Module 8 Income Effects, Substitution Effects, and Elasticity

What You Will Learn 1 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 2 3 4

Explaining the Law of Demand The substitution effect of a change in the price of a good is the change in the quantity consumed of that good as the consumer substitutes the good that has become relatively cheaper for the good that has become relatively more expensive.

Explaining the Law of Demand The income effect of a change in the price of a good is the change in the quantity consumed resulting from a change in the consumer’s purchasing power as a result of the change in the price of the good.

Economics in Action Giffen Goods Some observers claimed that Ireland’s demand curve for potatoes sloped upward, not downward. Suppose an inferior good—people demand less of it when their income rises—absorbs a large share of people’s budgets. Suppose the price of the good, say potatoes, increases. This would, other things equal, cause people to substitute other goods for potatoes. But other things are not equal: given the higher price of potatoes, people are poorer. This increases the demand for potatoes because potatoes are an inferior good.

Defining and Measuring Elasticity Economists use the concept of elasticity to measure the responsiveness of one variable to changes in another. The price elasticity of demand is the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (dropping the minus sign).

The Price Elasticity of Demand

Demand for Vaccinations 10.0 9.9 $21 20 Price of vaccination Quantity of vaccinations (millions) D When price rises to $21 per vaccination, world demand falls to 9.9 million vaccinations (point B). B Figure Caption: Figure 8-1: Demand for Vaccinations At a price of $20 per vaccination, the quantity of vaccinations demanded is 10 million per year (point A). When price rises to $21 per vaccination, the quantity demanded falls to 9.9 million vaccinations per year (point B). A

Calculating the Price Elasticity of Demand

Using the Midpoint Method The midpoint method is a technique for calculating the percent change. In this approach, we calculate changes in a variable compared with the average, or midpoint, of the starting and final values.

Using the Midpoint Method

Using the Midpoint Method

Price elasticity of demand < 1 Price elasticity of demand > 1 Economics in Action Estimating Elasticities Good Price elasticity Inelastic demand Eggs 0.1 Beef 0.4 Stationery 0.5 Gasoline 0.5 Elastic demand Housing 1.2 Restaurant meals 2.3 Airline travel 2.4 Foreign travel 4.1 Price elasticity of demand < 1 Price elasticity of demand > 1

Summary Elasticity is a general measure of responsiveness that can be used to answer such questions. The price elasticity of demand—the percent change in the quantity demanded divided by the percent change in the price (dropping the minus sign)—is a measure of the responsiveness of the quantity demanded to changes in the price.