Income and Substitution Effects and Elasticity

Lesson 3.46

Explaining the Law of Demand

• The Substitution Effect– As price of one item increases, the demand for that item drops, but

the demand for a similar item increases

• The Income Effect– As income increases, the demand for superior products increases– As income falls, the demand for generic items increases

Elasticity of Demand

• Elasticity of demand is a concept dealing with the changes in demand due to price changes.

• The amount of change of demand versus the amount of change of price determines elasticity.

• If the change of demand is small, then the demand is called inelastic.

• If the change in demand is large, then demand is called elastic, like a rubber band.

Defining and Measuring Elasticity• Calculating the Price Elasticity of Demand

– The Percent Change in Quantity Demanded and the Percentage Change in Price

– Ed = %ΔQd/ΔP

• Alternate Midpoint Method of Calculating Elasticity– The midpoint method yields the same answer in either direction– If Ed>1 then price is elastic– If Ed<1 then price is inelastic– If Ed =1 then price is unitary elastic

2 1 2 1

2 1 2 1

( ) /[( ) / 2]Price elasticity of demand =

( ) /[( ) / 2]

Q Q Q Q

P P P P