1. Income and Substitution Effects and Elasticity
Lesson 6
Sections 46, 47, 48

2. 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

3. 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.

4. Defining and Measuring Elasticity
Calculating the Price Elasticity of Demand
The Percent Change in Quantity Demanded and the Percentage Change in Price
Ed = %ΔQd/ΔP (depends on the direction)
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

5. Interpreting the Price Elasticity of Demand
How Elastic is Elastic?
Extreme conditions of elasticity
Perfect Elasticity
Perfect Inelasticity
Unit Elasticity

6. Figure Total Revenue Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

7. Price Elasticity Along the Demand Curve

8. What Factors Determine Price Elasticity of Demand
Substitutes
Necessity or Luxury
Share of Income
Time

9. Cross-Price Elasticity of Demand
The Demand for a good is often affected by the demand for other products, such as substitutes and complimentary items.
Substitute goods will have a positive cross-price elasticity (Price of B goes up, Demand for A goes up)
Complimentary goods will have a negative cross-price elasticity (Price of B goes up, Demand for A goes down)
Cross-Price Elasticity =
%Change in Demand A/%Change in Price B

10. Income Elasticity of Demand
How changes in Income affect the demand for a good.
When the Income elasticity is positive, and the good is a normal good, quantity demanded will increase as income increases.
When Income Elasticity is negative, demand decreases for inferior goods as income increases.
Income-Elastic
Demand will grow faster than income
Income-Inelastic
Demand will grow, but slower that income
%Change in Quantity Demanded/%Change in Income

11. Price Elasticity of Supply
The price-elasticity of supply is defined the same as with demand.
Price Elasticity of Supply = %Change in quantity supplied/%Change in price
Perfectly elastic and perfectly inelastic extremes
What factors determine price elasticity of supply?
Availability of inputs
Time