KRUGMAN'SMICROECONOMICS for AP*

The Income Effect, Substitution Effect, and Elasticity

Margaret Ray and David Anderson

46

Econ:

Module

What you will learnin 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

I. The Law of DemandA. 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

II. Defining Elasticity

A. Definition of elasticity- Elasticity measures the responsiveness of one variable to changes in another.

B.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?

III. Calculating Elasticity

A. Elasticity is the % change in the dependent variable divided by the % change in the independent variable

B. In symbols, elasticity is %∆dep/%∆ind

C. Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in the price.

D. In symbols: Ed = %ΔQd/ΔP note: we drop the negative sign for Ed only.

IV. The Midpoint Formula

A. There are problems with calculating percentage changes (if the starting and ending prices are reversed, elasticity is different)

B.The solution: Use the Midpoint formula!

1. %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity

2. %ΔP = 100*(New Price – Old Price)/Average Price

3. Ed = %ΔQd/ΔP

C. Midpoint Formula

Q2-Q1(Q2+Q1)/2

P2-P1(P2+P1)/2

If E is Greater than 1 = ElasticIf E is Equal to 1 = Unit ElasticIf E is Less than 1 = Inelastic

= E

•KRUGMAN'S

•MICROECONOMICS for AP*

Interpreting Price Elasticity of Demand

Margaret Ray and David Anderson

Econ: 47

Module

What you will learnin this Module:• 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

Interpreting Price Elasticity of Demand

What does the value of elasticity tell us?

• It indicates how steep or flat the curve will be.

What does an Elastic Demand Curve Look Like?

I. Determinants of Elasticity

Factors Determine the Price Elasticity of Demand include:

A. Number of substitutes1. More Substitutes = More elastic2. Less Substitutes = More inelastic

B. Luxury or necessity?1. The less necessary the item = More Elastic2. The more necessary the item = More Inelastic

Determinants of Elasticity Continued

C. Share of income spent1. The more expensive relative to budget the item

is = More Elastic2. The less expensive, relative to the budget the

item is = More Inelastic

D. Time1. Long Run Demand = More elastic2. Short Run Demand = More inelastic

The Determinants of Price Elasticity of Demand: The following factors determine whether demand for a good or service is elastic, unit elastic, or inelastic.

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.

SPLAT

Practice PED: NCEE Activities 17, 18 and 19

ElasticitiesPrice Elasticity of Demand

II. Elasticity and Total Revenue

A. Total Revenue and Elasticity1. TR = P x Q2. Total Revenue Test

B.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

C. Price effect (p469)1. After a price increase, each unit sold sells at a

higher price, which tends to raise revenue.

D. Quantity effect1. 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.

ElElasticity along the Demand Curve

• Elasticity Along the Demand Curve

•KRUGMAN'S

•MICROECONOMICS for AP*

Other Elasticities

Margaret Ray and David Anderson

Econ: 48

Module

What you will learnin this Module:

• 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.

Other Elasticities

• Cross-price elasticity of demand

• Income elasticity of demand

• Price elasticity of supply

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 = %∆ Qd of X / %∆ P of Y. Do not use absolute value, the +/- sign is very important.

1. Substitutes (positive)2.Complements (negative

B. The elasticity is measuring the shift of the demand curve

Cross-Price Elasticity of Demand Continued

C. ExamplesIf 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.

II. Income Elasticity of Demand

A. Measures the responsiveness of demand for a good to changes in income.

B. Ei = %∆ Qd / %∆ I1. Normal good (positive)

• Income elastic- positive greater than 1 (luxury goods)

• Income inelastic- positive but less than 1 (necessities)

2. Inferior good (negative)

III. Price Elasticity of Supply

A. Measures the responsiveness of quantity supplied to changes in price. (same as Demand, but using Quantity Supplied instead)

B.Es = %∆ Qs / %∆ P 1. If Es >1, supply is considered elastic.2. If Es < 1, supply is considered inelastic.3. If Es = 1, supply is considered unit elastic.

C. Determinants of Price Elasticity of Supply

1.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.

•KRUGMAN'S

•MICROECONOMICS for AP*

Consumer and Producer Surplus

Margaret Ray and David Anderson

Econ: 49

Module

What you will learnin this Module:

• The meaning of consumer surplus and its relationship to the demand curve.

• The meaning of producer surplus and its relationship to the supply curve.

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.

B. Willingness to Pay

1. Willingness to pay is shown on the demand curve

2. Difference in what the consumer is willing to pay and how much they have to pay is consumer surplus

Calculating Consumer Surplus

½ Base x height

II. Producer Surplus

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

B. Cost and Producer Surplus

1. Producer cost is shown by the supply curve

2. The difference between cost what the producer can charge is the producer surplus

Calculating Producer Surplus

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)

Total Surplus = Consumer Surplus + Producer Surplus

•KRUGMAN'S

•MICROECONOMICS for AP*

Efficiency and Deadweight Loss

Margaret Ray and David Anderson

Econ: 50

Module

What you will learnin this Module:

• 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

Consumer Surplus, Producer Surplus, And Efficiency

•495-499 on own

•Gains from trade

•The efficiency of markets

•Equity and Efficiency 

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.

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

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

I. No TaxesA. 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.

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.

C. A tax leads to;1.a decrease in quantity 2.an increase in the price paid by consumers.3.a decrease in the price received by sellers4.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.

A $2 Tax on Bottled Water

Pc

PpTax=Pc-Pp or $9-$7=$2

Q1Q2

III. Tax Revenue

A. Tax revenue is t x Q2.

A $2 Tax on Bottled Water

Pc

PpTax=Pc-Pp or $9-$7=$2

Tax Revenue=T x Q2 or $2x12 million = $24million

Q2Q1

IV. Who pays the tax?

A. 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.

B. 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.

A $2 Tax on Bottled Water

Pc

Pp

Tax=Pc-Pp or $9-$7=$2

Tax Revenue=T x Q2 or $2x12 million = $24million

Q2Q1

(Pc-Pe)xQ2=tax paid by Consumers(9-8)x12= 12 million dollars(Pp-Pe)xQ2=tax paid by Producers(8-7)x12= 12 million dollars

Pe

Results of a $2 Tax on Bottled Water

Tax Revenue

Dead Weight Loss

Reduced Consumer Surplus

Reduced Producer Surplus

V. Elasticity and Tax Incidence

A. Tax incidence: the measure of who really pays a tax

B. If the demand curve is relatively inelastic and the supply curve is relatively elastic, the buyers will pay the larger share of the excise tax.

C. If the demand curve is relatively elastic and the supply curve is relatively inelastic, the sellers will pay the larger share of the excise tax.

VI. The Benefits and Costs of Taxation

A. Benefits (Revenue)1. This is not a cost, but a redistribution of surplus

from consumers and producers to the government2. The government then can do what they feel

society needsB. Costs1. Inefficiency caused by the dead weight loss2. Is the government using the revenue wisely

(normative)

•KRUGMAN'S

•MICROECONOMICS for AP*

Utility Maximization

Margaret Ray and David Anderson

Econ: 51

Module

What you will learnin this Module:

• How consumers make choices about the purchase of goods and services

• Why a consumer’s goal is to maximizing utility

• Why the principle of diminishing marginal utility applies to the consumption of most goods and services

• How to use marginal analysis to find the optimal consumption bundle

Maximizing utility

In the Theory of Consumer Choice, consumers’ goal is to maximize their utility.

I. UtilityA. Utility: a measure of the satisfaction the consumer

derives from consumption of goods and services.

B. The principle of diminishing marginal utility- Each successive unit of a good or service consumed adds less to total utility than the previous unit

Budgets• The budget line• The optimal consumption bundle• The consumer’s challenge is two-fold:

1. Find the bundles of goods that are affordable, given income and prices, and

2. Choose the bundle that provides the highest utility

Good YB

A

C

Good X

II. Spending the Marginal Dollar

A. Marginal utility and MU per dollar

B. Optimal consumption1. The “utility maximization rule” says that the consumer

should spend all of his income on two goods such that: MU/P is equal for both (all) goods.

2. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.