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KRUGMAN'S MICROECONOMICS for AP* The Income Effect, Substitution Effect, and Elasticity Margaret Ray and David Anderson 46 10 Micro: Econ: Module

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Housekeeping Restroom procedure – ask first. Supply & demand grades in Genesis. Review this week. Read modules 46 and 47 for tomorrow.

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Today’s Questions : Why the demand curve slopes downwards? How we can measure consumer sensitivity to price?

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Do Now What is your reaction to price increases?

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Experiment – Round 1 Assume each team member has $2.00 Assume Starbursts and Lollipops cost $ 0.50. Have each team member write down how much they would buy of each. Count up the team total.

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Experiment – Round 2 Assume each team member has $2.00 Assume Starbursts cost $ 0.50, but Lollipops now cost $1.00. Have each team member write down how much they would buy of each. Count up the team total.

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Substitution Effect As price increases for one item, consumers will substitute a lower priced item.

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Experiment – Round 3 Assume each team member has $2.00 Assume Starbursts prices fall to $0.25, and Lollipops prices return to $0.50. Have each team member write down how much they would buy of each. Count up the team total.

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Income Effect As price decreases, consumers have greater purchasing power. Will increase spending on the item. Price increases have opposite effect of making people feel poorer, so they consume less of the item.

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Quick Write What products would be more impacted by the substitution effect? By the income effect?

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Elasticity Measures responsiveness of one variable (generally quantity) to changes in another. Price elasticity of demand measures responsiveness in quantity demanded to changes in price. % ∆ in Q / % ∆ in P

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Draw Graph with 5 points PointPriceQ A$ 5.001 B$4.002 C$3.003 D$2.004 E$1.005

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The Midpoint Formula The solution: Use the Midpoint formula! %ΔQ d = 100*(New Quantity – Old Quantity)/Average Quantity %ΔP = 100*(New Price – Old Price)/Average Price Ed = %ΔQ d /ΔP

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Desk Partners Calculate elasticity for three different curves on worksheet # 4.12.1

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Levels of Elasticity Elastic > 1 Unit Elastic = 1 Inelastic < 1 What does that mean in English?

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Summary Demand curves slope downward because of the income and substitution effects. Price elasticity of demand measures the responsiveness of quantity demanded to changes in price. Use mid-point formula Elastic, unit elastic and inelastic.

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Exit ticket Pizza demand in LHS cafeteria Price change $ 2.00 to $1.00 Quantity demanded increases from 100 to 300 Calculate elasticity using mid-point. Elastic or inelastic? Which is greater substitution or income effect?

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Figure 47.1 Two Extreme Cases of Price Elasticity of Demand Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

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Figure 47.2 Unit-Elastic Demand, Inelastic Demand, and Elastic Demand Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

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KRUGMAN'S MICROECONOMICS for AP* Interpreting Price Elasticity of Demand Margaret Ray and David Anderson Micro: Econ: 11 47 Module

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Today’s Questions : How does elasticity vary along the demand curve? How can we use elasticity to make money? What factors determine price elasticity of demand?

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Elasticity Investigation Desk partners. Graph a demand curve using at least 10 units. ½ do elastic curves, ½ inelastic curves

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Elasticity Investigation Swap your graph with someone across the room. Calculate three elasticities…..

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Elasticity Investigation Near Top In Middle Near Bottom

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Elasticity Investigation Compare your elasticities with two other groups. Is there a common pattern?

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R ElElasticity along the Demand Curve Why do we get this pattern???

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Elasticity and Total Revenue Total Revenue and Elasticity TR = P x Q Price effect – direct effect of lower / higher price. Quantity effect – change in quantity due to price change.

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Activity: Elasticity and Revenue Switch desk partners with row behind / in front. Calculate elasticity and revenue for the scenarios in the worksheet. Is there a predictable relationship between elasticity and revenue?

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Individual Practice Help the bookseller in worksheet 4.12.3 figure out which customer group should get a discount.

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Determinants of Price Elasticity of Demand Availability of substitutes Luxury or necessity Share of income spent Time

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Summary Price elasticity of demand changes depending upon where you measure it on the demand curve. Goes from elastic to inelastic. Understanding elasticity allows us to predict how firm revenue will react to price changes. Substitutes, Luxury vs. Necessity, Income Share and Time all determine the elasticity of demand for a product.

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