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# The Income Effect, Substitution Effect, and Elasticity

Module. 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 :. How the income and substitution effects explain the law of demand

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## The Income Effect, Substitution Effect, and Elasticity

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

2. What you will learnin thisModule: • 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. I. The Law of Demand A. The substitution effect- a change in the price of a good will cause a consumer to substitute the good due to the lower price creating more quantity demanded. B. The income effect- a change in the price of a good makes a consumer feel like they have more money, leading to an increase in quantity demanded. This is NOT an increase in income, but an increase in purchasing power. I

4. II. Defining Elasticity • Definition of elasticity- Elasticity measures the responsiveness of one variable to changes in another. • Law of demand- We know that when price increases, quantity demanded decreases, NOW we want to know “by how much?” • Example- What if the price of gasoline doubled? What if the price of pencils doubled?

5. III. Calculating 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 = %ΔQd/ΔP note: we drop the negative sign for Ed only.

6. IV. The Midpoint Formula • There are problems with calculating percentage changes (if the starting and ending prices are reversed, elasticity is different) • The solution: Use the Midpoint formula! • %ΔQd= 100*(New Quantity – Old Quantity)/Average Quantity • %ΔP = 100*(New Price – Old Price)/Average Price • Ed = %ΔQd/ΔP

7. C. Midpoint Formula Q2-Q1 (Q2+Q1)/2 P2-P1 (P2+P1)/2 If E is Greater than 1 = Elastic If E is Equal to 1 = Unit Elastic If E is Less than 1 = Inelastic = E

8. Interpreting Price Elasticity of Demand Module Econ: • KRUGMAN'S • MICROECONOMICS for AP* 47 Margaret Ray and David Anderson

9. What you will learnin thisModule: • The difference between elastic and inelastic demand • The relationship between elasticity and total revenue • Changes in the price elasticity of demand along a demand curve • The factors that determine price elasticity of demand

10. Interpreting Price Elasticity of Demand What does the value of elasticity tell us? • It indicates how steep or flat the curve will be.

11. What does an Elastic Demand Curve Look Like?

12. I. Determinants of Elasticity Factors Determine the Price Elasticity of Demand include: • Number of substitutes • More Substitutes = More elastic • Less Substitutes = More inelastic • Luxury or necessity? • The less necessary the item = More Elastic • The more necessary the item = More Inelastic

13. Determinants of Elasticity Continued C. Share of income spent • The more expensive relative to budget the item is = More Elastic • The less expensive, relative to the budget the item is = More Inelastic D. Time • Long Run Demand = More elastic • Short Run Demand = More inelastic

14. Elasticities Price Elasticity of Demand The Determinants of Price Elasticity of Demand: The following factors determine whether demand for a good or service is elastic, unit elastic, or inelastic. S The number of substitutes available. The more substitutes, more elastic demand, as consumers can replace a good whose price has gone up with one of its now relatively cheaper substitutes. The proportion of income the purchase of a good represents. If a good represent a higher proportion of a conumer's income, his demand tends to be more elastic. Luxury or necessity? If a good is a necessity, changes in price tend not to affect quantity demand, i.e. demand is inelastic. If it's a luxury that a consumer can go without, consumers tend to be more responsive. If a product is addictive or habit forming, demand tends to be inelastic. The amount of time a consumer has to respond to the price change. If prices remain high over a longer period of time, consumers can find substitutes or learn to live without, so demand is more elastic over time. P L A T Practice PED: NCEE Activities 17, 18 and 19

15. II. Elasticity and Total Revenue A. Total Revenue and Elasticity • TR = P x Q • Total Revenue Test • Total Revenue Test • P↑ TR ↑ = Inelastic Demand • P↓ TR ↓ = Inelastic Demand • P↑ TR − = Unit Elastic Demand • P↓ TR − = Unit Elastic Demand • P↑ TR ↓ = Elastic Demand • P↓ TR ↑ = Elastic Demand

16. Price effect (p469) • After a price increase, each unit sold sells at a higher price, which tends to raise revenue. • Quantity effect • After a price increase, fewer units are sold, which tends to lower revenue. Examples: • If a good has an elastic demand, quantity effect is stronger than price effect and TR will fall • If a good has an inelastic demand, quantity effect is weaker than price effect and TR will rise • If a good has a unit elastic demand, quantity effect and price effect are equal and TR will remain the same.

17. ElElasticity along the Demand Curve • Elasticity Along the Demand Curve

18. Other Elasticities Module Econ: • KRUGMAN'S • MICROECONOMICS for AP* 48 Margaret Ray and David Anderson

19. What you will learnin thisModule: • How cross-price elasticity of demand measures the responsiveness of demand for one good to changes in the price of another good. • The meaning and importance of the income elasticity of demand, a measure of the responsiveness of demand to changes in income. • The significance of the price elasticity of supply, which measures the responsiveness of the quantity supplied to changes in price. • The factors that influence the size of these various elasticities.

20. Other Elasticities • Cross-price elasticity of demand • Income elasticity of demand • Price elasticity of supply

21. I. Cross-Price Elasticity of Demand A. Measures the responsiveness of the demand for good “X” to changes in the price of good “Y” Exy = %∆ Qdof X/ %∆ P of Y. Do not use absolute value, the +/- sign is very important. 1. Substitutes (positive) • Complements (negative B. The elasticity is measuring the shift of the demand curve

22. Cross-Price Elasticity of Demand Continued C. Examples If cross elasticity is positive, then X and Y are substitutes. • Example: The price of Nike shoes increases 2% and quantity demanded for Converse shoes increases 4%. EConverse, Nike = 4%/2% = 2. If the cross elasticity is negative, then X and Y are complements. • The price of gasoline increases 20% and quantity demanded for large SUVs decreases by 5%. ESUV,gasoline = -5%/20% = - .25.

23. II. Income Elasticity of Demand • Measures the responsiveness of demand for a good to changes in income. • Ei = %∆ Qd / %∆ I • Normal good (positive) • Income elastic- positive greater than 1 (luxury goods) • Income inelastic- positive but less than 1 (necessities) • Inferior good (negative)

24. III. Price Elasticity of Supply • Measures the responsiveness of quantity supplied to changes in price. (same as Demand, but using Quantity Supplied instead) • Es = %∆ Qs/ %∆ P • If Es >1, supply is considered elastic. • If Es < 1, supply is considered inelastic. • If Es = 1, supply is considered unit elastic.

25. C. Determinants of Price Elasticity of Supply • Availability of inputs • If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic.

26. Time • The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. • The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. • The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. • Example: Think Agriculture and planting seasons

27. Consumer and Producer Surplus Module Econ: • KRUGMAN'S • MICROECONOMICS for AP* 49 Margaret Ray and David Anderson

28. What you will learnin thisModule: • The meaning of consumer surplus and its relationship to the demand curve. • The meaning of producer surplus and its relationship to the supply curve.

29. I. Consumer Surplus A. Consumer surplus measures the difference between what a consumer is willing to pay for a good and what he/she actually has to pay.

30. B. Willingness to Pay • Willingness to pay is shown on the demand curve • Difference in what the consumer is willing to pay and how much they have to pay is consumer surplus

31. Calculating Consumer Surplus ½ Base x height

32. II. Producer Surplus A. Producer surplus measures the difference between the price producers receive for a good and the cost of producing the good.

33. B. Cost and Producer Surplus • Producer cost is shown by the supply curve • The difference between cost what the producer can charge is the producer surplus

34. Calculating Producer Surplus

35. III. Changes in Price affect Consumer and Producer Surplus A. If price decreases, • Consumer surplus increases (willingness to pay is the same, but the price paid is lower) • Producer surplus deceases (costs are the same, but the price received is lower) B. If price increases, • Consumer surplus decreases (willingness to pay is the same, but the price paid is higher) • Producer surplus increases (costs are the same, but the price received is higher)

36. Total Surplus = Consumer Surplus + Producer Surplus

37. Efficiency and Deadweight Loss Module Econ: • KRUGMAN'S • MICROECONOMICS for AP* 50 Margaret Ray and David Anderson

38. What you will learnin thisModule: • The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets • How taxes affect total surplus and can create deadweight loss

39. Consumer Surplus, Producer Surplus, And Efficiency • 495-499 on own • Gains from trade • The efficiency of markets • Equity and Efficiency

40. Gains from Trade • Any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. • Gains from trade are represented by consumer and producer surplus. • At the market equilibrium price and quantity, total surplus is the sum of the CS and PS triangles.

41. The Efficiency of Markets • No reallocation of consumption among consumers could increase consumer surplus • No reallocation of sales among producers could increase producer surplus • No change in the quantity traded could increase total surplus

42. Equity and Efficiency • Efficiency is not society’s only concern. We are also concerned with equity. • What is considered “fair” or “equitable” depends on many factors. • Often equity and efficiency are at the root of the debate surrounding taxes. • Progressive, regressive, and proportional taxes

43. I. No Taxes A. In the absence of the tax, supply would equal demand at the equilibrium point E0, with a unit price of P0 and a quantity of Q0 units.

44. II. Taxes A. A tax on sellers will shift the supply curve to the left. B. A tax on buyers will shift the demand curve to the left.

45. C. A tax leads to; • a decrease in quantity • an increase in the price paid by consumers. • a decrease in the price received by sellers • a “wedge” between the price consumers pay and the price producers receive (equal to the amount of the tax) Example: Imposing an excise tax or per unit tax of t = (Pc–Pp) drives a wedge between the price paid by the consumer (Pc) and the price received by the producer (Pp). As the net price received by the seller falls, less is supplied (movement along the supply curve). The quantity of output falls from its original value (Q1) to its new value (Q2). Market equilibrium shifts from E1 to E2.

46. A \$2 Tax on Bottled Water Pc Pp Tax=Pc-Pp or \$9-\$7=\$2 Q2 Q1

47. III. Tax Revenue A. Tax revenue is t x Q2.

48. A \$2 Tax on Bottled Water Pc Pp Tax=Pc-Pp or \$9-\$7=\$2 Tax Revenue=T x Q2 or \$2x12 million = \$24million Q2 Q1

49. IV. Who pays the tax? • The upper portion of the revenue rectangle, (Pc– Pe) x Q2, is considered to be the share of the tax that falls on the consumer because he now pays a higher tax-inclusive price. • The bottom portion of the rectangle, (Pe–Pp) x Q2, is considered to be the share of the tax that falls on the producer in the form of a lower net-of-tax price and revenue received for selling the product.

50. A \$2 Tax on Bottled Water Pc Tax=Pc-Pp or \$9-\$7=\$2 Pp Tax Revenue=T x Q2 or \$2x12 million = \$24million Pe (Pc-Pe)xQ2=tax paid by Consumers (9-8)x12= 12 million dollars Q2 Q1 (Pp-Pe)xQ2=tax paid by Producers (8-7)x12= 12 million dollars

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