Background to Demand Flashcards
What does the law of diminishing marginal utility imply?
When you consume a unit of product (e.g. packet of crisps) you get a certain level of utils, when you consume a second you get another level of utils which is less than the first and so on.
Thus, if you consumed 4 packets of crisps, the law of diminishing marginal utility implies that MU1>MU2>MU3>MU4
What is utility?
The satisfaction a consumer derives from consuming a good or service
How is satisfaction measured when you consume a unit of a product?
Utils
What is marginal utility?
The extra utility derived from consuming one more unit of a product
What is total utility?
The utility derived from all the packet of crisps consumed
So if you consumed 4 packets of crisps the total utility will be:
TU = MU1+MU2+MU3+MU4
How is total utility maximised?
When the marginal utility of the last unit consumed is 0
What is consumer surplus?
If the price the consumer is willing to pay for a good (the MU of a good) is greater than the actual price (P) they are charged for the good (MU>P) then the consumer has consumer surplus
e.g. if a consumer is willing to pay £1 for a packet of crisps (MU=£1) and is only charged 60p (P=£0.60) then the consumer surplus for the unit i.e. the marginal consumer surplus (MCS) = £1 - £0.60 = £0.40
What is total consumer surplus?
TCS = MCS1 + MCS2 and so on
e.g. after consuming the first unit, the consumer’s satisfaction from a second unit will be less and may only be willing to pay £0.90 for the second packet of crisps, since the price is still £0.60, the MSC2 = £0.90 - £0.60 = £0.30, and the TCS = MCS1 + MCS2 = £0.40 + £0.30 = £0.70
How will a rational consumer maximise their total consumer surplus (TCS)?
By purchasing a good as long as the MU>P and will stop when MU=P (TCS is maximum)
What is the equi-marginal principle?
If there are 2 goods say X and Y, utility is maximised when the MUx/Px = MUy/Py
- Assume the last unit of GOOD X gives 3 times the utility of the last unit of GOOD Y and yet GOOD X only costs 2 times as much as GOOD Y
- You will gain by INCREASING CONSUMPTIONS of X and CUTTING PURCHASE of Y
- But as you switched from Y to X, the MARGINAL UTILITY OF X WOULD FALL due to diminishing marginal utility and conversely the MARGINAL UTILITY OF Y WOULD RISE
- To maximise utility, you would continue this substitution until the ratio of the marginal utilities (Mx/My) = prices of the goods (Px/Py) this is the optimum combination of goods to consume
What are indifference curves?
A line showing all of the various combinations of two goods that provide an equal amount of utility (satisfaction) to a consumer.
It avoids looking at the amount of utility one gains and instead merely rank the various combination of goods in the order of preference.
What is indifference analysis?
It has been used to overcome the limitation associated with the marginal utility approach to demand approach i.e. that utility cannot be measured in any absolute sense thus cannot say by how much the marginal utility of one good exceeds that of another good
What is the slope of the indifference curve called?
The marginal rate of substitution (MRS)
i.e. the amount a consumer is willing to substitute one good for one more unit of another good
THE MRS DIMINISHES AS ONE GOOD IS SUBSTITUTED FOR ANOTHER
What is an indifference map?
Where more than one indifference curve can be drawn, as the same consumer can have a second combination that provide the same level of satisfaction with this level of satisfaction (utility) being higher than the first set. And can have a third set with an even higher level of satisfaction than the previous one.
When these are drawn on the same graph they make the indifference map
- The indifference curves do not intersect
- They are parallel to each other
- The further away a curve is from the origin the higher the level of satisfaction it represents
What is a budget line?
It joins all of the combinations of two goods that can be purchased by the consumer at a given level of income
