Factors that affect the price elasticity of supply

Price elasticity of supply is a useful concept when we consider supply. It is also use to measure the responsiveness supply to a change in price when we are supplying a good. Below is the formula that use to calculate the price elasticity of supply.

Price elasticity of supply (PES) =

% change in quantity supplied

% change in price

There are a few factors that affect the price elasticity of supply. The first factor that affects the determinants of price elasticity of supply is the number of producers. If there are a lot of producers, the easier for the industry to increase the output and cause the price increase. For example, according to the law of supply, the price of a good increase, the quantity supplied of the good increase. That’s why when there are a lot of producers, more goods will be produced and caused the price increase.

Besides that, another factor that affects the price elasticity of supply is the time factor. Long run is usually more elastic for supply compare with short run. For example, in the long run period the industry can invest more equipment and build more factories. In addition, they can even enter a new market and start a bigger business. However, in the short run, industry cant extend their factory to produce more goods. Besides that, the prices of the goods are not responsive to the price. Therefore, supply is more elastic in the long run.

Part B

Businesses always use the concept price elasticity to decide on their pricing strategy. The strategy that used by the businesses to decide their price is price elasticity of demand (PED). Price elasticity of demand can be define as the measurement of the rate of response of quantity demanded due to a price change. There is a formula that uses to calculate the price elasticity of demand. The formula is shown in the figure below.

The percentage change in price

The percentage change in quantity demanded

PED =

There are many degrees that show in price elasticity of demand. Price elasticity of demand will normally be a negative relationship between quantity demanded. To determine the degree of PED, ignore the negative sign. The first degree that shows in PED is inelastic demand. This is a degree that show the percentage change in quantity demanded is less than the percentage change in price. For example, 20% decrease in price cause a 10% increase in quantity demanded. The value is less than 1 but greater than 0 (0<PED<1). Consumers are less responsiveness to a change in price,

The second degree that shows in PED is elastic demand. This is a situation that the percentage change in quantity demanded is greater than the percentage change in price. For example, a 20% decrease in price caused a 30% increase in quantity demanded. The value is greater than 1 but less than infinity (1<PED< ∞). Consumers are very responsive to a change in price.

The third degree will only happen during special cases. The degree is unitary elastic demand. This shows the percentage change in quantity demanded is equal to the percentage change in price. The value is equal to 1 (PED=1). The forth degree that happen in special cases is perfectly inelastic demand. This shows the quantity demanded does not change as the price changes. The value is equal to 0 (PED=0). Consumers do not response to the change in price. The fifth degree that happen only in special cases is perfectly elastic demand. This is a condition that a small percentage change in price brings about an infinite percentage change in quantity demanded. The value is equal to infinity (PED= ∞).

Beside that, businesses also use the total revenue to decide their price. The formula below is use to calculate the total revenue.

Total revenue = Price X Quantity demanded

If demand is inelastic, decrease in price will cause the lower revenue earned. If demand is elastic, the increase in price will cause the lower revenue earned. However, when the demand is unitary elastic, fall or rise in price will not affect the total revenue. If the demand is perfectly inelastic, rise or fall of price lead to a change in total revenue. If the demand is perfectly elastic, a rise in price leads the total revenue to fall to zero, however a fall in price will infinite change the total revenue.

Question 3

Part A

Supply defines as the total amount of a good or service available for purchase by consumers at different prices.

There are a few reasons that will cause the increase of supply. The supply curve will shift to rightward if the supply increases. The figure below shows the increase of supply.

Figure 3.1: Change in supply- Increase of supply

Price ($/unit)

S0 S1

Quantity supplied (unit)

The figure above shows that the supply curve shifts from S0 to S1 and cause the increase of supply.

The first reason that caused the increase of supply is the price of the product. All the producers are always aiming for the highest profit when doing a business. According the the law of supply, the higher the price of the good, the more thee quantity supplied. Therefore, if the price of a good increase, the producers will produce more good to get the highest profit. This will cause the supply to increase. For example, the price of rubber has increased. Therefore, producers will produce more rubber in order to gain a higher profit.

Secondly, technology change may also cause the increase of the supply. The longer the time, better technology will be invented. The better technology will make the producers to produce a good by using a easier way and faster time at cheaper cost. By using a better and cheaper way of producing, producers will increase the productivity to gain a higher profit. For example, the development in technology leads to a better production in rubber at cheaper cost. Producers of rubber will produce more rubber so that they can get a higher profit.

Thirdly, the low cost of the raw material may also lead to an increase of the supply. When the price of a raw material drops, the producers get to produce a good at a cheaper cost. Therefore, producers will increase the supply in order to get a higher profit. For example, the price of rubber has decrease. The producers of tyre get to produce the tyre at cheaper price. So, the producers will increase the supply of tyre so they will get a higher profit in producing tyres.

Part B

Market a place where consumers and producers influence the price in the market. Therefore, the price will not achieve due to the price ceiling and price floor. Price floor is the minimum price set above the equilibrium price. Some suppliers or producers will gain minimum profit due to the price floor. However, price ceiling is the maximum price set below the equilibrium price. Lowering the price of the good so that consumers are affordable to buy the goods. Figures below shows the price floor and price ceiling.

PriceFigure 3.2

S

Pe

D

Max price

Quantity

Figure 3

Price

S

Min price

Pe

D

Quantity

The function of prices is to able for both supply and demand get to set a price which both sides are willing to pay for it. When price floor happen, producer will sell the good with the price more than the equilibrium price. This will help the producer to get more benefit from the lower equilibrium price set my demand and supply curve. surplus will occurs means that quantity supplied more than quantity demanded.

Price of Good A

Surplus

Min price

Pe

Quantity of Good A

When the price ceiling happen, it will help the consumers to pay lesser from the equilibrium price. The price is lower than the equilibrium price. This will cause the shortage occurs when the quantity demanded is more than quantity supplied. Consumers is affordable to buy the goods when the price is lower than the equilibrium price.

Price of Good A

Pe

Max price

Question 5

Part A

Demand defines as the consumers would be willing and able to buy a good at different price level.

Figure 5.1

A change in demand is a shift in the demand curve. There are several factors that will affect the shift in the demand curve, besides the factor of the price of the good itself. The other factors, such as, the price of the other good. For example substitute goods and complements goods. Other than that, households’ income, expectation, tastes and fashion are also the factors of the shift in the demand curve. The demand curve will shift to the left when there is a decrease in the demand. For example, the price of the substitute of coffee, tea, has dropped from $1.50 to $1.20. This cause the demand of coffee decease because coffee is more expensive compare to tea. Consumers are more willing to drink tea and cause the demand of coffee dropped. Figure 5.1 below shows the decrease in demand.

Price of coffee

D0

D1

Quantity demanded

Quantity demanded define as the amount of goods which would be demanded at a particular price.

However, a change in quantity demanded is a movement along the demand curve. There is only one factor that affects the movement along the demand curve which is the price of the good itself. The decrease in the demand curve in quantity demanded will cause the movement of downward in the demand curve. When the price of a good increase, quantity demanded will decrease and vice versa. For example, when the price of a Pepsi increase from $2 to $3, quantity demanded of Pepsi decrease from 100 to 60. Figure 5.2 below shows a decrease in quantity demanded of Pepsi.

Price of Pepsi

3.90

100

60

Quantity demanded of Pepsi

D

B

A

3

2

Part B

Figure 5.3 Income elasticity of demand defines as the measurement of the responsiveness of the demand for a good to be a change in the income of the people demanding the good. It is calculated as the ratio of the percentage change in demand to the percentage change in income. The figure 5.3 below shows that the formula of the income elasticity of demand.

YED =

The percentage change in income

The percentage change in quantity demanded

There are three different types of degree about the income elasticity of demand. The first degree is positive income elasticity of demand. Positive income elasticity of demand can be divided into 3 parts. The first part is in unit income elasticity of demand. The value of unit income elasticity is 1. When there is an increase of income, demand will also increase proportionate. The second part is inelastic income elasticity of demand. The value of inelastic income elasticity of demand is less than 1 (0<YED<1). A change in income will lead to a less than proportionate change in demand. The third part is elastic income elasticity of demand. The value of elastic income elasticity of demand is more than 1 (YED>1). A small change in income will bring about a more than proportionate change in demand. The good examples of elastic income elasticity of demand are branded shoes, branded bags. They are luxury goods.

The second degree is negative income elasticity of demand. The value of negative income elasticity of demand is less than 0 or negative (YED<0). When the income increases, the amount demanded falls if the income elasticity of demand is negative. For example, when the income increases, the amount demanded for the inferior goods decrease. The example of the inferior goods are secondhand cars, secondhand bags.

The third degree is zero income elasticity of demand. The value of the third degree is 0 (YED=0). This means that whenever the income increase, the amount demanded will still remain the same. This is the zero income elasticity of demand. All the goods in this case are called necessity. For example, salt, sugar and rice are necessary goods. The consumers need the necessary goods in their daily life. That is why the changes in their income does not affect their demand for necessary goods.

Question 6

Part A

Market is a place where a lot of situation will happen. Consumers and producers are willing to buy and produce the goods at different price level. Market also has the situation like consumer’s surplus and producer’s surplus.

Consumer’s surplus is the difference between the price that consumers willing to pay over the price that consumers actually pay. The consumers actually get a benefit from paying less than the amount they are willing to pay on a good. For example, a consumer expect to pay $20 to buy a book. When the consumer go to a bookshop, he bought the book with only $15. Consumers get a benefit of $5. This explained the consumer’s surplus. The demand curve of the consumer’s surplus is downward sloping.

However, producer’s surplus is the difference between the prices that producers actually receive over the price they are willing to receive. The producers actually get a benefit from receiving a market price higher than the price they are willing to sell. For example, a producer wants to sell a book with $10 but the market price of the book is $15. The producer actually get a benefit of $5 for selling a book. This explained the producer’s surplus.

The figure 6.1 shows the consumer’s surplus and producer’s surplus.

Figure 6.1

Price of book

Consumer’s

surplus

Producer’s

surplus

Producer

surplus

10

Q

Quantity of book

D

S

15

20

Equilibrium

Benefit $5

Benefit $5

Part B

Production possibilities frontier is shows the three economics concept. The three economics concept are scarcity, choice and opportunity cost. Production possibilities frontier can be also called as production possibilities curve.

Production possibilities frontier is a graph shows the two outputs that the economy can possibly produce given the available factors and production technology. Production possibilities frontier can be determined by four principles. The principles are two products produced, efficient production, fixed resources and fixed technology.

Scarcity can be define as insufficiency of amount or supply. It can be define as shortage too. Scarcity in economy is where consumers and producers feel that have limited resources to make a choice for unlimited wants. Every choice that the consumers and producers make will have the opportunity cost. In order to maximize their satisfaction, producers and consumers have to make the choice to let go their opportunity cost. The opportunity cost the the second best good to let go.

Production possibilities frontier is bowed outward of the origin. This means that opportunity cost change as the country move away from one option to another. In production possibilities frontier has different point of view. The points that lies outside the Production possibilities frontier are called unattainable point, inside that Production possibilities frontier are called attainable points and on the curve called efficient points.

Good AFigure 6.2

K

H

K

H

Good B

Figure 6.2 shows that the shift in PPF. The shift from HH to KK shows the increase of production in the economy. If the industry is producing more goods and services, the industry will have more growth in economy. The factors that affect the PPF shift to the rightwards is the development in new technology and bigger labour force.

The shift from KK to HH shows a decrease of the production in the economy. There are a few factors that affect the PPF shift towards the left. The factors are natural disasters and depletion of natural resources.

Referencing

Essentials of Economics, 2nd edition, Robert L. Sexton, Thomson, South-Weston, 2006.

Comprehensive Economics Guide, Hashim Ali, Oxford University Press, 1990.

Essentials of Economics, 2nd edition, R. Glenn Hubbard, Anthony Patrick o’ Brien, Pearson, 2009.

Success in economics 3rd edition, Derek Lobley, Barking College of Technology, 1987, London. Department of Business Management Studies.