Module Micro 10 Econ 46 The Income Effect

Module Micro: 10 Econ: 46 The Income Effect, Substitution Effect, and Elasticity KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: • What drives the “Law of Demand? ” • What determines the slope of the demand curve?

Types of Goods I • Normal goods: ceteris paribus, when incomes go up, people generally want to buy more of it. If incomes go down they will buy less. • Inferior goods: ceteris paribus, when incomes go up people want to buy less of it, and they want to buy more of it when incomes go down.

The Law of Demand I • The income effect: people choose to buy more or less of something as their incomes change • Price changes, income changes, inflation, FOREX, etc. • Closely tied with good/service type!

The Law of Demand I • The substitution effect – if the price of something goes up, people choose to buy something else.

The Law of Demand • What happens when the price of cherries (a normal good) increases? Use the income and sub effect. I • What happens when the price of latiao (an inferior good) increases? Use the income and sub effect. BE CAREFUL! • Down the rabbit hole. . (Go. Formative) What would happen if the income effect for an inferior good was VERY strong compared the substitution effect?

Practice • Winners of lotteries are a good example to study • a. the substitution effect. • b. the income effect. George Stigler, 1982 Nobel Laureate in Economics, once wrote that, according to consumer theory, ” if consumers do not buy less of a commodity when their incomes rise, they will surely buy less when the price of the commodity rises. ” Explain this statement. Answer: This is because he is talking about normal goods. • c. how the income effect dominates the substitution effect. The price of mushrooms rise. Explain what will happen by first using the income effect, then by using the • d. how the substitution effect. dominates the income effect. Answer: It depends on whether you consider them to be normal or inferior! Assuming normal…because the • Answer: b. price of mushrooms rose, consumers buying mushrooms will have less overall income. Therefore they will buy less. They will probably buy other vegetables instead, demonstrating the substitution effect.

Elasticity? What does it mean? • Elasticity just means “can stretch” • Definition of elasticity: the % change in one variable related to the % change in another

Perfectly Inelastic

Perfectly Elastic

Inelastic [close to 0] or elastic [more than 1]? -0. 1 Very inelastic USA Japan -0. 55 -0. 25

Inelastic [close to 0] or elastic [more than 1]? Coach 1 st Class -0. 9 -0. 3 Short Run -0. 09 Long Run -0. 31

Stretch your vocabulary • Independent variable: something that can change on it’s own, for example – temperature • Dependent variable: something that changes because of something else, for example – the number of people wearing a coat today

Calculating Elasticity of Demand • Price elasticity of demand is the percentage change in quantity [dependent variable] demanded divided by the percentage change in the price [independent variable]. In symbols: Ed = %ΔQd/%ΔP • Let’s practice: How many students in the room are happy? • Now – if we drop the temperature to 12 degrees, how many would still be happy? • ATTENTION: You will need to figure out which variables are dependent and independent!

Calculating Price Elasticity of Demand When the price of CD increased from $20 to $22, the quantity of CDs demanded decreased from 100 to 87. What is the price elasticity of demand for CDs? Is it demand elastic or inelastic? The price increases from $20 to $22. Therefore % change = 2 / 20 = 0. 1 = 10% (0. 1 *100) Quantity fell by 13 / 100 = – 0. 13 (13%) Therefore PED = 13 / – 10 Therefore PED = -1. 3 Therefore Demand is elastic. Elastic demand occurs when % change in Quantity is greater than % change in price; when PED >1

Problems and Midpoint Mthd. • Elasticity computations change if the starting and ending prices (or quantities) are reversed. That’s why we use the midpoint formula. • Example: If a variable goes from a value of 100 to a value of 110, it is a 10% increase. If the variable were to go from a value of 110 to a value of 100, it is a 9. 1% decrease. • The solution: Use the Midpoint formula! • %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity • %ΔP = 100*(New Price – Old Price)/Average Price • Dojo point: how do we get an average? • Ed = %ΔQd/ΔP

The Midpoint Formula • The price of a college’s tuition increases from $20, 000 to $24, 000 per year. The college discovers that he entering class of first-year students declined from 500 to 450. • %ΔP = 100*(New Price – Old Price)/Average Price = 100*($4000)/$22, 000 = 18. 18% • %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity = 100*(-50)/475 = - 10. 5% • Ed = 10. 5%/ 18. 18%/ = -0. 6 or an inelastic response between these two points on the demand curve.

Price Elasticity of Demand Calculate PED using both the simple and midpoint method.

Price Elasticity of Demand • The price increases from $10 to $15. Therefore % change = 5 / 10 = 0. 5 = 50% (0. 5 *100) • Quantity fell by -2 / 8 = – 0. 25 (25%) • Therefore PED = 25% / – 50% • Therefore PED = -0. 5 • Therefore Demand is inelastic. Inelastic demand occurs when % change in Quantity is less than % change in price; when PED < 1

Price Elasticity of Demand • %ΔP = 100*(New Price – Old Price)/Average Price = 100*($15 -10)/$12. 5 = 40% • %ΔQd = 100*(New Quantity – Old Quantity)/Average Quantity = 100*(6 -8)/7 = - 28. 57% • Ed = 28. 57%/40%= -0. 714 or an inelastic response between these two points on the demand curve.

Price Elasticity of Demand Using the demand schedule below, use the midpoint method to calculate price elasticity of demand for business and vacation travelers when the price goes from 200$ to 250$. Price of Ticket Qd Business Travelers 150 2100 2000 250 1900 300 1800 Qd Vacation Travelers 1000 800 600 400

Price Elasticity of Demand Business Travelers: The price change is simple: Old price = 200, New Price = 250$ The quantities are: Old Q = 2000, New Q = 1900 So step 1 is: ((1900 -2000)/1950)*100 = (-100/1950)*100 = -0. 0513 or -5. 13% Step 2 is: (250 -200)/225 =. 2222 or 22. 22% Therefore, the Ed = -0. 0513/. 2222 = -0. 231

Price Elasticity of Demand Mini-Presentations Calculate the Ed for vacation travelers using the midpoint method, and be ready to present your work. Answer: Ed = -1. 29

Genius Question Why is elasticity ALMOST ALWAYS negative? Use every concept we have learned in this class. Work with your group for 3 minutes. Answer: The price elasticity of demand represents the percent change relationship across the demand curve. Because we know that price and quantity demanded have an obverse relationship, the percent change relationship will always include an increase in one value with a decrease in another. Therefore, one of the two variables will always be negative, therefore, price elasticity of demand is always negative.