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:
• 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
The Law of Demand
I
• The substitution effect
• The income effect
Defining Elasticity
• Definition of elasticity (Elasticity measures the
responsiveness of one variable to changes in
another.)
• Price elasticity of demand, for example,
measures the responsiveness of quantity
demanded to changes in price.
• Law of demand
• Example- if price of gas doubles??
Calculating Elasticity
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 = %ΔQd/ΔP note: we drop the negative
sign for Ed only.
% change in price = 5%
% change in quantity
demanded = -1%
Ed = %ΔQd/ΔP
Ed = 1%/5% = 0.2
Figure 46.1 The Demand for Vaccinations
Ray and Anderson: Krugman’s Economics for AP, First Edition
Copyright © 2011 by Worth Publishers
The Midpoint Formula
• The problem with calculating percentage changes:
Elasticity computations change if the starting and
ending prices (or quantities) are reversed. That’s
why we use the 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
The Midpoint Formula
• Example:
• 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*($2000)/$21,000 = 9.5%
• %ΔQd = 100*(New Quantity – Old Quantity)/Average
Quantity = 100*(-50)/475 = - 10.5%
• Ed = 9.5%/10.5% = .90 or an inelastic response between
these two points on the demand curve.
Table 46.1 Some Estimated Price Elasticities of Demand
Ray and Anderson: Krugman’s Economics for AP, First Edition
Copyright © 2011 by Worth Publishers