I. Review of markets
    B. Elasticity (finish)

Example 1: Linear demand

   Geometry and calculations (Excel)

Qd = a - bP =>     dQd/dP = -b =>    (dropping the sign on b) e  = b  ·  P/Qd     constant   falls as we move down the demand curve     P Qd e 1 a/b 0 Infinity 2 (1/2)(a/b) (1/2)a 1 3 0 a 0

    So note that a linear demand curve contains all the possible elasticity values:
    (1) elasticity drops continuously from infinity to 0 as you move down the demand curve.
    (2) elasticity switches from elastic to inelastic exactly halfway down. That means that lower prices keeps raising P·Q until the midpoint; after that, P·Q starts to fall again. So for a linear demand curve, TR and TE are maximized at the midpoint price and quantity.)

Example 2: Power-function demand
    Constant elasticity of demand function

(1) Qd = aPb with a>0 and b<0         dQd/dP = b·aP(b-1)         = b·aPb·P-1         = b·aPb/P =>   (2) dQd/dP = b·Qd/P             (using (1) to substitute for the numerator)    e = dQd/dP x P/Qd =>    e = b·Qd/P x P/Qd             (using (2) to substitute for the left-hand term)       = b     End result: e = b (a constant, the exponent on P)

    So note that for a power function demand:
    (1) elasticity = the exponent on P (true for every other variable that you add to the function).
    (2) elasticity remains constant everywhere along the demand curve

    2. How own-price elasticity (e) relates to total expenditure (TE)

    P and Q move in opposite directions when we move along D, so which effect wins?

    e tells us which direction TE moves when price changes.

    Rules:
(1) |e| < 1: inelastic: P and TE move in the same direction
(2) |e| > 1: elastic: P and TE move in opposite directions
(3) |e| = 1: unit elastic: TE is constant as P changes

    ? What would your advice be if the theater owner wants to raise total revenue?

Applying price elasticity

    See Elasticity Examples worksheet

II. Consumer demand

    Goal: to investigate more closely what makes consumers tick
    --what influences their decisions
    --what policies we might use and the effects of those policies

    We will now switch from what we call partial equilibrium to general equilibrium analysis

    Partial equilibrium analysis: studies individual markets in isolation
        Uses S&D diagrams

    General equilibrium analysis: studies how markets are linked together
        Uses diagrams which look at more than 1 item at a time
        Example: Production possibilities frontier (PPF)

    We'll introduce new tools for analyzing consumer behavior:
        budget lines and indifference curves.

    A. The rational consumer

--Basic setup

    A consumption set is made up of all possible consumption bundles.

How the consumption set looks:     Graph 2 points for 2 goods (R,C)

    Ex: U = U(Rum,Coke)

    Total utility = total consumer satisfaction or "psychic glow"
    Cardinal utility => consumers can measure their satisfaction level from their consumption units
        Ex: "utils" from early economist Jeremy Bentham
        Makes interpersonal comparisons possible
    Ordinal utility => consumers can rank their consumption bundles
        Ex: "Are you better off now than you were 4 years ago?"
        Interpersonal comparisons aren't possible

    We'll consider the budget constraint first, then their utility, and then how the two get combined in utility maximization