other decreases and vice versa.

3. CES = 0 This means that the commodities in consideration are not related at all, therefore change in price of one causes no effect in quantity supplied of the other e.g. a car and a table.

Factors of elasticity of supply

1. Nature of commodity Those commodities which are durable can be kept for a long time and such commodities like wheat and cloth have a greater elasticity of supply. The commodities which are perishable in nature like fish and milk have less elastic supply.

2. Costs of production The commodities which have high costs of production have less elastic supply and vice versa. Those commodities which are produced in a short period of time have greater elasticity and vice versa.

3. Methods of production The commodities which can be produced with the help of simple methods of production have more elasticity and if the method of production is complicated, supply will be less elastic.

4. Laws of returns The commodities which are produced under the conditions of increasing returns have greater elasticity of supply and the commodities which are produced under the condition of diminishing returns have smaller elasticity of supply.

The equilibrium between demand and supply

This is when quantity demanded is equal to quantity supplied, therefore there is neither shortage nor surplus. When the demand and supply curve meet at that particular point, quantity DD is equal to quantity SS.

The point of intersection is the equilibrium point, consisting of the equilibrium quantity and price.

Px	Dx	Sx
1	500	100
2	400	200
3	300	300
4	200	400
5	100	500

Price 3 is the equilibrium price and quantity 300 is the equilibrium quantity

• The price above the equilibrium price supply increases but demand decreases and hence a surplus
• The price below the equilibrium price, supply decreases but demand increases and hence a shortage

The effect of changes in demand on equilibrium point, price and quantity

The effect of change in supply on equilibrium point, price and quantity

Demand and supply functions

The demand function is a mathematical relationship between demand and factors that determine demand.

$Q_d = f(P_x, TP, Y, P_r)$

Whereby,

• $P_x$ = Price of the commodity
• $TP$ = Taste and preference
• $Y$ = Income level of consumers
• $P_r$ = Price of related goods

Since price is the major factor that affects demand, the demand function can as well be shown using the price quantity relationship as below:

$Q_d = f(P)$

The supply function is a mathematical relationship between supply and the determinants of supply.

$Q_s = f(P_x, T, NP, P_r, GP)$

Whereby,

• $P_x$ = Price of the commodity
• $T$ = Time
• $NP$ = Number of producers
• $P_r$ = Price of related commodities
• $GP$ = Gestation period

Since price is the major factor that affects supply, the supply function can as well be given as

$Q_{ns} = f(P)$

Ways of price determination

1. Price mechanism Under this, the price of the market is determined by the free interaction of the forces of demand and supply and hence determined at the point where the demand and supply curve intersect or meet.

2. Sale auction The price is determined through bidding; therefore, it is determined by the highest bidder

3. Haggling This is through bargaining.

4. Resale price mechanism Under this the price of the product is determined by the producer. The price can as well be determined by the government and this can either be a maximum or minimum price.

5. Price ceiling (maximum price) This is the price which is set by the government below the equilibrium price, this is normally done during the period of shortage, when price of essential goods are excessively high. Therefore, it aims at protecting consumers against such excessively high price.

Effects of price ceiling

1. Demand will increase hence a shortage ($Q_1 - Q_2$)
2. Supply will decrease
3. Black market – sellers are going to sell products in order to create an artificial shortage
4. Corruption and favoritism – they will sell the product to those who are willing to buy

Advantages of price ceiling

1. It helps to control inflation
2. It reduces exploitation on the consumers
3. It allows consumers to easily access essential goods at affordable prices during periods of shortage
4. It helps the government to win more support

Disadvantages of price ceiling

1. Discourages producers
2. It is expensive to administer
3. It creates black market

Price floor (minimum price)

This is the price which is set by the government above the equilibrium price. It aims at motivating producers after realizing that the prevailing market price is low.

Effects of price floor

1. Supply increases
2. Demand decreases
3. Sellers will be tempted to decrease price in order to get rid of surplus
4. It helps to improve the standard of living of workers

Disadvantages of price floor

1. Over production
2. It results into cost-push inflation
3. It can cause unemployment
4. In case of minimum wage discourages investments