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Module
Econ: 46
The Income Effect, Substitution
Effect, and Elasticity
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• How the income and substitution effects
explain the law of demand
• The definition of elasticity, a measure of
responsiveness to changes in prices or
incomes
• The importance of the price elasticity of
demand, which measures the
responsiveness of the quantity demanded
to changes in price
• How to calculate the price elasticity of
demand
I. The Law of Demand
A. The substitution effect- a
change in the price of a good will
cause a consumer to substitute
the good due to the lower price
creating more quantity
demanded.
B. The income effect- a change in
the price of a good makes a
consumer feel like they have
more money, leading to an
increase in quantity demanded.
This is NOT an increase in
income, but an increase in
purchasing power.
I
II. Defining Elasticity
A. Definition of elasticity- Elasticity measures the
responsiveness of one variable to changes in
another.
B. Law of demand- We know that when price
increases, quantity demanded decreases, NOW
we want to know “by how much?”
• Example- What if the price of gasoline doubled?
What if the price of pencils doubled?
III. Calculating Elasticity
A. Elasticity is the % change in the dependent variable
divided by the % change in the independent variable
B. In symbols, elasticity is %∆dep/%∆ind
C. Price elasticity of demand is the percentage change
in quantity demanded divided by the percentage
change in the price.
D. In symbols: Ed = %ΔQd/ΔP note: we drop the negative
sign for Ed only.
IV. The Midpoint Formula
A. There are problems with calculating percentage
changes (if the starting and ending prices are
reversed, elasticity is different)
B. The solution: Use the Midpoint formula!
1. %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity
2. %ΔP = 100*(New Price – Old Price)/Average Price
3. Ed = %ΔQd/ΔP
C. Midpoint Formula
Q2-Q1
(Q2+Q1)/2
=E
P2-P1
(P2+P1)/2
If E is Greater than 1 = Elastic
If E is Equal to 1 = Unit Elastic
If E is Less than 1 = Inelastic
Module
Econ: 47
Interpreting Price Elasticity of
Demand
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The difference between elastic and
inelastic demand
• The relationship between elasticity and
total revenue
• Changes in the price elasticity of demand
along a demand curve
• The factors that determine price elasticity
of demand
Interpreting Price Elasticity of Demand
What does the value of
elasticity tell us?
• It indicates how steep or
flat the curve will be.
What does an Elastic Demand
Curve Look Like?
I. Determinants of Elasticity
Factors Determine the Price Elasticity of Demand include:
A. Number of substitutes
1. More Substitutes = More elastic
2. Less Substitutes = More inelastic
B. Luxury or necessity?
1. The less necessary the item = More Elastic
2. The more necessary the item = More Inelastic
Determinants of Elasticity Continued
C. Share of income spent
1. The more expensive relative to budget the item is =
More Elastic
2. The less expensive, relative to the budget the item is
= More Inelastic
D. Time
1. Long Run Demand = More elastic
2. Short Run Demand = More inelastic
Elasticities
Price Elasticity of Demand
The Determinants of Price Elasticity of Demand: The following factors determine whether demand for a good or service is elastic,
unit elastic, or inelastic.
S
The number of substitutes available. The more substitutes, more elastic demand, as
consumers can replace a good whose price has gone up with one of its now
relatively cheaper substitutes.
P
The proportion of income the purchase of a good represents. If a good represent a
higher proportion of a conumer's income, his demand tends to be more elastic.
L
A
T
Luxury or necessity? If a good is a necessity, changes in price tend not to affect
quantity demand, i.e. demand is inelastic. If it's a luxury that a consumer can go
without, consumers tend to be more responsive.
If a product is addictive or habit forming, demand tends to be inelastic.
The amount of time a consumer has to respond to the price change. If prices remain
high over a longer period of time, consumers can find substitutes or learn to live
without, so demand is more elastic over time.
Practice PED: NCEE Activities 17, 18 and 19
II. Elasticity and Total Revenue
A. Total Revenue and Elasticity
1. TR = P x Q
2. Total Revenue Test
B. Total Revenue Test
• P↑ TR ↑ = Inelastic Demand
• P↓ TR ↓ = Inelastic Demand
• P↑ TR − = Unit Elastic Demand
• P↓ TR − = Unit Elastic Demand
• P↑ TR ↓ = Elastic Demand
• P↓ TR ↑ = Elastic Demand
C. Price effect (p469)
1. After a price increase, each unit sold sells at a
higher price, which tends to raise revenue.
D. Quantity effect
1. After a price increase, fewer units are sold, which
tends to lower revenue.
Examples:
• If a good has an elastic demand, quantity effect is
stronger than price effect and TR will fall
• If a good has an inelastic demand, quantity effect
is weaker than price effect and TR will rise
• If a good has a unit elastic demand, quantity
effect and price effect are equal and TR will
remain the same.
ElElasticity along the Demand Curve
• Elasticity Along the Demand Curve
Module
Econ: 48
Other Elasticities
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• How cross-price elasticity of demand measures the
responsiveness of demand for one good to changes
in the price of another good.
• The meaning and importance of the income
elasticity of demand, a measure of the
responsiveness of demand to changes in income.
• The significance of the price elasticity of supply,
which measures the responsiveness of the quantity
supplied to changes in price.
• The factors that influence the size of these various
elasticities.
Other Elasticities
• Cross-price elasticity of
demand
• Income elasticity of
demand
• Price elasticity of supply
I. Cross-Price Elasticity of
Demand
A. Measures the responsiveness of the demand for
good “X” to changes in the price of good “Y”
Exy = %∆ Qd of X / %∆ P of Y.
Do not use absolute value, the +/- sign is very important.
1. Substitutes (positive)
2. Complements (negative
B. The elasticity is measuring the shift of the demand curve
Cross-Price Elasticity of
Demand Continued
C. Examples
If cross elasticity is positive, then X and Y are substitutes.
• Example: The price of Nike shoes increases 2% and
quantity demanded for Converse shoes increases 4%.
EConverse, Nike = 4%/2% = 2.
If the cross elasticity is negative, then X and Y are
complements.
• The price of gasoline increases 20% and quantity
demanded for large SUVs decreases by 5%.
ESUV,gasoline = -5%/20% = - .25.
II. Income Elasticity of
Demand
A. Measures the responsiveness of demand for a good to
changes in income.
B. Ei = %∆ Qd / %∆ I
1. Normal good (positive)
• Income elastic- positive greater than 1 (luxury goods)
• Income inelastic- positive but less than 1 (necessities)
2. Inferior good (negative)
III. Price Elasticity of Supply
A. Measures the responsiveness of quantity supplied to
changes in price. (same as Demand, but using Quantity
Supplied instead)
B. Es = %∆ Qs / %∆ P
1. If Es >1, supply is considered elastic.
2. If Es < 1, supply is considered inelastic.
3. If Es = 1, supply is considered unit elastic.
C. Determinants of Price Elasticity of Supply
1.Availability of inputs
• If a firm can get inputs (labor, capital, raw
materials) into and out of production quickly,
the Es will be more elastic.
2. Time
• The “market period” is so short that elasticity of
supply is inelastic; it could be almost perfectly
inelastic or vertical.
• The short-run supply elasticity is more elastic
than the market period and will depend on the
ability of producers to respond to price changes
as to how elastic it is.
• The long-run supply elasticity is the most elastic,
because more adjustments can be made over
time and quantity can be changed more relative
to a small change in price.
• Example: Think Agriculture and planting
seasons
Module
Econ: 49
Consumer and
Producer Surplus
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The meaning of consumer surplus and
its relationship to the demand curve.
• The meaning of producer surplus and
its relationship to the supply curve.
I. Consumer Surplus
A. Consumer surplus
measures the
difference between
what a consumer is
willing to pay for a
good and what he/she
actually has to pay.
B. Willingness to Pay
1. Willingness to pay is shown on the demand curve
2. Difference in what the consumer is willing to pay
and how much they have to pay is consumer
surplus
Calculating Consumer
Surplus
½ Base x height
II. Producer Surplus
A. Producer surplus
measures the
difference between
the price producers
receive for a good and
the cost of producing
the good.
B. Cost and Producer
Surplus
1. Producer cost is shown by the supply curve
2. The difference between cost what the producer
can charge is the producer surplus
Calculating Producer
Surplus
III. Changes in Price affect
Consumer and Producer Surplus
A. If price decreases,
• Consumer surplus increases (willingness to
pay is the same, but the price paid is lower)
• Producer surplus deceases (costs are the
same, but the price received is lower)
B. If price increases,
• Consumer surplus decreases (willingness to
pay is the same, but the price paid is higher)
• Producer surplus increases (costs are the
same, but the price received is higher)
Total Surplus =
Consumer Surplus + Producer Surplus
Module
Econ: 50
Efficiency
and
•KRUGMAN'S
Deadweight Loss
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The meaning and importance of total
surplus and how it can be used to
illustrate efficiency in markets
• How taxes affect total surplus and can
create deadweight loss
Consumer Surplus, Producer
Surplus, And Efficiency
• 495-499 on own
• Gains from trade
• The efficiency of
markets
• Equity and Efficiency
Gains from Trade
• Any time a consumer makes a purchase from a
producer, a trade has been made and both
parties expect to gain.
• Gains from trade are represented by consumer
and producer surplus.
• At the market equilibrium price and quantity, total
surplus is the sum of the CS and PS triangles.
The Efficiency of Markets
• No reallocation of consumption among consumers
could increase consumer surplus
• No reallocation of sales among producers could
increase producer surplus
• No change in the quantity traded could increase
total surplus
Equity and Efficiency
• Efficiency is not society’s only concern. We are
also concerned with equity.
• What is considered “fair” or “equitable” depends
on many factors.
• Often equity and efficiency are at the root of the
debate surrounding taxes.
• Progressive, regressive, and proportional
taxes
I. No Taxes
A. In the absence of the tax, supply would
equal demand at the equilibrium point E0, with
a unit price of P0 and a quantity of Q0 units.
II. Taxes
A. A tax on sellers will shift the supply curve to the left.
B. A tax on buyers will shift the demand curve to the left.
C. A tax leads to;
1. a decrease in quantity
2. an increase in the price paid by consumers.
3. a decrease in the price received by sellers
4. a “wedge” between the price consumers pay and
the price producers receive (equal to the amount
of the tax)
Example:
Imposing an excise tax or per unit tax of t = (Pc–Pp)
drives a wedge between the price paid by the
consumer (Pc) and the price received by the producer
(Pp). As the net price received by the seller falls, less
is supplied (movement along the supply curve). The
quantity of output falls from its original value (Q1) to
its new value (Q2). Market equilibrium shifts from E1
to E2.
A $2 Tax on Bottled
Water
Pc
Tax=Pc-Pp or $9-$7=$2
Pp
Q2 Q1
III. Tax Revenue
A. Tax revenue is t x Q2.
A $2 Tax on Bottled
Water
Pc
Tax=Pc-Pp or $9-$7=$2
Pp
Tax Revenue=T x Q2 or
$2x12 million = $24million
Q2 Q1
IV. Who pays the tax?
A. The upper portion of the revenue
rectangle, (Pc– Pe) x Q2, is considered to
be the share of the tax that falls on the
consumer because he now pays a higher
tax-inclusive price.
B. The bottom portion of the rectangle, (Pe–
Pp) x Q2, is considered to be the share of
the tax that falls on the producer in the
form of a lower net-of-tax price and
revenue received for selling the product.
A $2 Tax on Bottled
Water
Tax=Pc-Pp or $9-$7=$2
Tax Revenue=T x Q2 or Pc
$2x12 million = $24million
Pe
Pp
(Pc-Pe)xQ2=tax paid by
Consumers
(9-8)x12= 12 million dollars
(Pp-Pe)xQ2=tax paid by
Producers
(8-7)x12= 12 million dollars
Q2 Q1
Results of a $2 Tax on Bottled Water
Reduced Consumer Surplus
Tax Revenue
Reduced Producer
Surplus
Dead Weight Loss
V. Elasticity and Tax Incidence
A. Tax incidence: the measure of who really pays a tax
B. If the demand curve is relatively inelastic and the supply
curve is relatively elastic, the buyers will pay the larger
share of the excise tax.
C. If the demand curve is relatively elastic and the supply
curve is relatively inelastic, the sellers will pay the larger
share of the excise tax.
VI. The Benefits and Costs of Taxation
A. Benefits (Revenue)
1. This is not a cost, but a redistribution of
surplus from consumers and producers to
the government
2. The government then can do what they feel
society needs
B. Costs
1. Inefficiency caused by the dead weight loss
2. Is the government using the revenue wisely
(normative)
Module
Econ:
51
Utility Maximization
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• How consumers make choices about the
purchase of goods and services
• Why a consumer’s goal is to maximizing
utility
• Why the principle of diminishing
marginal utility applies to the
consumption of most goods and services
• How to use marginal analysis to find the
optimal consumption bundle
Maximizing utility
In the Theory of
Consumer Choice,
consumers’ goal is
to maximize their
utility.
I. Utility
A. Utility: a measure of the satisfaction the consumer
derives from consumption of goods and services.
B. The principle of diminishing marginal utility- Each
successive unit of a good or service consumed adds less
to total utility than the previous unit
Budgets
• The budget line
• The optimal consumption bundle
• The consumer’s challenge is two-fold:
1. Find the bundles of goods that are affordable, given income
and prices, and
2. Choose the bundle that provides the highest utility
Good Y
B
C
A
Good X
II. Spending the Marginal
Dollar
A. Marginal utility and MU per dollar
B. Optimal consumption
1. The “utility maximization rule” says that the consumer should
spend all of his income on two goods such that: MU/P is equal
for both (all) goods.
2. As long as one good provides more utility per dollar than another,
the consumer will buy more of the first good; as more of the first
product is bought, its marginal utility diminishes until the amount
of utility per dollar just equals that of the other product.