KRUGMAN'S

1
The Income Effect, Substitution Effect, and
Elasticity
Module
Econ
46

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
2
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

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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
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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?

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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 ?Qd/?P note we drop the
  negative sign for Ed only.

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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!
• ?Qd 100(New Quantity Old Quantity)/Average
  Quantity
• ?P 100(New Price Old Price)/Average Price
• Ed ?Qd/?P

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C. Midpoint Formula

• Q2-Q1
• (Q2Q1)/2
• P2-P1
• (P2P1)/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

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
9
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

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Interpreting Price Elasticity of Demand

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

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What does an Elastic Demand Curve Look Like?
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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

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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

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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.
Practice PED NCEE Activities 17, 18 and 19
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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

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• 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

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Other Elasticities

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
19
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.

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Other Elasticities

• Cross-price elasticity of demand
• Income elasticity of demand
• Price elasticity of supply

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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)
• Complements (negative
• B. The elasticity is measuring the shift of the
  demand curve

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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.

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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)

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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 gt1, supply is considered elastic.
• If Es lt 1, supply is considered inelastic.
• If Es 1, supply is considered unit elastic.

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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

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
28
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.

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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.

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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

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Calculating Consumer Surplus
½ Base x height
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II. Producer Surplus

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

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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

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Calculating Producer Surplus
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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
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Efficiency and Deadweight Loss

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
38
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

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

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Equity and Efficiency

• Efficiency is not societys 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

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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.

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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.

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• 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
  (PcPp) 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.

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A 2 Tax on Bottled Water
TaxPc-Pp or 9-72
Q1
Q2
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III. Tax Revenue

• A. Tax revenue is t x Q2.

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A 2 Tax on Bottled Water
TaxPc-Pp or 9-72
Tax RevenueT x Q2 or 2x12 million 24million
Q2
Q1
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IV. Who pays the tax?

1. 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.
2. The bottom portion of the rectangle, (PePp) 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
TaxPc-Pp or 9-72
Tax RevenueT x Q2 or 2x12 million 24million
Pe
(Pc-Pe)xQ2tax paid by Consumers (9-8)x12 12
million dollars
Q2
Q1
(Pp-Pe)xQ2tax paid by Producers (8-7)x12 12
million dollars
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Results of a 2 Tax on Bottled Water
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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.

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VI. The Benefits and Costs of Taxation

• Benefits (Revenue)
• This is not a cost, but a redistribution of
  surplus from consumers and producers to the
  government
• The government then can do what they feel society
  needs
• Costs
• Inefficiency caused by the dead weight loss
• Is the government using the revenue wisely
  (normative)

54
Utility Maximization

• KRUGMAN'S
• MICROECONOMICS for AP

Margaret Ray and David Anderson
55
What you will learnin this Module

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

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Maximizing utility

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

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I. Utility

1. Utility a measure of the satisfaction the
   consumer derives from consumption of goods and
   services.
2. The principle of diminishing marginal utility-
   Each successive unit of a good or service
   consumed adds less to total utility than the
   previous unit

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Budgets

• The budget line
• The optimal consumption bundle
• The consumers challenge is two-fold
• Find the bundles of goods that are affordable,
  given income and prices, and
• Choose the bundle that provides the highest
  utility

Good X
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II. Spending the Marginal Dollar

• Marginal utility and MU per dollar
• Optimal consumption
• 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.
• 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.