# The Income Effect, Substitution Effect, and Elasticity

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

Housekeeping Restroom procedure – ask first.
Supply & demand grades in Genesis. Review this week. Read modules 46 and 47 for tomorrow. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

Today’s Questions: Why the demand curve slopes downwards?
How we can measure consumer sensitivity to price? The purpose of this module is to get “behind the scenes” of the demand curve to explain why it is downward sloping and why some demand curves are more responsive to a price change than others. In order to do this, we develop the concepts of income and substitution effects, and price elasticity.

Do Now What is your reaction to price increases?
Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

Substitution Effect As price increases for one item, consumers will substitute a lower priced item. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

Quick Write What products would be more impacted by the substitution effect? By the income effect? Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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 Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

Draw Graph with 5 points Point Price Q A \$ 5.00 1 B \$4.00 2 C \$3.00 3
\$2.00 4 E \$1.00 5 Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

The Midpoint Formula The solution: Use the Midpoint formula!
%ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity %ΔP = 100*(New Price – Old Price)/Average Price Ed = %ΔQd/ΔP Elasticity computations change if the starting and ending prices (or quantities) are reversed. That’s why we use the midpoint formula. Example: If a variable goes from a value of 100 to a value of 110, it is a 10% increase. If the variable were to go from a value of 110 to a value of 100, it is a 9.1% decrease. Because of this, the value of the price elasticity will change, depending upon whether the price is rising or falling. To address this issue, we use the average price and average quantity between two points on a demand curve. This method is called the midpoint method. %ΔP = 100*(New Price – Old Price)/Average Price Likewise with %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity Example: The price of a college’s tuition increases from \$20,000 to \$24,000 per year. The college discovers that he entering class of first-year students declined from 500 to 450. %ΔP = 100*(New Price – Old Price)/Average Price = 100*(\$2000)/\$21,000 = 9.5% %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity = 100*(-50)/475 = % Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve.

Desk Partners Calculate elasticity for three different curves on worksheet # Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

Levels of Elasticity Elastic > 1 Unit Elastic = 1 Inelastic < 1
What does that mean in English? Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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. Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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? Elasticity measures the responsiveness of one variable to changes in another. We start with the price elasticity of demand, but elasticity is a general concept that can be applied to any two related variables. And we cover several other elasticity measures in later modules, so learning elasticity as a general concept is useful. Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. We KNOW that when price increases, Qd decreases (this is the law of demand). The question here is, decreases by how much? This will be very important, for example to firms when they decide whether or not to raise their price. Ask the students how their consumption of gasoline would be affected if the price of gasoline doubled. Then compare this response to how they would respond if the price of ballpoint pens doubled. Use this example to help them understand that elasticity measures the responsiveness of 1 variable to changes in another (in this case price and Qd).

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

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

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

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? The purpose of this module is to show students how to interpret the numerical measure of price elasticity of demand, to show how price elasticity changes along a demand curve, and why this is important. The module also describes the various factors that determine whether demand for a good is price elastic or inelastic.

Elasticity Investigation
Desk partners. Graph a demand curve using at least 10 units. ½ do elastic curves, ½ inelastic curves Suppose we find that a price elasticity is equal to 10. What does this mean? We need a way to interpret the value of elasticity Take a look at the formula again. Ed = %ΔQd/%ΔP = 10 Now suppose that price were to increase by 1%. And since, Ed = %ΔQd/%1 = 10, we can predict that Qd will fall by a whopping 10%, which is a pretty big response. What would be the largest response to a price increase? Consumers immediately reduce consumption to zero. What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount.

Elasticity Investigation
Swap your graph with someone across the room. Calculate three elasticities….. Suppose we find that a price elasticity is equal to 10. What does this mean? We need a way to interpret the value of elasticity Take a look at the formula again. Ed = %ΔQd/%ΔP = 10 Now suppose that price were to increase by 1%. And since, Ed = %ΔQd/%1 = 10, we can predict that Qd will fall by a whopping 10%, which is a pretty big response. What would be the largest response to a price increase? Consumers immediately reduce consumption to zero. What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount.

Elasticity Investigation
Near Top In Middle Suppose we find that a price elasticity is equal to 10. What does this mean? We need a way to interpret the value of elasticity Take a look at the formula again. Ed = %ΔQd/%ΔP = 10 Now suppose that price were to increase by 1%. And since, Ed = %ΔQd/%1 = 10, we can predict that Qd will fall by a whopping 10%, which is a pretty big response. What would be the largest response to a price increase? Consumers immediately reduce consumption to zero. What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount. Near Bottom

Elasticity Investigation
Compare your elasticities with two other groups. Is there a common pattern? Suppose we find that a price elasticity is equal to 10. What does this mean? We need a way to interpret the value of elasticity Take a look at the formula again. Ed = %ΔQd/%ΔP = 10 Now suppose that price were to increase by 1%. And since, Ed = %ΔQd/%1 = 10, we can predict that Qd will fall by a whopping 10%, which is a pretty big response. What would be the largest response to a price increase? Consumers immediately reduce consumption to zero. What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount.

ElElasticity along the Demand Curve
Why do we get this pattern??? As the price rises, initially total revenue rises because of the inelastic response in quantity demand. However, further price increases eventually cause total revenue to decline because of a larger elastic response. Think about this intuitively: When prices are high, we are more responsive to price changes A 10% increase in a high price makes a BIG difference (e.g. a 10% of a \$100 good is \$10) , so our quantity is very responsive when prices are high. When prices are low, a 10% increase does not make a very big difference (e.g. 10% of a \$1.00 good is only 10 cents), so our quantity is not very responsive. Along the same demand curve, price elasticity is inelastic at low prices and grows more elastic at higher prices.

Elasticity and Total Revenue
Who cares about the price elasticity of demand for a product? Producers of those products would care! Why? When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect. 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.

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? Who cares about the price elasticity of demand for a product? Producers of those products would care! Why? When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

Individual Practice Help the bookseller in worksheet figure out which customer group should get a discount. Who cares about the price elasticity of demand for a product? Producers of those products would care! Why? When a firm sells products to consumers, the firm earns something called revenue. The total revenue earned by a firm is equal to the price of the product multiplied by how many units were sold at that price. In other words: TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example 1: Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example 2: Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example 3: Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect.

Determinants of Price Elasticity of Demand
Availability of substitutes Luxury or necessity Share of income spent Time What Factors Determine the Price Elasticity of Demand? 1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand. If a product has many substitutes, and the price rises, consumers will have an elastic response because they can easily find alternative products. 2. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. In the case of a luxury, if the price increases, consumers will just do without and have an elastic response. 3. Share of income spent on the good: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

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. What Factors Determine the Price Elasticity of Demand? 1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand. If a product has many substitutes, and the price rises, consumers will have an elastic response because they can easily find alternative products. 2. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. In the case of a luxury, if the price increases, consumers will just do without and have an elastic response. 3. Share of income spent on the good: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.