Module The Income Effect, Substitution Effect, and Elasticity 10 Micro: 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: What drives the “Law of Demand?” What determines the slope of the demand curve? 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. 2

Types of Goods Normal goods: ceteris paribus, when incomes go up, people generally want to buy more of it. If incomes go down they will buy less. Inferior goods: ceteris paribus, when incomes go up people want to buy less of it, and they want to buy more of it when incomes go down. I Explaining the Law of Demand   The law of demand is very intuitive: when the price of chocolate rises, all else equal, people buy less chocolate. But why? A. The Substitution Effect Consumers have many items from which to choose. Suppose Eli can buy candy ($1 each) or chocolate ($2 each) with his $6 of weekly income. Currently, Eli is buying 4 packages of candy and 1 package of chocolate. If Eli buys one package of chocolate, he must give up buying two packages of candy. In other words, the opportunity cost of chocolate is two candies. Suppose the price of chocolate falls to $1, while income and the price of candy remains unchanged. Now a package of chocolate only requires the sacrifice of one package of candy. So relative to candy, chocolate is now less expensive, and we predict that Eli will substitute and consume less candy and more chocolate. B. The Income Effect Revisit the previous example before the price of chocolate fell. If Eli spent all of his income on candy, he could buy 6 packages. If Eli spent all of his income on chocolate, he could buy 3 packages. Now the price of chocolate has fallen to $1 each. If Eli spent all of his income on chocolate, he could buy 6 packages. So Eli’s income hasn’t increased, but his purchasing power, has increased and more purchasing power will likely cause Eli to buy more chocolate. Alternatively, if the price of chocolate goes up he will buy less because he will have less left over income. Thus the income effect works both positively and negatively. 3

The Law of Demand The income effect: people choose to buy more or less of something as their incomes change Price changes, income changes, inflation, FOREX, etc. Closely tied with good/service type! I Explaining the Law of Demand   The law of demand is very intuitive: when the price of chocolate rises, all else equal, people buy less chocolate. But why? A. The Substitution Effect Consumers have many items from which to choose. Suppose Eli can buy candy ($1 each) or chocolate ($2 each) with his $6 of weekly income. Currently, Eli is buying 4 packages of candy and 1 package of chocolate. If Eli buys one package of chocolate, he must give up buying two packages of candy. In other words, the opportunity cost of chocolate is two candies. Suppose the price of chocolate falls to $1, while income and the price of candy remains unchanged. Now a package of chocolate only requires the sacrifice of one package of candy. So relative to candy, chocolate is now less expensive, and we predict that Eli will substitute and consume less candy and more chocolate. B. The Income Effect Revisit the previous example before the price of chocolate fell. If Eli spent all of his income on candy, he could buy 6 packages. If Eli spent all of his income on chocolate, he could buy 3 packages. Now the price of chocolate has fallen to $1 each. If Eli spent all of his income on chocolate, he could buy 6 packages. So Eli’s income hasn’t increased, but his purchasing power, has increased and more purchasing power will likely cause Eli to buy more chocolate. Alternatively, if the price of chocolate goes up he will buy less because he will have less left over income. Thus the income effect works both positively and negatively. 4

The Law of Demand The substitution effect – if the price of something goes up, people choose to buy something else. I Explaining the Law of Demand   The law of demand is very intuitive: when the price of chocolate rises, all else equal, people buy less chocolate. But why? A. The Substitution Effect Consumers have many items from which to choose. Suppose Eli can buy candy ($1 each) or chocolate ($2 each) with his $6 of weekly income. Currently, Eli is buying 4 packages of candy and 1 package of chocolate. If Eli buys one package of chocolate, he must give up buying two packages of candy. In other words, the opportunity cost of chocolate is two candies. Suppose the price of chocolate falls to $1, while income and the price of candy remains unchanged. Now a package of chocolate only requires the sacrifice of one package of candy. So relative to candy, chocolate is now less expensive, and we predict that Eli will substitute and consume less candy and more chocolate. B. The Income Effect Revisit the previous example before the price of chocolate fell. If Eli spent all of his income on candy, he could buy 6 packages. If Eli spent all of his income on chocolate, he could buy 3 packages. Now the price of chocolate has fallen to $1 each. If Eli spent all of his income on chocolate, he could buy 6 packages. So Eli’s income hasn’t increased, but his purchasing power, has increased and more purchasing power will likely cause Eli to buy more chocolate. Alternatively, if the price of chocolate goes up he will buy less because he will have less left over income. Thus the income effect works both positively and negatively. 5

The Law of Demand What happens when the price of cherries (a normal good) increases? Use the income and sub effect. What happens when the price of latiao (an inferior good) increases? Use the income and sub effect. BE CAREFUL! Down the rabbit hole.... (GoFormative) What would happen if the income effect for an inferior good was VERY strong compared the the substitution effect? I Explaining the Law of Demand   The law of demand is very intuitive: when the price of chocolate rises, all else equal, people buy less chocolate. But why? A. The Substitution Effect Consumers have many items from which to choose. Suppose Eli can buy candy ($1 each) or chocolate ($2 each) with his $6 of weekly income. Currently, Eli is buying 4 packages of candy and 1 package of chocolate. If Eli buys one package of chocolate, he must give up buying two packages of candy. In other words, the opportunity cost of chocolate is two candies. Suppose the price of chocolate falls to $1, while income and the price of candy remains unchanged. Now a package of chocolate only requires the sacrifice of one package of candy. So relative to candy, chocolate is now less expensive, and we predict that Eli will substitute and consume less candy and more chocolate. B. The Income Effect Revisit the previous example before the price of chocolate fell. If Eli spent all of his income on candy, he could buy 6 packages. If Eli spent all of his income on chocolate, he could buy 3 packages. Now the price of chocolate has fallen to $1 each. If Eli spent all of his income on chocolate, he could buy 6 packages. So Eli’s income hasn’t increased, but his purchasing power, has increased and more purchasing power will likely cause Eli to buy more chocolate. Alternatively, if the price of chocolate goes up he will buy less because he will have less left over income. Thus the income effect works both positively and negatively. 6

Practice George Stigler, 1982 Nobel Laureate in Economics, once wrote that, according to consumer theory,” if consumers do not buy less of a commodity when their incomes rise, they will surely buy less when the price of the commodity rises.” Explain this statement. Answer: This is because he is talking about normal goods. The price of mushrooms rise. Explain what will happen by first using the income effect, then by using the substitution effect. Answer: It depends on whether you consider them to be normal or inferior! Assuming normal…because the price of mushrooms rose, consumers buying mushrooms will have less overall income. Therefore they will buy less. They will probably buy other vegetables instead, demonstrating the substitution effect. Winners of lotteries are a good example to study a. the substitution effect. b. the income effect. c. how the income effect dominates the substitution effect. d. how the substitution effect dominates the income effect. Answer: b. 7

Elasticity? What does it mean? Elasticity just means “can stretch” Definition of elasticity: the % change in one variable related to the % change in another 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). 8

Perfectly 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). 9

Perfectly Elastic 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). 10

Inelastic [close to 0] or elastic [more than 1]? -0.1 Very inelastic USA Japan -0.55 -0.25 11

Inelastic [close to 0] or elastic [more than 1]? Coach 1st Class -0.9 -0.3 Short Run Long Run -0.09 -0.31 12

Stretch your vocabulary Independent variable: something that can change on it’s own, for example – temperature Dependent variable: something that changes because of something else, for example – the number of people wearing a coat today 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). 13

Calculating Elasticity of Demand Price elasticity of demand is the percentage change in quantity [dependent variable] demanded divided by the percentage change in the price [independent variable]. In symbols: Ed = %ΔQd/%ΔP Let’s practice: How many students in the room are happy? Now – if we drop the temperature to 12 degrees, how many would still be happy? ATTENTION: You will need to figure out which variables are dependent and independent! 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. Help students see the connection between the concept of elasticity and the elasticity formula. Use words, then symbols. 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? 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. Ed = %ΔQd/ΔP will often be the starting point when working with elasticity. 14

Calculating Price Elasticity of Demand When the price of CD increased from $20 to $22, the quantity of CDs demanded decreased from 100 to 87. What is the price elasticity of demand for CDs? Is it demand elastic or inelastic? The price increases from $20 to $22. Therefore % change = 2 / 20 = 0.1 0.1 = 10% (0.1 *100) Quantity fell by 13 / 100 = – 0.13 (13%) Therefore PED = 13 / – 10 Therefore PED = -1.3 Therefore Demand is elastic. Elastic demand occurs when % change in Quantity is greater than % change in price; when PED >1 15

Problems and Midpoint Mthd. 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. The solution: Use the Midpoint formula! %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity %ΔP = 100*(New Price – Old Price)/Average Price Dojo point: how do we get an average? 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 16

The Midpoint Formula 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*($4000)/$22,000 = 18.18% %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity = 100*(-50)/475 = - 10.5% Ed = 10.5%/ 18.18%/ = -0.6 or an inelastic response between these two points on the demand curve. 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 17

Price Elasticity of Demand Calculate PED using both the simple and midpoint method. 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 18

Price Elasticity of Demand The price increases from $10 to $15. Therefore % change = 5 / 10 = 0.5 0.5 = 50% (0.5 *100) Quantity fell by -2 / 8 = – 0.25 (25%) Therefore PED = 25% / – 50% Therefore PED = -0.5 Therefore Demand is inelastic. Inelastic demand occurs when % change in Quantity is less than % change in price; when PED < 1 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 19

Price Elasticity of Demand %ΔP = 100*(New Price – Old Price)/Average Price = 100*($15-10)/$12.5 = 40% %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity = 100*(6-8)/7 = - 28.57% Ed = 28.57%/40%= -0.714 or an inelastic response between these two points on the demand curve. 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 20

Price Elasticity of Demand Using the demand schedule below, use the midpoint method to calculate price elasticity of demand for business and vacation travelers when the price goes from 200$ to 250$. 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. Price of Ticket Qd Business Travelers Qd Vacation Travelers 150 2100 1000 200 2000 800 250 1900 600 300 1800 400 21

Price Elasticity of Demand Business Travelers: The price change is simple: Old price = 200, New Price = 250$ The quantities are: Old Q = 2000, New Q = 1900 So step 1 is: ((1900-2000)/1950)*100 = (-100/1950)*100 = -0.0513 or -5.13% Step 2 is: (250-200)/225 = .2222 or 22.22% Therefore, the Ed = -0.0513/.2222 = -0.231 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 22

Price Elasticity of Demand Mini-Presentations Calculate the Ed for vacation travelers using the midpoint method, and be ready to present your work. Answer: Ed = -1.29 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 23

Genius Question Why is elasticity ALMOST ALWAYS negative? Use every concept we have learned in this class. Work with your group for 3 minutes. Answer: The price elasticity of demand represents the percent change relationship across the demand curve. Because we know that price and quantity demanded have an obverse relationship, the percent change relationship will always include an increase in one value with a decrease in another. Therefore, one of the two variables will always be negative, therefore, price elasticity of demand is always negative. 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 = - 10.5% Ed = 9.5%/10.5% = .90 or an inelastic response between these two points on the demand curve. 24