Tuesday, August 4, 2009

Why Supply Is Highly Inelastic In Short Run?

Source: economicshelp

Price elasticity of supply (PES) measures the responsiveness of supply for a good to a change in price. It is given by the formula of:

PES = (% of change in quantity supplied) / (% of change in price)

It is meant to determine whether the supply of a good is sensitive to price changes or not. The sign obtained from the calculation must always be positive due to the natural relationship between the decision to supply and market price. The higher the price the more will be supplied and the lower the price the lesser will be supplied. However, not all the time producers can be very responsive to market price. In this case the PES < 1. The interpretation is, a large change in price leads to a smaller than proportionate change in quantity supplied. In other word, say even with large increase in market price, producers will be unable to supply much

In real world, there are several items that fall into this. For instance supply of new housing, fresh vegetables and commodities (this may be arguable). Consider a property developer. Even if he receives the information that the area will be booming in nearest time, he will not be able to suddenly increase the quantity of houses and shop lots due to constraint in factors of production. He needs more time to hire necessary workers, obtain planning permission to enlarge the housing area, order raw materials and getting the right number of construction machines

In some extreme cases, PES could be 0 (perfectly inelastic). How is that possible? Yes it is, if we are considering a very immediate time period. Last week when I was in a hobby shop, I planned to get an item called Fallen from Transformers: Revenge of the Fallen and at that time I am willing to offer much higher market price due to its rarity. However I was told by the shop owner that next wave of stocks will arrive the following two weeks. This means, no matter what price I offer he will be unable to supply me that item. So his PES at that time was zero

In short, PES is largely concern with time frame under consideration. The shorter the time, the more inelastic is the supply and the longer the time, the more elastic it will be

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