Title: KRUGMAN'S
1The Income Effect, Substitution Effect, and
Elasticity
Module
Econ
46
- KRUGMAN'S
- MICROECONOMICS for AP
Margaret Ray and David Anderson
2What 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
3I. 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
4II. 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?
5III. 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.
6IV. 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
7C. 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
8Interpreting Price Elasticity of Demand
- KRUGMAN'S
- MICROECONOMICS for AP
Margaret Ray and David Anderson
9What 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
10Interpreting Price Elasticity of Demand
- What does the value of elasticity tell us?
- It indicates how steep or flat the curve will be.
11What does an Elastic Demand Curve Look Like?
12I. 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
13Determinants 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
14Elasticities 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
15II. 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
16- 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.
17ElElasticity along the Demand Curve
- Elasticity Along the Demand Curve
18Other Elasticities
- KRUGMAN'S
- MICROECONOMICS for AP
Margaret Ray and David Anderson
19What 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.
20Other Elasticities
- Cross-price elasticity of demand
- Income elasticity of demand
- Price elasticity of supply
21I. 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
22Cross-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.
23II. 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)
24III. 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.
25C. 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
27Consumer and Producer Surplus
- KRUGMAN'S
- MICROECONOMICS for AP
Margaret Ray and David Anderson
28What 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.
29I. 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.
30B. Willingness to Pay
- Willingness to pay is shown on the demand curve
- Difference in what the consumer is willing to pay
and how much they have to pay is consumer surplus
31Calculating Consumer Surplus
½ Base x height
32II. Producer Surplus
- A. Producer surplus measures the difference
between the price producers receive for a good
and the cost of producing the good.
33B. Cost and Producer Surplus
- Producer cost is shown by the supply curve
- The difference between cost what the producer can
charge is the producer surplus
34Calculating Producer Surplus
35III. 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)
36Total Surplus Consumer Surplus Producer
Surplus
37Efficiency and Deadweight Loss
- KRUGMAN'S
- MICROECONOMICS for AP
Margaret Ray and David Anderson
38What 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
39Consumer Surplus, Producer Surplus, And Efficiency
- 495-499 on own
- Gains from trade
- The efficiency of markets
- Equity and Efficiency
40Gains 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.
41The 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
42Equity 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
43I. 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.
44II. 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.
45- 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.
46A 2 Tax on Bottled Water
TaxPc-Pp or 9-72
Q1
Q2
47III. Tax Revenue
- A. Tax revenue is t x Q2.
48A 2 Tax on Bottled Water
TaxPc-Pp or 9-72
Tax RevenueT x Q2 or 2x12 million 24million
Q2
Q1
49IV. Who pays the tax?
- 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. - 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.
50A 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
51Results of a 2 Tax on Bottled Water
52V. 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. -
53VI. 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)
54Utility Maximization
- KRUGMAN'S
- MICROECONOMICS for AP
Margaret Ray and David Anderson
55What 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
56Maximizing utility
- In the Theory of Consumer Choice, consumers
goal is to maximize their utility.
57I. Utility
- Utility a measure of the satisfaction the
consumer derives from consumption of goods and
services. - The principle of diminishing marginal utility-
Each successive unit of a good or service
consumed adds less to total utility than the
previous unit
58Budgets
- 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
59II. 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.