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Title: 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

3
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
4
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?

5
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.

6
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

7
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

10
Interpreting Price Elasticity of Demand
  • What does the value of elasticity tell us?
  • It indicates how steep or flat the curve will be.

11
What does an Elastic Demand Curve Look Like?
12
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

13
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

14
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
15
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

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.

17
ElElasticity along the Demand Curve
  • Elasticity Along the Demand Curve

18
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.

20
Other Elasticities
  • Cross-price elasticity of demand
  • Income elasticity of demand
  • Price elasticity of supply

21
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

22
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.

23
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)

24
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.

25
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.

29
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.

30
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

31
Calculating Consumer Surplus
½ Base x height
32
II. Producer Surplus
  • A. Producer surplus measures the difference
    between the price producers receive for a good
    and the cost of producing the good.

33
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

34
Calculating Producer Surplus
35
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
37
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

42
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

43
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.

44
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.

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.

46
A 2 Tax on Bottled Water
TaxPc-Pp or 9-72
Q1
Q2
47
III. Tax Revenue
  • A. Tax revenue is t x Q2.

48
A 2 Tax on Bottled Water
TaxPc-Pp or 9-72
Tax RevenueT x Q2 or 2x12 million 24million
Q2
Q1
49
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
51
Results of a 2 Tax on Bottled Water
52
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.

53
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

56
Maximizing utility
  • In the Theory of Consumer Choice, consumers
    goal is to maximize their utility.

57
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

58
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
59
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.
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