MODULE 46: INCOME EFFECTS, SUBSTITUTION EFFECTS, AND ELASTICITY

Student learning objectives: 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. Duffka School of Economics

Key Economic Concepts For This Module: • Demand curves slope downward due to the substitution and income effects. • When one good, like coffee, becomes more expensive relative to other goods, consumers buy less coffee and more of other goods. This is known as the substitution effect. • When a good becomes more expensive, the purchasing power of consumer income falls, and this further reduces consumption of most goods. This is known as the income effect. • Elasticity in economics always measures the same thing: the response of one variable (dependent) to a change in another variable (independent). • The price elasticity of demand = %ΔQd/ΔP. Duffka School of Economics

MODULE 46 : INCOME EFFECTS, SUBSTITUTION EFFECTS, AND ELASTICITY I. Explaining the Law of Demand A. The Substitution Effect B. The Income Effect II. Defining and Measuring Elasticity A. Calculating the Price Elasticity of Demand B. An Alternative Way to Calculate Elasticities: the Midpoint Method Duffka School of Economics

I. Explaining the Law of Demand The law of demand is very intuitive: when the price of jellybeans rises, all else equal, people buy fewer jellybeans. Why? Duffka School of Economics

I. Explaining the Law of Demand A. The Substitution Effect Consumers have many items from which to choose. Suppose Edwin can buy jellybeans ($1 each) or gummy worms ($2 each) with his $6 of weekly income. Currently, Edwin is buying 4 packages of jellybeans and 1 package of gummy worms. If Edwin buys one package of gummy worms, he must give up buying two packages of jellybeans. In other words, the opportunity cost of gummy worms is two jellybeans. Duffka School of Economics

I. Explaining the Law of Demand A. The Substitution Effect Suppose the price of gummy worms falls to $1, while income and the price of jellybeans remains unchanged. Now a package of gummy worms only requires the sacrifice of one package of jellybeans. So relative to jellybeans, gummy worms are now less expensive, and we predict that Edwin will substitute and consume fewer jellybeans and more gummy worms. In other words, the substitution effect of a lower price creates an increase in quantity demanded. . Duffka School of Economics

I. Explaining the Law of Demand B. The Income Effect Revisit the previous example before the price of gummy worms fell. If Edwin spent all of his income on jellybeans, he could buy 6 packages. If Edwin spent all of his income on gummy worms, he could buy 3 packages. Now the price of gummy worms has fallen to $1 each. If Edwin spent all of his income on gummy worms, he could buy 6 packages. Duffka School of Economics

I. Explaining the Law of Demand B. The Income Effect So Edwin’s income hasn’t increased, but his purchasing power, has increased and more purchasing power will likely cause Edwin to buy more gummy worms. So when we combine the substitution effect with the income effect, we can see that lower prices create increased quantity demand, thus explaining the law of demand. Note: if the good is an inferior good (like Spam perhaps) then a lower price creates an income effect to purchase less of such a good. In order for demand curves to be downward sloping, the substitution effect must dominate the income effect for inferior goods. Duffka School of Economics

II. Defining and Measuring Elasticity What happens to quantity of gasoline demanded when the price rises? It will decrease Yes, but by how much? Will gas stations go out of business? Will consumers completely stop driving to school, work, and the shopping mall? Duffka School of Economics

II. Defining and Measuring Elasticity Law of demand tells us that consumers will respond to a price decline by buying more of a product (other things remaining constant), but it does not tell us how much more. Degree of Responsiveness. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. 1. If consumers are relatively responsive to price changes, demand is said to be elastic. 2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic. 3. Note that with both elastic and inelastic demand consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows. Duffka School of Economics

II. Defining and Measuring Elasticity A. Calculating the Price Elasticity of Demand Simply defined: Ed = %ΔQd/ΔP Example The price of digital cameras increases by 1% and quantity demand falls by 2%: Ed = -2%/1% = -2, or simply = 2. Note: economists ignore the negative sign because downward sloping demand curves will insure a negative price elasticity, what’s important is the magnitude of that elasticity. In the case of the digital camera example, the % decrease in Qd (the effect) was twice as large as the % increase in P (the cause). Consumers have exhibited a sensitive, or elastic, response to a higher price. Duffka School of Economics

II. Defining and Measuring Elasticity Milk Example Example The price of milk increases by 10% and quantity demand falls by 5%. Ed = -5%/10% = - ½ , or simply = .50 . In the case of the milk example, the % decrease in Qd (the effect) was only half the size as the % increase in P (the cause). Consumers have exhibited an insensitive, or inelastic, response to a higher price. Duffka School of Economics

II. Defining and Measuring Elasticity Doughnut Example Example The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut consumption from 20 to 19. %ΔP = 100*(New Price – Old Price)/Old Price = 100*(1.15 – 1)/1 = 15% increase %ΔQd = 100*(New Quantity – Old Quantity)/Old Quantity = 100*(19 – 20)/20 = 5% decrease Homer’s price elasticity of demand for doughnuts is: 5%/15% = 1/3. Duffka School of Economics

Midpoint Formula 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 Duffka School of Economics

II. Defining and Measuring Elasticity Total Revenue Test—THE BEST $21 X 9.9 =207.9 Total Revenue $20 X 10=$200 Total Revenue When Price increases and TR Increases, D is Inelastic. Duffka School of Economics

II. Defining and Measuring Elasticity The Total Revenue Test is Covered in Mod 47 Duffka School of Economics

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Percentage change in # of questions Percentage change in e.c. points Duffka School of Economics

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20 .12 170 .18 1 .67 1.5 20 90 .22 1.22 1 .18 5.5 Duffka School of Economics

1/20 or .05 1/20 or .05 Duffka School of Economics

Practice Question # 1 a. I only b. II only c. III only 1. Which of the following statements is true?    I. When a good absorbs only a small share of consumer spending, the income effect explains the demand curve’s negative slope.    II. A change in consumption brought about by a change in purchasing power describes the income effect.    III. In the case of an inferior good, the income and substitution effects work in opposite directions. a. I only b. II only c. III only d. II and III only e. I, II, and III Duffka School of Economics

Practice Question # 2 2. The income effect is most likely to come into play for which of the following goods? a. water b. clothing c. housing d. transportation e. entertainment Duffka School of Economics

Practice Question # 3 QD=(20/110)X100=18 P=(1/1.5)X100=66.666 3. If a decrease in price from $2 to $1 causes an increase in quantity demanded from 100 to 120, using the midpoint method, price elasticity of demand equals a. 0.17. b. 0.27. c. 0.40. d. 2.5. e. 3.72. QD=(20/110)X100=18 P=(1/1.5)X100=66.666 18/66.66=.27 Duffka School of Economics

Practice Question # 4 4. Which of the following is likely to have the highest price elasticity of demand? a. eggs b. beef c. housing d. gasoline e. foreign travel Duffka School of Economics

Practice Question # 5. If a 2% change in the price of a good leads to a 10% change in the quantity demanded of a good, what is the value of price elasticity of demand? a. 0.02 b. 0.2 c. 5 d. 10 e. 20 Duffka School of Economics