Applying PES — Demand Shifts

Idea

When demand shifts, price and quantity move in the same direction, so total revenue moves in that direction too — regardless of elasticity. What the price elasticity of supply governs is how far each of price and quantity moves: a rise in demand raises price more (and quantity less) the more inelastic supply is.

Diagram

Mechanism

A rise in demand raises both price and quantity. With

$PES = \frac{\%\,\text{change in quantity supplied}}{\%\,\text{change in own price}}$

• Price elastic supply ($PES > 1$): quantity supplied rises more than proportionately than price, so quantity moves a long way and price a short way ($P_0$ to $P_e$, $Q_0$ to $Q_e$).

• Price inelastic supply ($PES < 1$): quantity supplied rises less than proportionately, so price moves a long way and quantity a short way ($P_0$ to $P_i$, $Q_0$ to $Q_i$).

In both cases price, quantity and total revenue rise with the increase in demand; only the split between the price rise and the quantity rise differs. A steeper supply curve through the equilibrium is the more inelastic one. PES measures a movement along supply, not a shift.

Considerations

The determinants of PES are remembered as SNIT:

• Spare capacity — idle resources let producers raise output quickly, so supply is more elastic.

• Nature of production — high factor mobility (easily switching inputs between goods) and a short production period both raise elasticity; long agricultural lead times make supply inelastic.

• Inventory — goods easily and cheaply stocked have elastic supply; perishables that cannot be stored are inelastic.

• Time period — supply is more inelastic in the short run and more elastic in the long run, as producers adapt.

These determine, for evaluation, whether a demand-side shock (a tax, a boom, a subsidy to buyers) feeds mainly into price or mainly into quantity.