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Elasticity AP Microeconomics 1 Substitution Effect. Change in ..., Study notes of Microeconomics

The Courtauld Institute of Art, University of London Microeconomics

Substitution effect of a lower price creates an increase in QD. Income Effect. Change in the price of a good is the change in the quantity of that good ...

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Elasticity AP Microeconomics

1

Substitution Effect. Change in the price of a good is the change in the quantity of that good

demanded as the consumer substitutes the good that has become relatively more expensive.

Substitution effect of a lower price creates an increase in QD.

Income Effect. Change in the price of a good is the change in the quantity of that good demanded

that results from a change in the consumer’s purchasing power when the price of the good changes.

Combining substitution and income effects, lower prices create increased QD, thus explaining the

law of demand.

Note on inferior and normal goods. If the good is an inferior good 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.

Law of demand states that consumers will respond to a decrease in price by buying more of a

product (other things remaining constant), but it does not tell us how much more. That’s where

elasticity comes in.

Price elasticity of demand. Ratio of the percent change in QD to percent change in P as we move

along demand curve. Sensitivity of consumers to a change in price is measured by price elasticity of

demand. The terms elastic or inelastic describe the degree of responsiveness.

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. With both elastic and inelastic demand consumers behave according to the law of demand--

they are responsive to price changes.

Elastic: ED > 1

Inelastic: ED < 1

Unit elastic: ED = 1

Calculating the Price Elasticity of Demand: 𝐸!=%∆!!

%∆!

Example. P of digital cameras increases by 1% and QD decreases by 2%.

𝐸!=

−2%

1% =−2

𝐸!=2

Ignore negative sign because downward sloping demand curves will insure a negative price elasticity,

what’s important is the magnitude of that elasticity. For the digital camera, the % decrease in QD

(the effect) was twice as large as the % increase in P (the cause). Consumers have exhibited an elastic

response to a higher price.

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Substitution Effect. Change in the price of a good is the change in the quantity of that good demanded as the consumer substitutes the good that has become relatively more expensive. Substitution effect of a lower price creates an increase in QD. Income Effect. Change in the price of a good is the change in the quantity of that good demanded that results from a change in the consumer’s purchasing power when the price of the good changes. Combining substitution and income effects, lower prices create increased QD, thus explaining the law of demand. Note on inferior and normal goods. If the good is an inferior good 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. Law of demand states that consumers will respond to a decrease in price by buying more of a product (other things remaining constant), but it does not tell us how much more. That’s where elasticity comes in. Price elasticity of demand. Ratio of the percent change in QD to percent change in P as we move along demand curve. Sensitivity of consumers to a change in price is measured by price elasticity of demand. The terms elastic or inelastic describe the degree of responsiveness.

If consumers are relatively responsive to price changes, demand is said to be elastic.
If consumers are relatively unresponsive to price changes, demand is said to be inelastic.
With both elastic and inelastic demand consumers behave according to the law of demand-- they are responsive to price changes. Elastic: ED > 1 Inelastic: ED < 1 Unit elastic: ED = 1 Calculating the Price Elasticity of Demand: 𝐸! = %∆!! %∆! Example. P of digital cameras increases by 1% and QD decreases by 2%. 𝐸! =

Ignore negative sign because downward sloping demand curves will insure a negative price elasticity, what’s important is the magnitude of that elasticity. For the digital camera, the % decrease in QD (the effect) was twice as large as the % increase in P (the cause). Consumers have exhibited an elastic response to a higher price.

Example. P of milk increases by 10% and QD decreases by 5%. 𝐸! =

For the milk, the % decrease in QD (the effect) was only half the size as the % increase in P (the cause). Consumers have exhibited an inelastic response to a higher price. % change equation—NOOO! %∆ =

Example. The price of a doughnut rises from $1.00 to $1.15 and Bob reduces his weekly doughnut consumption from 20 to 19. %∆𝑃 =

Bob’s ED for doughnuts is 5%/15% = 0.33. Midpoint Method. Elasticity computations change if the new and old prices (or quantities) are reversed. 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. Because of this, the value of the price elasticity will change, depending upon whether the price is increasing or decreasing. In order to account for this, economists sometimes use the average price and average quantity between two points on a demand curve. 𝐸! =

Example. Now assume that ED = 10. ED = %ΔQD/%ΔP = 10. Assume P increases by 1%. Since, ED = %ΔQD/ 1 % = 10, it can be predicted that QD will decrease by a 10%, which is a big response.

The largest response to a price increase would be that consumers immediately decrease consumption to zero.
The largest response to a price decrease would be that consumers immediately increase consumption to an infinitely large amount. If P increased 1%, and there was an enormous change to QD, %ΔQD = ∞ so ED = ∞. D is horizontal, or perfectly elastic. Consumers have an infinitely large response to higher or lower prices. Quick read of elasticity graphs: If D is closer to vertical (steeper), it will tend to be more inelastic than D that is closer to horizontal (flatter, elastic ). Total Revenue and Elasticity. When a firm sells products to consumers, the firm earns revenue. Total revenue (TR) earned by a firm is equal to P of product multiplied by Q sold at P. TR = (P)(QD) Assume that a firm wants to increase TR by increasing P. QD will decrease. Increasing P and decreasing QD both influence TR, but in opposite directions. It ultimately depends upon which effect, higher P or lower Q , is stronger—price effect or quantity effect.
Price effect. After an increase in P, each unit sold sells at a higher price, which tends to increase revenue.
Quantity effect. After an increase in P, fewer units are sold, which tends to lower revenue_._ Example. P increases 1%, QD decreases 5%, elastic. TR will decrease, because downward quantity effect is stronger than upward price effect. Example. P increases 10%, QD decreases 5%, inelastic. TR will increase, because downward quantity effect is weaker than upward price effect.

Example. P increases 10%, QD decreases 10%, unit elastic (ED = 1). TR will not change, because downward quantity effect is equal to upward price effect. Example. Initial price of pizza slices is equal to $2 and 50 slices are sold every day. This is point A on D. TR = (P)(QD) = ($2)( 50 ) = $ This is the area marked TR on the graph, the rectangle below D. Pizzeria wishes to increase P of a slice to $ and estimates that 40 slices will be sold each day. This is point B on D. TR = (P)(QD) = ($3)( 40 ) = $ The $20 gain can be seen through both P and Q effects. Area L is revenue lost due to decreased Q. Ten slices were lost, at $2 each, so area L represents $20 of lost revenue. Area G is revenue gained due to increased P. Forty slices were sold, at a price $1 higher than before, so area G represents $40 of gained revenue. Area G – Area L = $40 - $20 = $20, which is the total increase from the higher price. If upward price effect is stronger than downward quantity effect, demand must be inelastic. If upward price effect is weaker than downward quantity effect, demand must be elastic.

why even bother? Look at the D curve above again, noting where unit elastic is. Unit-elastic is the dividing point between elastic and inelastic. It’s also the highest point of total revenue. Factors Determining ED

Substitutes for the product. More substitutes, more elastic the demand. If a product has many substitutes, and P increases, consumers will have an elastic response because they can easily find alternatives.
Luxury or a necessity. Less necessary the item, more elastic the demand. n the case of a luxury, if P increases, consumers will not buy the product and have an elastic response.
Percentage of income spent on good. Larger the expenditure relative to a budget, more elastic the demand, because buyers notice the change in price more.
Amount of time. Longer the time period involved, more elastic the demand becomes. Cross-Price Elasticity of Demand. Between two goods, this measures the effect of change in one good’s P on the QD of other good. It is equal to percent change in QD of one good divided by percent change in other good’s P. Another way, the effect of a change in a product’s P on QD for another product. In other words, complements and substitutes. 𝐸!" =

Substitutes  cross-elasticity is positive. P of Nikes increase by 2% and QD for Converse increases by 4%. Exy = 4%/2% = 2. Nikes and Converse are substitutes.
Complements  cross-elasticity is negative. P of gas increases 20% and QD for large SUVs decreases by 5%. Exy = - 5%/20% = - 0.25. Gas and SUVs are complements.
Unrelated  cross-elasticity is zero. P of Cinnamon Toast Crunch increases. QD Hollister t- shirts are unaffected. Income Elasticity of Demand. Percent change in QD of good when a consumer’s income changes divided by the percent change in consumer’s income. In other words, normal and inferior goods. 𝐸! =

Normal good  income elasticity is positive. American consumer income decreases by 2% and quantity of flights to Europe declines by 8%. EI = 8%/2% = 4. Normal good. Income- elastic response. Luxury. o Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%. EI = 1%/4% = 0.25. Normal good. Income-inelastic response. Necessity.
Inferior good  income elasticity is negative. Consumer income decreases by 5% and consumers increase consumption of Blech, a meat substitute, by 4%. EI = 4%/-5% = - 0.80. Inferior good. o For inferior goods, there is no distinction between luxuries and necessities. Income-elastic. Demand for good is income-elastic if EI for that good is greater than 1. Income-inelastic. Demand for good is income-inelastic if EI for that good positive but less than 1.

Price Elasticity of Supply. Measure of the responsiveness of the QS of a good to P of that good. It is the ratio of the percent change in QS to percent change in price as it moves along the S curve. ES = %ΔQS/%ΔP Elastic: ES > 1 Inelastic: ES < 1 Unit elastic: ES = 1 Perfectly Inelastic and Elastic Supply. Same analysis as in elasticity of demand. This graph shows an upward sloping supply curve, a perfectly elastic supply curve, and a perfectly inelastic supply curve. A vertical S curve like S 3 implies that even at the highest of prices, there is something that prevents firms from increasing QS. (e.g., technological problem or seasonal issue). A horizontal S curve like S 2 implies that even smallest increase in P would dramatically increase QS. A small decrease in P would decrease Qs to zero. Factors Determining ES

Availability of inputs. If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, ES will be more elastic.
Time period.
- Market period. Market period is so short that ES is inelastic, possibly perfectly inelastic.
- Short-run ES is more elastic than market period and will depend on ability of producers to respond to P changes as to how elastic it is.
- Long-run ES is most elastic, because more adjustments can be made over time and Q can be

Elasticity AP Microeconomics 1 Substitution Effect. Change in ..., Study notes of Microeconomics

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