ECN 203 1st Edition Lecture 8Outline of Last Lecture II. Two Basic Players a. Individuals b. Firms c. The circular flowIII. General Equilibrium IV. Cases of GEa. General Competitive Equilibrium b. Two Conditions V. Perfect Competition and Efficiency a. Pareto Optimal VI. Exploring the market system under our nice assumptions Outline of Current Lecture VII. Why does product demand slope down?VIII.Own Price Elasticity of Demand a. Elastic vs. Inelastic IX. Perfectly Inelastic Demand a. More Elastic vs. Less Elastic X. Representing Own Price Elasticity Mathematically XI. Why does it matter?Current LectureLecture 8 2/2/15The Product Market - Demand relationship:o Q1^D = D (p1 I shift variables)- Supply relationshipo Q1^S = S (p1 I shift variables)These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- Why does product demand slope down?o We maximize our utility by maintaining our balance at the margin  Setting the marginal utility per dollar equal across all choices  We have adjusted our equation for the fact that in reality different goods have different prices o As the price of good 1 rises why does the price of good 2 fall? Suppose good 1 does go up, you are out of balance.  To maintain U-maxing “balance” MU2 must rise by the same amount We assume diminishing MU, so for MU2 to rise, Q2 just fall.  So we see that a rise in price causes a fall in quantity demanded Just as the downward sloping demand line shows o If the price 1 does change what conditions determine how significantly the quantity demanded, Q1, will respond? Elasticity - Own Price Elasticity of Demand o This is a measure of the responsiveness of the Quantity Demanded to a change in its Own Price o If the quantity demanded changes proportionally more than the price, we say that demand is responsive or ELASTICo If the quantity demanded changes, proportionally less than the price, we say that demand is not very responsive or INELASTIC o If you were selling a product, you would want the demand to be perfectly inelastic because that would allow you to raise the price without losing any quantity demanded - Perfectly Inelastic Demand – determining factors o A necessity o Has not reasonable substitute o Needed immediately o Affordable give income and wealth  Together they determine the own price elasticity for any good or service.  More Elastic =- Luxury, good substitutes, time to adjust, price high relative to income Less Elastic = - Necessity, no good substitutes, little time to adjust, price low relative to income. - Representing Own Price Elasticity Mathematically o How the “quantity demanded changes proportionally to price” can be represented by the equation: ἐ = %QuantityChange / %Own QuantityChange- epsilon = “own price elasticity” If epsilon > 1, Q changes proportionally more than p, so this is the elastic case If epsilon < 1, Q changes proportionally less than p, so this is the inelastic case- Why does it matter?o Privacy Policy case: Suppose you’re McDonalds and you want increase revenue from hamburger sales- Total Revenue = Price x Quantity  You cannot just simply raise the price  If the demand is epsilon < 1- p goes up more than Q goes down, so this inelastic case a price rise would generate more revenue. - If p rises proportionally more than Q falls Total Revenue goes up.  If demand is epsilon > 1- Demand is responsive- Q falls proportionally more than p rises. - Total revenue goes down What to do?- By doing a data analysis in a test market…- Test market is one that is as representative as possible of the total market.  If demand is elastic, lower the price.- p goes down less than Q goes up, so in this elastic case a price fall wouldgenerate more