Revise Price elasticity of supply for Cambridge 2281 (2.8)

Price elasticity of supply (PES) measures the degree of responsiveness of the quantity supplied of a good or service to a change in its price. The formula is calculated as the percentage change in quantity supplied divided by the percentage change in price. Unlike price elasticity of demand, the PES value is always positive, reflecting the direct relationship outlined in the Law of Supply: as price increases, firms are willing and able to supply more. The resulting value indicates the nature of supply: a value greater than 1 signifies elastic supply, where firms are highly responsive. A value less than 1 indicates inelastic supply, where responsiveness is low. Special cases include perfectly inelastic supply (PES = 0), perfectly elastic supply (PES = infinity), and unitary elastic supply (PES = 1).

Several factors determine whether supply is price elastic or inelastic. The most significant is the time period. In the short run, at least one factor of production is fixed, constraining a firm's ability to increase output, thus making supply inelastic. In the long run, all factors are variable, allowing for greater adjustment and more elastic supply. The availability of spare capacity is also crucial; a firm with idle machinery and a flexible workforce can quickly raise production, leading to elastic supply. Furthermore, the mobility of factors of production plays a key role. If resources can be easily reallocated to produce a different good, supply will be more elastic. Finally, the ability to hold stocks (inventories) allows a firm to respond instantly to price rises by releasing goods, making supply highly elastic in the very short term.

The elasticity of supply can be visually interpreted from a supply curve diagram. For a linear supply curve, its point of origin is a key indicator. A supply curve that intercepts the vertical price axis is price elastic (PES > 1) at all points. Conversely, a supply curve that intercepts the horizontal quantity axis is price inelastic (PES < 1) at all points. A special case is a linear supply curve that passes through the origin, which has unitary price elasticity (PES = 1) along its entire length. The two extreme cases are a vertical supply curve, representing perfectly inelastic supply (PES = 0), where quantity supplied is fixed regardless of price (e.g., seats in a theatre). A horizontal supply curve represents perfectly elastic supply (PES = infinity), where any quantity will be supplied at one specific price.

Price elasticity of supply is critical in determining the incidence of an indirect tax—that is, who bears the greater burden. The burden of the tax falls more heavily on the side of the market that is less price elastic. If supply is price inelastic relative to demand, producers cannot easily reduce their output when the tax is imposed. As a result, they are forced to absorb a larger proportion of the tax, meaning their producer surplus is significantly reduced. If supply is price elastic relative to demand, producers can easily cut back production or switch to other markets. They can therefore pass a larger share of the tax burden onto consumers in the form of a higher price. This demonstrates a key principle: lack of responsiveness means bearing the burden.

PES = (ΔQ/Q) ÷ (ΔP/P) | PES > 1 elastic | PES < 1 inelastic | Tax incidence: inelastic side pays more