Unit 2.6: Price elasticity of supply

Introduction

This lesson focuses on the price elasticity of supply.  You will have already established that there is a direct relationship between the price of a product and the level of quantity supplied.  However, it would be wrong for students to think that the rate of change of quantity supplied does not vary, depending on the good or service.  I find that students will very often get the factors that determine PES and PED confused and presume that factors such as degree of necessity also impact on supply.  I explain the factors that determine PES in the following way:  It is safe to assume that all entrepreneurs would normally wish to raise output levels following a rise in price, ceteris paribus.  The question is can they?  Are they able to gain access to additional raw materials or skilled labour?  Does the factory have spare capacity and lastly, how long is the production process?  The page contains a simple investigation exercise, containing simple calculations.  Elasticity calculations can be found on the paper three (HL only paper).

Enquiry question

What factors determine the extent to which the quantity supplied for different goods and services changes in response to movements in selling price.

Teacher notes

Lesson time: 70 minutes

Lesson objectives:

To understand the concept of price elasticity of supply, as the responsiveness of
quantity supplied to a change in price along a given supply curve.

To calculate PES using the following equation - PES (percentage change in quantity supplied) percentage change in price.

Explain the determinants of PES, including time, mobility of factors of production, unused capacity and ability to stock pile components and supplies.

Teaching notes:

1 Opening activity - begin the lesson with the introductory exercise, which asks students to consider how easy or difficult it would be for the producers of three different products to alter their production levels, following a change in the price of the product. (5 minutes)

2. Processes - technical vocabulary - the students can learn the vocabulary and the relevant concepts by studying either the class handout or by watching and making notes on the power point presentation that you will distribute.  Activities 2,3 and 4 also focus on the technical vocabulary. (20 minutes)

3. Processes - complete the other pracise activities attached to the handout.  The first is investigative, how long is the production process for the following three products: car manufacturers, bespoke shoe producers and coffee producers.  The purpose of this reflection is to then consider how their answers might then effect the level of PES.  Students should be able to make the connection between the length of production process and the firms ability to change production levels at short notice. (5 minutes)

5. Activity 6 is called degree of elasticity and students are required to use their knowledge to fill in the blank spaces so that they have two complete paragraphs, summarising the difference between PES elastic and inelastic goods.  (5 minutes)

4. Activity 7 and 8 starts with a video and then contains a series of short relevant questions attached to the handout.  This can be completed after the handout and the two activities together should last around 15 minutes.  These are paper three in type but you may also decide to provide your SL students with these questions to practise on.

6. Activity 9 is a reflection exercise - this reflection asks students to consider the potential uses for PES theory.  I have also included some suggestions linking PES to topical issues in economics. (10 minutes)

7. Assessment 10 - is called 'link to the assessment' and this contains an example of a paper one question on PES, along with my sample response. (10 minutes)

1. Beginning question

Firms will adjust their supply of a good or service in response to changes in the selling price.  Following a rise in the price, which of the following businesses will find it easiest to raise their output levels?

  • car manufacturers
  • bespoke shoe producers
  • coffee producers.

Hint:

All three businesses would seek to raise their production levels following a rise in selling price, ceteris paribus.  However some producers will find this much easier than others.  For example like most manufacturing business a car producer can raise production levels relatively easily - ask workers to volunteer for extra overtime work and order more raw materials.  However, our coffee producer will find it more difficult to change their production.  This is for the simple reason that coffee has a fixed growing season and so the farmer must wait for the next harvest to increase its output.

Key term: Price elasticity of supply

A measure of the responsiveness of quantity supplied to changes in price.  When the price of a good or service changes we would also expect a change in the quantity supplied BUT not a change in supply – i.e a movement along the supply curve not a shift in the supply curve. 

The degree to which the quantity supplied changes depends on the price elasticity of supply for the product, measured by the formulae:

% change in quantity supplied for the good or service / % change in the price of the product.

Range of price elasticity of supply (PES) values

Goods and services with a PES value > 1 and < infinity are PES elastic (i.e a top heavy fraction).  Following a change in the price of a good or service then the % change in quantity supplied for the product is greater than the initial % change in price.

Goods and services with a PES value < 1 and > 0 are PES inelastic (i.e a bottom heavy fraction).  Following a change in the price of product the % change in quantity supplied for the good or service is less than the initial % change in price.

Goods and services with a PES value = 1 have unitary elasticity.  Following a change in price the resulting % change in quantity supplied will be equal to the % change in price.

Available as a class handout at:  PES notes 

Activity 2

The following diagrams illustrate the supply curve for two products, one represents a firm producing children's toys and the other an olive farmer.  Which is which?

The olive farmer is illustrated by the first to the left, while the children's toy factory is represented by diagram 2 (to the right).

Activity 3: A comparison of two businesses

Diagram 1 illustrates the market for children's toys, or indeed many manufactured products.

(a) Illustrate on the diagram a rise in demand for children's toys.  Draw the new equilibrium. 

(b) Following the rise in demand for their product, how is the factory owner likely to change her production levels in response to both higher demand and higher prices?

The owner of the business will sense a potential rise in profit levels and will probably decide to raise production levels in response.

(c) How easy will this be for the factory owner, presuming that skilled labour and sufficient raw materials are available to increase production levels?

This should be relatively easy because the children's toys are made by a manufacturing process. The owner of the factory may have to employ more staff temporarily and purchase more supplies, he may even need to get his factory working longer hours - but she would probably be able to raise production levels to meet this demand.  This should be represented on your diagram, where following a rise in price, there should be a greater than proportional change in quantity supplied.

A comparison with the olive farmer

Diagram 2 illustrates the market for olives, or indeed many agricultural or primary products.

(a) Illustrate on the diagram a rise in demand for olives.  Draw the new equilibrium. 

(b) Following the rise in demand for his olives, how is the olive farmer likely to change his production levels in response to both higher demand and higher prices?

The owner of the business will sense a potential rise in profit levels and will probably also decide to raise production levels in response.

(c) How easy will this be for the farmer?

Unlike our toy manufacturer, however, he cannot easily increase his crop yields as growing olives for olive oil is a long process. Our farmer needs to make decisions about how much of his field to devote towards olive trees at the beginning of the growing season. The growing process then takes many months or years to turn into olive oil and so our farmer is unable to change production levels mid season.  This makes the product PES inelastic and should be represented on your diagram, where following a rise in price, there should be a lower than proportional change in quantity supplied.

Activity 4: Other determinants of PES

Describe the impact of the following on the level of PES for any good or service.

(a) The degree to which costs rise in response to changes in output

If the production costs for a product were to rise significantly following a rise in output then firms will be more reluctant to change output levels - making the good or service less PES elastic.

(b) The level of unused capacity in the production unit

If a firm has significant unemployed resources in its production process then it will more inclined to raise output in response to a change in price, making the product more price elastic.  By contrast if a firm is operating at, or close to capacity, then it will tend to be less PES elastic. 

(c) The degree of mobility of the necessary factors of production

If a firm can easily move factors of production around, between its different products then this would tend to make the good or service more elastic.  This might apply to a factory producing different size containers in circumstances where the firm can easily switch production factors between the production of one size of container and another. 

(d) The ability of the business to store stock or other raw materials

If a firm is able to build up large volumes of stock then they will be able to respond to changes in price easily and swiftly.  This would make the product relatively price elastic.

Activity 5 investigation

Investigate how long it takes to produce the following items:

  • a Toyota car
  • coffee (from planting the original tree to drinking your first cup)
  • drilling for oil
  • bespoke suit.

Explain the likely impact of your findings on the price elasticity of supply?

Toyota - 17 - 18 hours

Coffee - 4 years

Oil - 3 - 10 years depending on whether a government chooses to slow down the process

bespoke suit - 24 - hours

The impact this has on supply is as follows: It is safe to assume that all entrepreneurs would wish to raise output following a rise in price.  The question is can they?  Are they able to gain access to additional raw materials or skilled labour?  Does the factory have spare capacity and lastly, how long is the production process?  In other words from the information above we can observe that the PES of Toyota (and most manufactured goods) is probably elastic.  By contrast the PES of oil and coffee (and most primary goods) is likely to be PES inelastic, while the PES of bespoke manufactured goods is likely to be unitary.

Activity 6: Degree of elasticity

Place the following descriptions in the box below the arrow, indicating the likely degree of PES elasticity associated with the statement:

PES inelasticity (PES=0)                                              PES=1                                                Perfect elasticity (PES=)

Goods with a PES close to 0 would be those with  ________ spare capacity.  They are also likely to have a ________ production time, use highly ________________ factor resources, such as skilled labour or scarce resources.  They are generally but not always agricultural / _____________ products.

By contrast, goods with a high PES, will be those where the production facility has ____________ spare capacity.  They are also likely to have a ________ production time, use factor resources, which are easy to substitute, such as ________ labour or __________ resources.  PES elastic goods are usually __________ goods or _____________.

Goods with a PES close to 0 would be those with limited spare capacity.  They are also likely to have a long production time, use highly scarce factor resources, such as skilled labour or scarce resources.  They are generally but not always agricultural / primary products.

By contrast, goods with a high PES, will be those where the production facility has significant spare capacity.  They are also likely to have a short production time, use factor resources, which are easy to substitute, such as unskilled labour or plentiful resources.  PES elastic goods are usually manufactured goods or services.

Activity 7 (Paper three type)

Watch the following short video before attempting the short questions that follow:

Questions:

1. Using the formulae % change in supply / % change in price, calculate the PES elasticity of the following goods and services and state whether each is PES elastic, inelastic or PES unitary:

a. Price goes from 50 TL to 90 TL forcing supply to increase from 60 units to 100 

67 / 80 = 0.84 (inelastic)

b. Supply rises from 10 – 20 following a rise in price from 10 TL to 50 TL

100 / 400 = 0.25 (inelastic)

c. Price falls from 100 – 50 and supply is unchanged

0 / 50 = 0 (perfectly inelastic)

d. Supply rises from 10 – 30 when price rises from 100 TL to 110 TL

200 / 10 = 20 (very elastic)

Activity 8 – practise questions

1. A computer manufacturer produces computers and increases the price from $ 600 to $ 800.  Following the rise in price, the quantity supplied by the firm, each week, rises from 1 million to 1.1 million units.  In the months that follow the weekly output rises further to 1.8 million units

(a) Calculate the level of PES in the short run

10% / 33% = 0.33

(b) Calculate the level of PES in the long run

80% / 33% = 2.42

(c) Explain why the level of PES is greater in the long run than the short run

In the week following the price rise, the computer manufacturer found it difficult to increase production significantly.  The factory would have been constrained by its relatively fixed supply of labour and raw materials, required to raise output.

6 months later, however, the firm had the time to increase their production to meet the higher price level.  The firm could have increased its purchases of raw materials and diverted workers towards production of the computer.

2. The price and output of coffee beans is included in the table below:

$ per Kg

Output (Kgs)

PES

4 July 2018

1.60

350

-

13 August 2018

0.93

335

4.29 / 42 = 0.1

22 October 2018

1.45

345

3 / 52 = 0.058

11 March 2019

0.90

325

5.79 / 38=0.15

a. Complete the table by calculating the PES for coffee

b. Explain why the PES for the crop is PES inelastic

Unlike the computer manufacturer, who is able to respond to the rise in price by quickly diverting resources towards increased production, this option is not available for the coffee farmer.  The coffee takes a fall season to grow and ripen before it can be picked, making sudden changes during the season almost impossible. 

c. Use an explanation of PES theory to explain why the price of coffee fluctuates over relatively short periods of time?

With production levels relatively fixed, any change in demand for the product will result in significant variations in price, with producers unable to adapt their output levels to satisfy changes in demand.

3. Assign each of the following products to one of the following PES and PED curves - ski equipment, bespoke shoes, diamonds, tickets for a football stadium, cheap T-shirts and bread:

                       

                      

                           

Diagram 1 - ski equipment which is both a luxury product and a manufactured good.

Diagram 2 - diamonds as both a luxury good and a primary good.  Miners cannot easily increase their production following a change in price.

Diagram 3 - bread is an agricultural good and hence PES inelastic and also a basic necessity making it PED inelastic.

Diagram 4 - mass production T−shirts, this is a manufactured good and hence PES elastic (the manufacturer can easily change production output in response to changes in price).  T−shirts are also PED inelastic because they are low priced items and unlikely to be affected too heavily by price.

Diagram 5 - tickets for a football stadium, as the supply is fixed and the demand would generally be PED inelastic.

Diagram 6 - bespoke shoes, being a luxury product and hence elastic PED.  Bespoke manufactured products are also likely to PES unitary.                                        

Activity 9: Reflection activity

Reflect on how PES theory can be used to explain some topical applications of economic theory, which may be of use in your IB course?

Examples of appropriate responses:

Shortages of skilled labour in the workforce

The abundance of unskilled labour in many developing nations and the difficulty faced by many Developed nations in absorbing large numbers of unskilled migrants into the workforce

Satisfying demand for products using increasingly scarce resources / raw materials

The supply of new housing and the difficulty of providing housing for rapidly growing populations

The supply of renewable energies as well as traditional carbon based energy sources

The impact of a low PES for many primary commodities on the economies of many Developing nations.

Activity 10: Link to the assessment (HL)

PES questions will generally be found in paper one, with examples of PES questions including:

Part (a)

Explain why the price elasticity of supply for primary commodities tends to be lower than the price elasticity of supply for manufactured products.  [10 marks]

Command term: Explain

Explain means to provide reasons and causes - or in other words, explain why the economic reasons why the PES of primary commodities is normally lower than the price elasticity of supply for manufactured products.

Key terms to define: price elasticity of supply, primary products and manufactured goods.

This question also requires a recognition that two factors which have a significant influence on the value of PES include the length of time to produce the good or service and the degree to which costs rise in response to changes in output.  As primary goods are extracted from the ground it is very difficult to change output levels in the short run.  For example crops require a full growing season.  By contrast firms producing manufactured goods and services can more easily change their output levels.

Responses should also include suitable diagrams and provide examples of exceptions to this rule, i.e. primary goods with high PES elasticity and manufactured goods or services with low PES elasticity.

A diagram illustrating one PES inelastic good and one PES elastic good should also be added.

Part (b)

“The price elasticity of supply for primary products tends to be lower than that for manufactured goods and services.” Using real life examples, evaluate the implications of this for producers of primary products, manufactured goods and services. [15 marks]

Command term: Evaluate

Evaluate requires IB students to determine the significance of PES elasticity on the producers of primary products, in comparison to firms producing manufactured goods and services. 

Key terms to define: YED

Relevant real life examples include: LEDCs whose primary exports come from agricultural and primary goods with low PES, making those nations particularly exposed to sharp changes in the price of that commodity, over which they have little control and is a restraint to growth and development.  

Primary goods are generally extracted from the ground and so it is very difficult to change output levels in the short run.  For example crops require a full growing season.  By contrast firms producing manufactured goods and services can more easily change their output levels.  Many manufactured goods and services have a low marginal cost.

This means that producers of primary goods will find it difficult to change their production levels in response to changing market conditions, leaving those businesses exposed to changing market conditions.  A current example might include a number of LEDCs whose primary export is oil and are suffering as a consequence of low oil prices. Those businesses will also find it difficult to increase output levels in response to improving market conditions.

The situation facing producers of primary products should then be compared with that of firms producing manufactured goods or services by way of comparison.

The better responses may also link their response to the difficulties faced by many LEDCs, whose main export revenues come from the sale of primary goods.

Responses should also include diagrams to illustrate goods with high / low PES elasticity. 

Internal assessment

The concept of supply elasticity is also one of the more popular concepts to include in an IA portfolio, for example an article concerning the low PES of oil or other primary commodities and how this impacts on the market price for that product.

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