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

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

The Law of Demand The substitution effect The income effect I

Defining Elasticity Definition of elasticity ( Elasticity measures the responsiveness of one variable to changes in another.) Price elasticity of demand, for example, measures the responsiveness of quantity demanded to changes in price. Law of demand Example- if price of gas doubles??

Calculating Elasticity elasticity Elasticity is the % change in the dependent variable divided by the % change in the independent variable In symbols, elasticity is % ∆dep/%∆ind Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price. In symbols: Ed = %ΔQ d /ΔP note: we drop the negative sign for Ed only.

Figure 46.1 The Demand for Vaccinations Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers Ed = %ΔQ d /ΔP Ed = 1%/5% = 0.2 % change in price = 5% % change in quantity demanded = -1%

The Midpoint Formula The problem with calculating percentage changes: Elasticity computations change if the starting and ending prices (or quantities) are reversed. That’s why we use the midpoint formula. The solution: Use the Midpoint formula! %ΔQ d = 100*(New Quantity – Old Quantity)/Average Quantity%ΔQ d = 100*(New Quantity – Old Quantity)/Average Quantity %ΔP = 100*(New Price – Old Price)/Average Price%ΔP = 100*(New Price – Old Price)/Average Price Ed = %ΔQ d /ΔPEd = %ΔQ d /ΔP

The Midpoint Formula Example: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.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%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 = %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.Ed = 9.5%/10.5% =.90 or an inelastic response between these two points on the demand curve.

Table 46.1 Some Estimated Price Elasticities of Demand Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers