Chapter 6

Question 1

Differentiate between utility, total utility and marginal utility.

Answer 1

•Utility is the satisfaction that a consumer receives from consuming some good or service.

•Total utility is the consumer’s total satisfaction resulting from the consumption of a given product.

•Marginal utility is the additional satisfaction obtained from consuming one additional unit of a product.

Question 2

Describe diminishing marginal utility.

Answer 2

The utility that any consumer derives from successive units of a particular product consumed over some period of time diminishes as total consumption of the product increases.

Question 3

Describe the consumer’s maximizing decision and give an example.

Answer 3

• Consumers seek to maximize their total utility subject to the constraints they face - their income and market price.
• A utility-maximizing consumer allocates expenditures so that the marginal utility obtained from the last dollar spent on each product is equal.

Example:

–Consider Alison, whose utility from the last dollar spent on juice is more than from the last dollar spent on burritos.

–She increases her total utility by spending a dollar more on juice and a dollar less on burritos.

–She maximizes total utility when the marginal utility per dollar spent on juice equals the marginal utility per dollar spent on burritos.

Question 4

What is the utility-maximizing condition?

Answer 4

Question 5

What happens when there is a change in a product’s price?

Answer 5

• The hypothesis of diminishing marginal utility tells us that as a consumer buys less of a product, the marginal utility rises.
• This leads to the basic prediction of demand theory:
  
  • A rise in the price of a product leads each utility-maximizing consumer to reduce the quantity demanded of the product.

Question 6

What is the basic prediction of demand theory?

Answer 6

A rise in the price of a product leads each utility-maximizing consumer to reduce the quantity demanded of the product.

Question 7

What does the theory of consumer behaviour predict about the market demand curve?

Answer 7

• The theory of consumer behaviour predicts a negatively sloped market demand curve as well as a negatively sloped demand curve for each individual consumer.

Question 8

What is real income?

Answer 8

• A change in price has two distinct effects—it alters the relative price and it changes consumers’ real income.
  
  • Real income is income expressed in terms of the purchasing power of money income—that is, the quantity of goods and services that can be purchased with the money income.

Question 9

What is the substitution effect?

Answer 9

• The substitution effect is the change in the quantity of a product demanded resulting from a change in its relative price (holding real income constant).
• The substitution effect increases the quantity demanded of a product whose price has fallen and reduces the quantity demanded of a product whose price has risen.
• Substitution effect = ΔQd due to a Δ relative price, holding real income constant.
• Substitution effect is always negative ⇒ As P falls, consumer will always substitute into cheaper goods

Question 10

What is the income effect?

Answer 10

• The income effect is the change in the quantity of a product demanded resulting from a change in real income (holding relative prices constant).
• The income effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good.
• The size of the income effect depends on the amount of income spent on the product whose price changes and on the amount by which the price changes.
• Income effect = ΔQd due to a Δreal income, holding new relative prices constant.

Question 11

What are Giffen Goods and what are their two key characteristics?

Answer 11

• Products with a positively sloped demand curve.
• Giffen goods have two key characteristics:
  
  1. The good must be an inferior good—a reduction in real income leads households to purchase more of that good
  2. The good must take a large proportion of total household expenditure and therefore have a large income effect

Question 12

What happens to the slope of the demand curve because of the combined operation of the substitution and income effects

Answer 12

• The substitution effect leads consumers to increase their demand for all normal goods whose prices fall.
• The income effect leads consumers to buy more of all normal goods whose prices fall.
• Because of the combined operation of the income and substitution effects, the demand curve for any normal good will be negatively sloped.
• A fall in price will increase the quantity demanded.

Question 13

What does the magnitude of the income effect depend on? [2]

Answer 13

1. The proportion of income spent on the good.
2. The magnitude of the price change.

Question 14

Describe the substitution and income effect for normal, inferior, and Giffen goods.

Answer 14

• For a normal good, the income and substitution effects work in the same direction.
• For most inferior goods, the income effect only partially offsets the substitution effect.
• For a few inferior goods - Giffen goods - the income effect outweights the substitution effect

Question 15

What are conspicuous consumption goods?

Answer 15

• Goods consumed because they have “snob appeal”.
• Does this behaviour violate our theory of utility maximization
  
  • Snobs would still buy more at a lower price as long as other people thought they had paid a high price.
  • If such consumption exists, it is unlikely the market demand curve is positively sloped. Lower-income consumers would buy inexpensive diamonds or BMWs. Their behaviour would likely offset the behaviour of the relatively few higher-income “snobs”.

Question 16

What is consumer surplus?

Answer 16

The difference between the market price and the maximum price that the consumer is willing to pay to obtain that unit.

• Consumer surplus is the difference between the total value that consumers place on all units consumed of a product and the payment that they actually make to purchase that amount of the product.
• The area under the demand curve shows the total value a consumer places on a good.
• The market demand curve shows the valuation that consumers place on each unit of the product.
• For any given quantity, the area under the demand curve and above the price line shows the consumer surplus received from consuming those units.

Question 17

What is total consumer surplus?

Answer 17

• Total consumer surplus is the area under the demand curve and above the price line.
• The area under the curve shows the total valuation that consumers place on all units consumed.

Question 18

What is the paradox of value?

Answer 18

• Why is it that water, which is essential to life, has a low price, while diamonds, which are not essential to life, have a high price?
• Early economists thought the price or “value” of a good depended only on the demand by consumers.
• This view ignores two important aspects of the determination of price.
  1. Supply plays just as important a role as demand in determining price.
  2. Consumers purchase units of a good until the marginal value of the last unit purchased is equal to its market price
• ​So water has a plentiful supply, and hence a low price; diamonds have a relatively scarce supply and hence a high price.
• Since water has a low price, consumers buy water to the point where the marginal value placed on the last unit consumed is very low, and the total value is high.
  
  • So water has a low price, a low marginal value, and a high total value.
• Since diamonds have a high price, consumer buy diamonds to the point where the marginal value placed on the last unit consumed is very high, and the total value is low.
  
  • Diamonds have a high price, a high marginal value, and a low total value.

Question 19

How is market demand determined from household demand?

Answer 19

Sum household demands curves horizontally.

Question 20

What acts as a signal to allocate resources?

Answer 20

Equilibrium price

Question 21

What is marginal utility theory? [3]

Answer 21

Question 22

What is the law of diminishing marginal utility?

Answer 22

Marginal utility decreases as successive consumption increases, after a certain point, ceteris paribus. Why?

Recall: Opportunity cost principle “The cost of something is what you give up to get it.”

Usually a consumer is willing to give up more for the first than the last (psychology). This is a behavioural assumption.

Notes:

• Total utility increases at decreasing rate, after a certain point, ceteris paribus.
• Marginal utility = ΔTU/ΔQ = slope of TU = derivative
• Total utility = sum of marginal utilities = integral
• Generally, total utility curve is an ‘S shaped curve’

Question 23

What are conditions to maximize total?

Answer 23

Equate marginals

Consume good until MB = MC

MUx/MUy = Px/Py

Question 24

Describe Prof. G’s pizza and beer maximization of total utility example.

Answer 24

Question 25

Describe utility maximization methodology. [4]

Answer 25

Question 26

How is demand derived from marginal utility analysis?

Answer 26

Question 27

Compare the income elasticity of demand for normal and inferior goods.

Answer 27

Question 28

What causes the substitution and income effects?

Answer 28

Changes in price.

Question 29

What type of goods do income elasticity and price elasticity differentiate between?

Answer 29

Income elasticity ⇒ normal and inferior goods

Price elasticity ⇒ ordinary and Giffen Goods (very rare)

Question 30

Describe how the equation for the marginal benefit is established.

Answer 30

Question 31

How is demand transformed to marginal utility?

Answer 31

Question 32

What is producer surplus?

Answer 32

Question 33

What is a budget line? What factors does it incorporate?

Answer 33

The budget line shows all possible consumption combinations of two goods, given income Y, and the price of the two goods.

It incorporates two factors, income and price.

Question 34

What is the definition of the budget line?

Answer 34

PxQx + PyQy = Y

Question 35

What is the slope of the budget line?

Answer 35

• From the equation of the budget line, slope = -Px/Py
• From the graph of the budget line, slope = maxQy/maxQx
  
  • slope = (Y/Py) / (Y/Px)
• The slope is also equal to the marginal rate of transformation (MRT).
  
  • ratio of the relative prices (i.e., the opportunity cost of X)

Question 36

Describe shifts of the budget line. [2]

Answer 36

• Change in real income
  
  • Parallel shift of budget line
  • positive relation; an increase causes budget line to shift right
• Change in relative price
  
  • Rotation of the budget line
  • negative relation; as price increases, budget line rotates inwards
• Notes
  
  • a proportional change in both prices, with income constant, is like an income change
  • a proportional change in prices and income, budget line does not move

Question 37

How does a change in income affect the budget line?

Answer 37

• Increase in income → parallel outward shift in the budget line
• Decrease in income → parallel inward shift in the budget line

Question 38

How does a change in price affect the budget line?

Answer 38

• Decrease the price of X → rotate the budget line outward along the X-axis
• Increase in the price of X → rotates budget line inward along the X-axis

Question 39

Describe how consumers rate their preferences.

Answer 39

• Consumers can rank their preferences
  
  • Ordinal ranking
  • Assume consumer preferences are consistent
  • These conditions may be the definition of rational
  • 3 assume: complete, reflex, transitive, non-satiation
• Complete = consumer must say he prefers one over h
  
  • Consumer knows his preferences
  • consumer cannot say ‘I don’t know.’
• Reflexive
• Transitive

Question 40

What is a well-behaved indifference curve? [3]

Behavioural assumptions - needed for model to work - some realistic justificiation

Answer 40

• non-satiable = ‘more is better’ = monotonicity
  
  • there is some overall best (bliss point / satiation)
  • monotonicity implies II-curve negative slope
• averages are preferred to extremes
  
  • ​normally, consumer wants to trade one good for another, rather than specializing in one of the two goods
  • imples II-curves are convex to the origin
• strict convexity = weighted average of two bundles
  
  • convex II-curves may have flat bottoms
  • strictly convex II-curves rounded bottoms

Question 41

What is the utility function?

Answer 41

TU = TU (X, Y) X is ‘bundle’

• (x₁,x₂) > (y₁,y₂) if and only if u(x₁,x₂) > u(y₁,y₂)
• higher number means it is ‘chosen’
• choices represented by the utility function

Question 42

What is the indifference curve?

Answer 42

All combinations of quantities of X and Y that yield a given level of total satisfaction.

• Adds the third decision variable, tastes or preferences.
• TU is constant
  
  • ΔTU = 0

Question 43

What are the four characteristics of II-curves?

Answer 43

• infinite number increasing outward (map)
• downward sloping
• cannot cross
• convex to origin - (law of diminishing marginal rate of substitution)

ΔY * MU_y + ΔX * MU_x = 0

(total value lost = total value gained)

Question 44

What does the slope of the indifference curve measure?

Answer 44

The marginal rate of substitution

Question 46

How is total utility maximized?

Answer 46

1. Max TU _(utility), subject to constraint of budget line _{income and prices}
2. In other words, get on the highest indifference curve (II), subject to the budget line.
3. Real issue is what levels of beer and pizza to buy?
   
   • ^​​⇒ choosing (X*, Y*) that maximizes TU
4. II-curve is TANGENT to the budget line; MRS = MRT (marginal rate of substitution / transformation)

Question 47

How is the demand curve derived from II-curve analysis?

Answer 47

1. As the Px falls, the budget line rotates out, and Qx increases (ordinary goods)
   
   • P2 < P1
   • As P falls, Qx increases, necessary to max total utility (TU)
   • Inverse demand relation between P and Qd.

Question 48

Describe how the substitution effect and the income effect impact the budget line.

Answer 48

Question 49

Describe how the substitution and income effect impact the budget line.

Answer 49

Question 50

Give a comparison of Marginal utility analysis and indifference curve analysis.

Answer 50