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

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

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.

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

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

Figure 47.3 Total Revenue Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Price Elasticity Along the Demand Curve

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

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

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

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