Price Elasticity of Supply

A Primer on the Price Elasticity of Supply

Koenigsegg CCXR Trevita
Consider the demand for the world's most expensive automobile, the ​Koenigsegg CCXR Trevita ($4.8 million). What do you think might happen if the manufacturer raised the price to $5.2M or lowered it to $4.4M?. Courtesy Koenigsegg

This is the third article in this series on the economic concept of elasticity. The first, A Beginner's Guide to Elasticity: Price Elasticity of Demand, explains the basic concept of elasticity and illustrates it using price elasticity of demand as an example. The second article in the series, as the title explains, considers Income Elasticity of Demand.  

A brief review of the concept of elasticity and of price elasticity of demand appears in the section immediately following.

In the section following that income elasticity of demand is also reviewed.  In the final section, price elasticity of supply is explained and its formula given in the context of the discussion and reviews in the previous sections.

A Brief Review of Elasticity in Economics

Consider the demand for a certain good -- aspirin, for example. What happens to the demand for one manufacturer's aspirin product when that manufacturer -- which we'll call manufacturer X --  raises the price? Keeping that question in mind, consider a different situation: the demand for the world's most expensive new automobile, the Koenigsegg CCXR Trevita. Its reported retail price is $4.8 million. What do you think might happen if the manufacturer raised the price to $5.2M or lowered it to $4.4M? 

Now, return to the question of the demand for manufacturer X's aspirin product following an increase in the retail price. If you guessed that the demand for X's aspirin might decline substantially, you'd be right.

It makes sense, because, first, every manufacturer's aspirin product is essentially the same as another's -- there's no health advantage whatsoever in selecting one manufacturer's product over another. Second, the product is widely available from a number of other manufacturer's -- the consumer always has a number available choices.

So, when a consumer selects an aspirin product, one of the few things that distinguish manufacturer X's product from others is that it costs a little more. So why would the consumer choose X? Well, some might continue to buy aspirin X out of habit or brand loyalty, but many very probably would not.

Now, let's return to the Koenigsegg CCXR, which currently costs $4.8M, and think about what might happen if the price went up or down a few hundred thousand. If you thought it might not change the demand for the car by that much, you're right again. Why? Well, first of all, anyone in the market for a multi-million dollar automobile is not a price shopper. Someone who has money enough to consider the purchase is unlikely to be concerned about price. They're concerned primarily about the car, which is unique. So the second reason why the demand might not change much with price is that, really, if you want that particular driving experience, there's no alternative.

How would you state these two situations in more formal economic terms? Aspirin has a high price elasticity of demand, meaning that small changes in price have greater demand consequences. The Koenigsegg CCXR Trevita has a low elasticity of demand, meaning that changing the price doesn't greatly change buyer demand.

 Another way of stating the same thing a little more generally is that when the demand for the product has a percentage change that's less than the percentage change in the product's price, the demand is said to be inelastic. When the percentage increase or decrease in demand is greater than the percentage increase in price, the demand is said to be elastic.  

The formula for price elasticity of demand, which is explained in a little more detail in the first article in this series, is

Price Elasticity of Demand (PEoD) = (% Change in Quantity Demanded/ (% Change in Price)

A Review of Income Elasticity of Demand

The second article in this series,"Income Elasticity of Demand," considers the effect on demand of a different variable, this time consumer income. What happens to consumer demand when consumer income drops?

The article explains that what happens to consumer demand for a product when consumer income drops depends upon the product. If the product is a necessity -- water, for instance -- when consumer income drops they will continue to use water -- perhaps a little more carefully -- but they'll probably cut back on other purchases. To generalize this idea slightly, consumer demand for essential products will be relatively inelastic with respect to changes in consumer income, but elastic for products that are not essential. The formula for this is

Income Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Income)

Price Elasticity of Supply

The price elasticity of supply (PEoS) is used to see how sensitive the supply of a good is to a price change. The higher the price elasticity, the more sensitive producers and sellers are to price changes. A very high price elasticity suggests that when the price of a good goes up, sellers will supply a great deal less of the good and when the price of that good goes down, sellers will supply a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on supply.

The formula for price elasticity of supply is

PEoS = (% Change in Quantity Supplied)/(% Change in Price)

As with the elasticity of other variables

  • If PEoS > 1 then Supply is Price Elastic (Supply is sensitive to price changes)
  • If PEoS = 1 then Supply is Unit Elastic
  • If PEoS < 1 then Supply is Price Inelastic (Supply is not sensitive to price changes)

Incidentally, we always ignore the negative sign when analyzing price elasticity, so PEoS is always positive.