I understand elastisity of demand, but I’m having difficulty getting my mind around elastisity of supply. When I think of E of demand, I think of neighboring gas stations. One raises it’s price 5% and sales drop off 25% because of close substitutes. What would be a good example of elastisity on the supply side? And, if there is elastisity of supply, does that necessarily mean that demand is inelastic? Thank you,
The elasticity of supply is how much the quantity supplied is affected by the MARKET price: Using the example from SN: Let’s say the demand for coffee increases and thus the price per pound increases. With the new higher price more coffee producers will be willing to supply more coffee and thus the quanity supplied increases as well. There are also several factors that affect how the quantity supplied will respond to changes in price (page 15 of SN). I’m not sure about your second question–I think the elasticity of supply and the elasticity of demand are independent but I’m not sure.
Okay, so regarding natural resources… The CFAI text says that the supply of a nonrenewable resource (oil) is perfectly elastic, while the supply of the renewable resource (wind) is perfectly inelastic. How is this possible? A nonrenewable resource, by definition, has a finite supply (albeit in the ground), whereas a renewable resource has an unlimited supply. For instance, if I wanted to harness wind for electrical power, I could always build more wind farms.
Robert, It’s been a while, but I’ll take a shot: Wrt to oil - the supply taken out of the ground this year is this year’s stock. It can’t change regardless of price change. Sounds inelastic right? However, lets say the price of oil drops below the present value of next year’s price, owners simply hold the oil (let it sit on a tanker in the middle of the ocean) until next year (reducing this year’s supply) and sell then. On the other hand, if this year’s oil price is greater than the present value of next year’s expected price, then oil suppliers will sell it all this year. This extreme sensitivity to price is what makes oil (and other nonrenewable resources) highly elastic. With the wind example - who cares if this year’s price drops? Selling this year’s wind does not reduce the ability to get more wind and sell it next year (unlike oil) since it is so renewable, this the supply is not particularly sensitive to price changes.
So if I understand your examples correctly, elastisity has to do with producer’s choice. If the producer has a choice to use or not use, the supply is said to be elastic. OTOH, if there is no choice (wind just gets wasted if not used), supply is inelastic. How would this relate, then, to a more common example. Say, a gas station owner in a highly competitive market?
Well, I think it is better to think of it more fundamentally. We know generally: If price falls demand increases. If price rises demand decreases. Demand elasticity simply measures how much the demand changes, i.e. its sensitivity to price. We know generally: If prices rise, supply increases. If prices fall, supply decreases. Supply elasticity simply measures how sensitive the supply side is as a result of price changes. Elasticity attempts to explain how sensitive demand and supply are to changes in price. I don’t think a gas station owner in a competitive market (competing with other gas stations) really relates. You are just substituting one guys gas for another’s guys gas, which doesn’t change elasticity of gasoline in the aggregate, only who it is purchased from.
So, back to our natural resource example… Oil producers (as a group) decide to pump more oil and the unit price of oil drops. We have some measure of elastisity here. But wind farmers face the same situation. They install more wind turbines (or activate the ones sitting still), and the unit price for their output drops. Elastisity again. So I’m still confused about the natural resource example.
I might be wrong but the supply of wind does not change no matter what the wind farmers do. The price of the electricity the wind farms generate does, but this is irrelevant to the elasticity/inelasticity of WIND.
Kind of like how the SUPPLY of SUNLIGHT will not change no matter how many solar panels you install.
You are thinking too long term. For both oil and wind, it takes time to harvest it and get it to market. (Build new refineries, or build more windfarms) Lets say there are 100 barrels of oil currently pumped, processed, ready to sell, etc. If oil is priced higher than the present value of next year’s expected price, all of the supply that currently exists is sold, so supply = 100 barrels. If it is market price is lower, even by one cent, then oil companies just let it float out on the tankers until next year, and none of it is sold and supply = 0. It is incredibly sensitive, or highly elastic, to small changes in prices. Now wind - lets say the supply of wind is 100 units and the price is $1 each unit. Well, price goes up, so the suppliers say, I want to increase wind supply. But, I can’t, I need to first purchase new land for wind farms, then construct turbines or whatever, so supply, for this year, is still 100 even if price goes to $1.50. Or lets say, the price of wind drops to $0.50. Do you hold on to this year’s wind and wait to sell it next year? Probably not, especially knowing that you’ll have new wind next year because it is renewable. So, supply is still 100 units at all prices and hence it is perfectly inelastic.
I get it. Thanks.