Page 502 - Krugmans Economics for AP Text Book_Neat

However, in the case of an inferior good, a good for which demand increases when in-
come falls, the income and substitution effects work in opposite directions. Although
the substitution effect decreases the quantity of any good demanded as its price in-
creases, the income effect of a price increase for an inferior good is an increase in the
quantity demanded. This makes sense because the price increase lowers the real income
of the consumer, and as real income falls, the demand for an inferior good increases.
If a good were so inferior that the income effect exceeded the substitution effect, a
price increase would lead to an increase in the quantity demanded. There is controversy
over whether such goods, known as “Giffen goods,” exist at all. If they do, they are very
rare. You can generally assume that the income effect for an inferior good is smaller
than the substitution effect, and so a price increase will lead to a decrease in the quan-
tity demanded.

Defining and Measuring Elasticity
As we saw in Section 1, dependent variables respond to changes in independent variables.
For example, if two variables are negatively related and the independent variable in-
creases, the dependent variable will respond by decreasing. But often the important
question is not whether the variables are negatively or positively related, but how re-
sponsive the dependent variable is to changes in the independent variable (that is, by
how much will the dependent variable change?). If price increases, we know that quan-
tity demanded will decrease (that is the law of demand). The question in this context is
by how much will quantity demanded decrease if price goes up?
Economists use the concept of elasticity to measure the responsiveness of one variable
to changes in another. For example, price elasticity of demand measures the responsiveness
of quantity demanded to changes in price—something a firm considering changing its
price would certainly want to know! Elasticity can be used to measure responsiveness
using any two related variables. We will start by looking at the price elasticity of demand
and then move on to other examples of elasticities commonly used by economists.
Think back to the opening example of the 2004 flu shot panic. In order for Flu-
nomics, a hypothetical flu vaccine distributor, to know whether it could raise its rev-
enue by significantly raising the price of its flu vaccine during the 2004 flu vaccine
panic, it would have to know whether the price increase would decrease the quantity
demanded by a lot or a little. That is, it would have to know the price elasticity of de-
mand for flu vaccinations.

Calculating the Price Elasticity of Demand
Figure 46.1 shows a hypothetical demand curve for flu vaccinations. At a price of $20 per
vaccination, consumers would demand 10 million vaccinations per year (point A); at a price
of $21, the quantity demanded would fall to 9.9 million vaccinations per year (point B).
Figure 46.1, then, tells us the change in the quantity demanded for a particular
change in the price. But how can we turn this into a measure of price responsiveness?
The answer is to calculate the price elasticity of demand. The price elasticity of de-
mand compares the percent change in quantity demanded to the percent change in price as we
move along the demand curve. As we’ll see later, the reason economists use percent
changes is to get a measure that doesn’t depend on the units in which a good is meas-
ured (say, a child-size dose versus an adult-size dose of vaccine). But before we get to
that, let’s look at how elasticity is calculated.
To calculate the price elasticity of demand, we first calculate the percent change in the
quantity demanded and the corresponding percent change in the price as we move along the
The price elasticity of demand is the ratio
of the percent change in the quantity demand curve. These are defined as follows:
demanded to the percent change in the price
as we move along the demand curve (46-1) % change in quantity demanded = Change in quantity demanded × 100
(dropping the minus sign). Initial quantity demanded
460 section 9 Behind the Demand Curve: Consumer Choice