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

2. 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

3. The Law of Demand-inverse relationship due to: The substitution effect- we will substitute cheaper “like” goods until price is reduced The income effect-if price is reduced, gain “purchasing power” so buy more I

4. Defining Elasticity “-responsiveness of one variable to changes in another ” Price elasticity of demand-dominant measure- other measures of elasticity used like elasticity of supply, income elasticity, and cross elasticity If change in price – how much of a change in Qd can be expected? Important as firms consider increasing their price to evaluate impact on Total Revenue

5. Calculating Elasticity w/ % Elasticity is the % change in the dependent variable divided by the % change in the independent variable or % ∆dep/%∆ind Ed = %ΔQ d /%ΔP note: we drop the negative sign for Ed only. A 10% change in price yields a 15% change in Qd. What is Ed?.15/.10 = 1.5

6. The Midpoint Formula w/ #s If % change is not given and raw numbers are try this: %ΔQ d = 100*(New Quantity – Old Quantity)/Average Quantity 450-500=-50 450+500/2=475 %ΔP = 100*(New Price – Old Price)/Average Price 22,000 - $20,000=$2000 22,000+20,000/2=$21,000 -50/475 divided by $2000/$21000 =.105/.095=1.10