Income and Substitution Effects and Elasticity Lesson 3.46

Explaining the Law of Demand The Substitution Effect – As price of one item increases, the demand for that item drops, but the demand for a similar item increases The Income Effect – As income increases, the demand for superior products increases – As income falls, the demand for generic items increases

Elasticity of Demand Elasticity of demand is a concept dealing with the changes in demand due to price changes. The amount of change of demand versus the amount of change of price determines elasticity. If the change of demand is small, then the demand is called inelastic. If the change in demand is large, then demand is called elastic, like a rubber band.

Defining and Measuring Elasticity Calculating the Price Elasticity of Demand – The Percent Change in Quantity Demanded and the Percentage Change in Price – Ed = %ΔQ d /ΔP Alternate Midpoint Method of Calculating Elasticity – The midpoint method yields the same answer in either direction – If Ed>1 then price is elastic – If Ed<1 then price is inelastic – If Ed =1 then price is unitary elastic