1.2.4 Price Elasticity of Supply (PES)

Syllabus Statement: Explain the concept of price elasticity of supply, understanding that it involves responsiveness of quantity supplied to a change in price, along a given supply curve Explain, using diagrams and PES values, the concepts of price elastic supply, price inelastic supply, unit elastic supply, perfectly elastic supply and perfectly inelastic supply

PRICE ELASTICITY OF SUPPLY (PES)

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PRICE ELASTICITY OF SUPPLY (PES): Measures the responsiveness of the quantity supplied of a good to a change in price

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• Inelastic Supply ( PES < 1 ) : Quantity supplied is relatively unresponsive to price

• Elastic Demand ( PES > 1 ) : Quantity supplied is relatively responsive to price

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Formula:

• As there is a Positive Causal Relationship between the price of a good and quantity supplied, the price elasticity of supply (PES) is a positive number:

• For any percentage increase in price (a positive denominator), there results a percentage increase in quantity supplied (a positive numerator), thus leading to a positive PES

• Similarly, for any percentage decrease in price (a negative denominator), there results a percentage decrease in quantity supplied (a negative numerator), also leading to a positive PES

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Example: Strawberries

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    Suppose the price of strawberries increases from $3 per kg to $3.50 per kg, and the quantity of

    strawberries supplied increases from 1000 to 1100 tonnes per season. Calculate the PES for

    strawberries.

    As the PES is 0.59 < 1, the supply of Strawberries is Inelastic

TYPES OF PRICE ELASTICITY OF SUPPLY (PES) 

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As the price elasticity of supply (PES) compares the percentage change in quantity supplied of a good to the percentage change in price, the PES can take a range of values with varying significance:

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SPECIAL CASES:

Syllabus Statement: Explain the determinants of PES, including time, mobility of factors of production, unused capacity and ability to store stocks

DETERMINANTS OF PRICE ELASTICITY OF SUPPLY (PES)

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DETERMINANTS OF PRICE ELASTICITY OF SUPPLY: Factors that affect the elasticity of a good or service

1) TIME PERIOD 

• In a short time period, producers have no time to adjust inputs to change the quantity of good supplied; hence, the supply for the good will be price inelastic

• In a long time period, producers have more time to adjust inputs to change the quantity of good supplied; hence, the supply for the good will be price elastic

2) MOBILITY OF FACTORS OF PRODUCTION 

• If a good is produced using mobile factors of production, producers can quickly shift resources and production between different products; hence, the supply for the good will be price elastic

• If a good is produced using immobile factors of production, producers cannot quickly shift resources and production between different products; hence, the supply for the good will be price inelastic

3) SPARE (UNUSED) CAPACITY OF FIRM

• Spare capacity refers to the availability of factors of production to produce additional units of a good (for example, factories or equipment may be idle for some hours each day)

• If a good is produced in spare capacity, producers have a surplus of resources to change the quantity of a good supplied; hence, the supply for the good will be price elastic

• If a good is produced in full capacity, producers have no surplus of resources to change the quantity of a good supplied; hence, the supply for the good will be price inelastic

4) ABILITY TO STORE STOCK

• Goods produced by a firm may be perishable or non-perishable

• If a good is perishable, producers cannot store stock of output and must supply all quantity available; hence, the supply for the good will be price inelastic

• If a good is non-perishable, producers can store stock of output and change the quantity of good supplied; hence, the supply for the good will be price elastic

Syllabus Statement: Explain why the PES for primary commodities is relatively low and the PES for manufactured products is relatively high

PRICE ELASTICITY OF SUPPLY (PES) OF PRIMARY COMMODITIES

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PRIMARY COMMODITIES: Goods arising directly from the use of natural resources or the factor of production ‘land’: this includes agricultural (food and non-edible products such as cotton), fishing, and forestry products, as well as products of extractive industries (oil, coal, and minerals)

The price elasticity of Supply (PES) of primary commodities is relatively low:

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• As primary commodities require a long period of time to be extracted and produced, producers cannot quickly change the quantity supplied

• For this reason, the supply for primary commodities is relatively unresponsive to price, with a change in price leading to a smaller percentage change in quantity supplied

• Hence, the supply for primary commodities is price inelastic

PRICE ELASTICITY OF SUPPLY (PES) OF MANUFACTURED PRODUCTS

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MANUFACTURED PRODUCTS: Processed goods arising from factors of production ‘capital’ and ‘labour’ using raw materials and intermediate inputs

The price elasticity of supply (PES) of manufactured products is relatively high:

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• As manufactured products are often produced in spare capacity using mobile factors of production - specifically labour and capital - producers can quickly adjust inputs to change quantity supplied

• For this reason, the supply for manufactured products is relatively responsive to price, with a change in price leading to a larger percentage change in quantity supplied

• Hence, the supply for manufactured products is price elastic

1.2.3 Income Elasticity of Demand (YED)

Syllabus Statement: Explain the concept of income elasticity of demand, understanding that it involves responsiveness of demand (and hence a shifting demand curve) to a change in income Show that normal goods have a positive value of YED and inferior goods have a negative value of YED

INCOME ELASTICITY OF DEMAND

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INCOME ELASTICITY OF DEMAND (YED): Measures the responsiveness of demand to change in income

The income elasticity of demand (YED) provides two pieces of information: 

1) Sign of YED: Positive (Normal Good) or Negative (Inferior Good) 

• Normal Good ( YED > 0 ) : Quantity demanded and income changes in the same direction

• Inferior Good ( YED < 0 ) : Quantity demanded and income changes in the opposite direction

2) Absolute Value of YED: Less than one (Necessities) or Greater than one (Luxuries) 

• Necessities ( YED < 1 ) : Quantity demanded is relatively unresponsive to income

• Luxuries ( YED > 1 ) : Quantity demanded is relatively responsive to income

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Formula:

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NOTE: Change in income refers to the change in consumer income

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INCOME ELASTICITY OF DEMAND (YED): NORMAL GOOD

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NORMAL GOOD: Good for which demand increases as consumer income increases (most goods are normal goods)

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• Normal Good ( YED > 0 ) : Quantity demanded and income changes in the same direction

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A good is normal if the income elasticity of demand (YED) is a positive value:

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• As the demand for a normal good varies directly with income, quantity demanded and income changes in the same direction:

• If consumer income increases, the quantity demanded of normal good increases; hence, a positive change in quantity demanded over a positive change in income will produce a positive value

• Alternatively, if consumer income decreases, the quantity demanded of normal good decreases; hence, a negative change in quantity demanded over a negative change in income will produce a positive value

• Thus, the income elasticity of demand (YED) of a Normal Good will be a positive value

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Example: Clothes

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    Suppose an individual’s income increases from $800 per month to $1000 per month, and their

    purchase of clothes increases from $100 to $140 during this period. Calculate the income elasticity

    of demand.

    As the value of YED is 0 < 1.6, Clothing is a Normal Good

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INCOME OF DEMAND (XED): INFERIOR GOODS

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INFERIOR GOOD: Good for which demand decreases as consumer income increases (example of inferior good includes bus rides, second-hand clothes, and used cars)

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• Inferior Good ( YED < 0 ) : Quantity demanded and income changes in the opposite direction

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A good is Inferior if the income elasticity of demand (YED) is a negative value:

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• As the demand for a normal good varies inversely with income, quantity demanded and income changes in the opposite direction:

• If consumer income increases, the quantity demanded of inferior good decreases; hence, a negative change in quantity demanded over a positive change in income will produce a negative value

• Alternatively, if consumer income decreases, the quantity demanded of inferior good increases; hence, a positive change in quantity demanded over a negative change in income will produce a negative value

• Thus, the income elasticity of demand (YED) of an Inferior Good will be a negative value

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Example: Cheese sandwiches

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    Suppose an individual’s income increases from $1000 per month to $1200 per month, and their

    purchase of cheese sandwiches decreases from 15 to 10 during this period. Calculate the income

    elasticity of demand.

    As the value of YED is 0 > - 1.65, Cheese Sandwiches are an Inferior Good

Syllabus Statement: Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods

INCOME ELASTICITY OF DEMAND (YED): NECESSITIES

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NECESSITIES: An essential good

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• Necessities ( YED < 1 ) : Quantity demanded is relatively unresponsive to income

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A good is categorized as necessity if the income elasticity of demand (YED) is less than one; hence, demand is income inelastic:

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• As necessities are essential, consumers have no choice but to consume the good regardless of income

• For this reason, the demand for necessities is relatively unresponsive to income, with a change in income leading to a smaller percentage change in quantity demanded

• Hence, the demand for necessities is income inelastic

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NOTE: Whether a good is a necessity or a luxury will depend on the income level of consumers; hence,

as income increases, certain items that used to be luxuries become necessities

INCOME ELASTICITY OF DEMAND (YED): LUXURIES

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LUXURIES: A non-essential good

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• Luxuries ( YED < 1 ) : Quantity demanded is relatively responsive to income

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A good is categorized as a luxury if the income elasticity of demand (YED) is greater than one; hence, demand is income elastic:

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• As luxuries are non-essential, consumers have a choice in whether to consume the good

• For this reason, the demand for luxuries is relatively responsive to income, with a change in income leading to a larger percentage change in quantity demanded

• Hence, the demand for luxuries is income elastic

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NOTE: Whether a good is a necessity or a luxury will depend on the income level of consumers; hence,

as income increases, certain items that used to be luxuries become necessities

Syllabus Statement: Examine implications for producers and for the economy of a relatively low YED for primary products, a relatively higher YED for manufactured products and an even higher YED for services

INCOME ELASTICITY OF DEMAND AND THE ECONOMY

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As countries undergo economic growth, the real income of consumers increases, resulting in a growing demand for goods and services; hence, producers interested in producing in an expanding market may want to know the income elasticity of demand (YED) of various goods and services:

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• The lower the YED of a good or service, the smaller the expansion of the market in the future

• The higher the YED of a good or service, the greater the expansion of the market in the future

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Primary Products

• As primary products are necessities with no close substitutes, consumers cannot refuse to consume the good and cannot switch to an alternative substitute; hence, the demand for primary products is relatively unresponsive to income and is thus income inelastic (relatively low YED):

• During periods of economic growth, the rise in consumer income will lead to a smaller percentage increase in quantity demanded, resulting in a slow market expansion of the primary sector; producers are therefore worse off as they cannot increase sales and total revenue

• Alternatively, during periods of economic contraction, the fall in consumer income will lead to a smaller percentage decrease in quantity demanded, resulting in a slow market contraction of the primary sector; producers are therefore better off as they avoid loss in sales and total revenue

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Manufactured Products

• As manufactured products are luxuries with close substitutes, consumers can refuse to consume the good and can switch to an alternative substitute; hence, the demand for primary products is relatively responsive to income and is thus income elastic (relatively higher YED):

• During periods of economic growth, the rise in consumer income will lead to a larger percentage increase in quantity demanded, resulting in rapid market expansion of the manufacturing sector; producers are therefore better off as they can increase sales and total revenue

• Alternatively, during periods of economic contraction, the fall in consumer income will lead to a larger percentage decrease in quantity demanded, resulting in a rapid market contraction of the manufacturing sector; producers are therefore worse off as they incur large losses in sales and total revenue

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Services

• As services are often luxuries with many close substitutes, consumers can refuse to consume the service and can switch to an alternative substitute; hence, the demand for services is relatively responsive to income and is thus more income elastic (high YED):

• During periods of economic growth, the rise in consumer income will lead to a larger percentage increase in quantity demanded, resulting in a rapid market expansion of the tertiary (service) sector; producers are therefore better off as they can increase sales and maximize total revenue

• Alternatively, during periods of economic contraction, the fall in consumer income will lead to a larger percentage decrease in quantity demanded, resulting in a rapid market contraction of the tertiary sector; producers are therefore worse off as they incur large losses in sales and total revenue

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INCOME ELASTICITY OF DEMAND AND THE ECONOMY

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As countries undergo economic growth, the relative importance of sectors changes over time, with the respective share of output in economy shifting from the primary sector, to the manufacturing sector, and lastly, to the service sector:

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Primary Products

• The primary sector produces primary products involving agriculture, forestry, fishing, and extractive industries

• As the demand for primary products is income inelastic, during periods of economic growth, the rise in consumer income will lead to a smaller percentage increase in quantity demanded; hence, the demand for primary output grows more slowly than the growth in income

• Thus, with economic growth, the primary sector becomes less important and the share of primary output in the economy shrinks

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Manufactured Products

• The manufacturing sector produces manufactured goods

• As the demand for manufactured products is income elastic, during periods of economic growth, the rise in consumer income will lead to a larger percentage increase in quantity demanded; hence, the demand for manufactured output grows faster than the growth in income

• Thus, with economic growth, the manufacturing sector becomes more important and replaces the primary sector

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Services

• The service sector provides services such as entertainment, travel, and banking

• As the demand for services is more income elastic, during periods of economic growth, the rise in consumer income will lead to a significantly larger percentage increase in quantity demanded; hence, the demand for services grows significantly faster than the growth in income

• Thus, with economic growth, the service sector becomes more important and replaces the primary and manufacturing sector

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NOTE: Over time, the share of agricultural output in the economy shrinks, while the share of manufactured output grows; with continued growth, the services sector expands at the expense of both primary sector and manufacturing