Chapter 6

Question 1

What is utility?

Answer 1

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

Question 2

What is total utility?

Answer 2

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

Question 3

What is marginal utility?

Answer 3

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

Question 4

What causes the utility that any consumer derives from successive units of a particular product consumed over some period of time to diminish the marginal utility?

Answer 4

The increasing total consumption of the product

Question 5

How can a consumer maximize their total utility?

Answer 5

By noting their constraints: their income and market price

Question 6

What does a utility-maximizing consumer do to maximize their utility?

Answer 6

They allocate their expenditures so that the marginal utility obtained from the last dollar spent on each product is equal

Question 7

When is total utility maximized?

Answer 7

When the marginal utility of product a is equal to the marginal utility of product b

Question 8

How do you calculate the utility-maximizing condition (MUx=MUy)

Answer 8

MUx/MUy = px/py

Question 9

What do economists assume consumers are when observing how they adjust their behaviour to maximize utility?

Answer 9

That they are “rational”

Question 10

What does evidence tell us about the true nature of consumer behaviour in relation to maximizing utility?

Answer 10

That consumers may deviate “rational” behaviour if available choices are “framed” differently

Question 11

What has the finding of “framing” available choices differently lead to?

Answer 11

It has lead to the idea of policy “nudges” - interventions that preserve freedom of choice, but that also steer people in certain directions

Question 12

What happens when there is a change in the price of a product? What does the consumer do in order to restore the equality?

Answer 12

If the price of the product (X) rises, then at the previous utility maximizing point:
MUx/MUy < px/py

In order to restore the equality, the consumer reduces their consumption of juice because consuming less of the product (X) causes MUx to decrease so there will be more money to purchase more y causing consumption of y to increase so MUy increases

Question 13

What does the hypothesis of diminishing marginal utility tell us?

Answer 13

It tells us that as a consumer buys less of a product, the marginal utility rises

Question 14

What prediction does the hypothesis of diminishing marginal utility lead us to?

Answer 14

It leads us to the basic prediction of demand theory

Question 15

What is the basic prediction of demand theory?

Answer 15

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

Question 16

What are indifference curves?

Answer 16

They are curves that represent all the bundles of goods which give the same utility to a consumer (make the consumer indifferent)

Question 17

What are the characteristics of the indifference curve?

Answer 17

Indifference curves are negatively sloped and are convex (because of decreasing marginal utility)

Question 18

Special Utility functions: What does a curve look like when it is representing the relationship between perfect compliments?

Answer 18

Like an L

Question 19

Special Utility functions: What does a curve look like when it is representing the relationship between perfect substitutes?

Answer 19

Like a downward sloping straight line

Question 20

Is utility constant along the indifference curve?

Answer 20

Yes it is, so ΔU=0

Question 21

What happens at the optimal consumption?

Answer 21

The slope of the budget line is the same as the slope of the indifference curve so MUy/py = MUx/px

Question 22

What does Slutsky decomposition show?

Answer 22

It shows the link between normal or inferior goods and ordinary goods

Question 23

What does the theory of consumer behaviour predict?

Answer 23

It predicts a negatively sloped market demand curve as well as a negatively sloped demand curve for each individual consumer
(Aggregating consumer demands to get demand)
We add up the quantities demanded by all consumers for each price point
Note: We NEVER add prices (on the vertical axis), we always add quantities

Question 24

What are the 2 distinct effects of a change in price?

Answer 24

It alters the relative price and changes consumers’ real income

Question 25

In what terms is real income expressed in?

Answer 25

It is expressed in terms of purchasing power of money income - that is, the quantity of goods and services that can be purchased with the money income

Question 26

What is the substitution effect?

Answer 26

It is the change in the quantity of a product demanded resulting from a change in its relative price

Question 27

What does the substitution effect do?

Answer 27

It increases the quantity demanded of a product whose price has fallen and reduces the quantity demanded of a product price has risen

Question 28

What is the income effect?

Answer 28

The income effect is the change in the quantity of a product demanded resulting from a change in real income (holding relative prices constant)

Question 29

What does the income effect lead consumers to do?

Answer 29

It leads them to buy more of a product whose price has fallen, provided that the product is a normal good

Question 30

What does the size of the income effect depend on?

Answer 30

It depends on the amount of income spent on the product whose price changes and on the amount by which the price changes

Question 31

What does the substitution effect lead consumers to do for all normal goods whose prices fall?

Answer 31

To increase their demand

Question 32

What does the income effect lead consumers to do for all normal goods whose prices fall?

Answer 32

To buy more of all normal goods whose prices fall

Question 33

Because of the combined operation of the income and substitution effects, the demand curve for any normal good will be [positively/negatively] sloped

Answer 33

Negatively

Question 34

What will a fall in price do to the demand curve?

Answer 34

It will increase the quantity demanded

Question 35

What are giffen goods?

Answer 35

Giffen goods are products with a positively sloped demand curve
They are extremely inferior goods that occupy a large part of the budget such that the income effect outweighs the substitution effect)

Question 36

What are the 2 characteristics of giffen goods?

Answer 36

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 37

What is conspicuous consumption of goods?

Answer 37

They are goods that are consumed because they have “snob appeal”

Question 38

How does the behaviour related to the conspicuous consumption of goods violate the theory of utility maximization?

Answer 38

Snobs would still buy more at a lower price as long as other people thought they had paid a higher price (what matters is not what you paid, but what others think you paid)
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 relatively few higher-income “snobs”

Question 39

What is consumer surplus?

Answer 39

It 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
It is like a “profit” for consumers because they can purchase a product for less than the maximum amount they are prepared to pay

Question 40

What does the area under the demand curve show us?

Answer 40

It shows us the total value a consumer places on a good

Question 41

What does the market demand curve show?

Answer 41

It shows the valuation that consumers place on each unit of the product

Question 42

What does the area under the demand curve and above the price line show for any given quantity?

Answer 42

It shows the consumer surplus received from consuming those units

Question 43

Where is the total consumer surplus located?

Answer 43

It is located in the area under the demand curve and above the price line

Question 44

What does the area under the demand curve show?

Answer 44

It shows the total valuation that consumers place on all units consumed

Question 45

What is the paradox of value?

Answer 45

It is a view that questions why products that are essential to life have a low price while products that are not essential to life have a high price

Question 46

What does the paradox of value ignore?

Answer 46

It ignores 2 important aspects of the determination of price:
1. Supply plays just as an important 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
Ex: Water has a plentiful supply so it has a low price. Diamonds have a relatively scarce supply and therefore have a high price

Question 47

Since water has a low price, consumers buy water to the point where the [marginal/total] value placed on the last unit consumed is very low, and the [marginal/total] value is high

Answer 47

Marginal
Total

Question 48

Since diamonds have a high price, consumers buy diamonds to the point where the [marginal/total] value placed on the last unit consumed is very high, and the [marginal/total] value is low

Answer 48

Marginal
Total