Chapter 6 Flashcards
Define Utility
Satisfaction gained from consuming a good or a service
Define Marginal Utility
Additional satisfaction gained from consuming additional units of a good or a service.
Marginal utility gained will influence the willingness of a person to repurchase the item.
Why is marginal utility downward sloping?
Due to law of diminishing marginal returns
Define the law of diminishing marginal returns
This law states that the more units consumed, the lower the utility gained. For instance, first bite of the sandwich is always the most favourable, but slowly you get fuller.
Define total utility
Total utility gained from consuming all the chosen units of a good or a service
Explain the relationship between demand, marginal utility and price.
Demand for a good is based on utility derived from it.
At a higher price, a rational consumer would be less willing to demand since the utils gained per dollar are not worth it. They will not be satisfied, and won’t think that they’re getting their money’s worth
But, if the price decreases, their marginal utility will increase and people will be more likely to purchase since they’ll gain higher utils person dollar, and they’ll value the product more.
Define equi-marginal principle
This is used to determine how much of each good should be consumed to keep utility constant
Limitations of marginal utility theory
- Utility cannot be measured
- Utility is not standardized
- Consumers do not always react rationally
- Difficult to apply to multiple goods
Derivation of demand curve using marginal utility analysis
Marginal utility analysis includes utility, marginal utility and total utility. Utility, in general, is the satisfaction gained from consuming a good or a service. Marginal utility can be defined as the additional satisfaction gained from consuming additional units from a good or service, and last total utility is the total satisfaction received from consuming all chosen units from a good or a service.
Consumers aim to maximize their utility within budget, and this could be done through the help of the equi-marginal principle, where [FORMULA]. This helps make the choice of goods that give highest constant utility.
According to the law of diminishing marginal returns, the more you consume from the good, the lower the utility gained in return. For instance, the first bite of the sandwich is always the most favourable, but eventually the person feels fuller and can get sick at some point. This can be directly linked to the demand curve, where it demonstrates consumer behaviour, and how much quantity they’re willing to buy at different prices.
At a higher person, consumers buy a fewer quantity since the util gained per dollar is low, and not worth the money that’s being paid; the consumer feels as if they’re not getting their money’s worth. However, at a lower price, consumers will be more willing to purchase the good since the marginal utility gained will be higher at a lower price.
By tracking the quantities demanded at different prices, the demand curve could be derived, where it shows the relationship between price and quantity demanded. The downward slope of the demand curve reflects law of diminishing marginal returns where the consumer needs a lower price to justify buying more of a good.
[EVALUATION]
Budget line
Boundary of an individual’s consumption.
You cannot spend more than what you have.
Define indifference curve
Demonstrates consumer preference as well as the combination of 2 goods that give the highest constant utility.
A rational consumer will always try to achieve highest I.C.
Features of indifference curve
- Shows trade-offs
- Shows consumer preference
- Shows how consumer is capable of allocating budget to maximize utility.
Define marginal rate of substitution
MRS is the slope of the indifference curve which shows the rate at which consumer is willing to give up one good for the other; how much is given up to consume another good.
Is demand curve always downward sloping?
No, incase it’s a Giffen good, then it’s upwards sloping because as the price of the good increases, people are more willing to demand it more.
What causes a shift in IC?
An increase in income. (Abdul’s example)
Define income effect (YED)
Effect of income on quantity demanded.
Increase in price -> Real incomes decreased
Decrease in price -> Real incomes increased
Define substitution effect
Replacing a product with a cheaper alternative
How to determine income and substitution effect?
By drawing a shadow budget line that is:
- Touching indifference curve 1
- Parallel to budget line 2
Normal good: Point C is in the middle of A and B
Inferior good: Point C is always outwards in either corner.
Limitations of indifference curve
- Utility is immeasurable
- Utility is not standardized
- Unable to use if more than 2 goods
- Consumer is not always thinking rationally
Use the indifference curve analysis to derive demand curve for a normal good. [Decrease in price]
The indifference curve demonstrates consumer preferences as well as a combination of 2 goods that maximize utility, and the budget lines shows the boundary of an individuals consumption. A rational consumer cannot spend more than what they have, and they must maximize their utility within budget, and this can be done through the indifference curve.
To derive a demand curve for a normal good, an indifference curve must be analyzed. To start with, the decrease in price of a normal good would cause the budget line to pivot to the right as consumers are more capable of affording more of this good. There is a huge difference between the total effect since normal goods are elastic; they take a huge proportion out of the income, and if there’s a slight decrease in price, the quantity demanded will significantly increase.
Regarding the substitution effect, it is always positive because rational consumers are more likely to shift their demand to something that is relatively cheaper, and it can be seen in the diagram as movement from A to C.
The income effect is positive because according to YED, an increase in income would make people demand normal goods more as they’re of higher quality and people are more likely to demand it because purchasing power became stronger. (Real incomes increased).
By tracking quantities demanded at different prices, the demand curve can be derived, and it shows the relationship between price and quantity demanded. It is both downward sloping and slightly horizontal as the variables have an inverse relationship and it is elastic.
Use the indifference curve analysis to derive demand curve for a normal good. [Increase in price]
The indifference curve demonstrates consumer preference as well as a combination of 2 goods that give maximum utility to consumer, and the budget line shows the boundary of an individual’s consumption; they cannot spend more than what they own, so they must maximize their utility as much as possible within budget, and this is done by the help of the indifference curve.
To derive the demand curve for a normal good, the indifference curve must be analyzed. The increase in price of a normal good would cause the budget line to pivot inwards to the left since less people will be willing to purchase the good as they’re incapable of doing so. The value of the total effect is large since normal goods are elastic, so a slight change in price would impact the quantity demanded greatly.
Regarding the substitution effect, it is negative because any rational consumer is likely to demand a cheaper alternative as the price of the normal good increased. This increase in the price of the normal good will cause the purchasing power of money to weaken and real incomes will decrease, according to YED, the decrease in incomes would also cause less people to demand normal goods as they take a higher proportion out of incomes, so income effect will also be negative.
Overall, there has been a decrease in quantity demanded for normal good, and this is evident in the diagram.
By tracking quantities demanded at different prices, a demand curve could be drawn where it shows the relationship between utility, price and Q.D The demand curve is downward sloping because there’s an inverse relationship between both variables, and it is horizontal because normal goods are elastic.
Use the indifference curve analysis to derive demand curve for an inferior good. [Decrease in price]
The indifference curve demonstrates consumer preference as well as showing the combination of 2 goods that give maximum constant utility, and the budget line shows the boundary of an individuals consumption; they cannot spend more than what they have, so they must maximize their utility within budget.
To derive a demand curve for an inferior good, an indifference curve must be analyzed. The decrease in price of an inferior good will cause the budget line to pivot to the right because people are more capable of purchasing the inferior good since it’s cheaper and will take a lower proportion out of their incomes. The overall value of total effect is low since inferior goods are inelastic demand, a huge decrease in price of the good will barely affect quantity demanded since people are insensitive towards price change.
Regarding substitution effect, it is positive as any rational consumer is likely to demand the cheaper alternative more, and in this case, they’ll demand the inferior good over good y. This can be seen as movement along the curve from point A to C.
This decrease in price indicates that consumer’s purchasing power became stronger, and people’s real incomes have increased, so according to YED, if incomes increased, they are less likely to demand inferior goods because they can instead afford more higher and better quality items.
By tracking quantities demanded at different prices, the demand curve can be derived, and it shows the relationship between price, utility and quantity demanded. The demand curve is downward sloping due to the inverse relationship between the variables, and it’s almost vertical as inferior goods are inelastic.
Use the indifference curve analysis to derive demand curve for an inferior good. [Increase in price]
To derive a demand curve for an inferior good, an indifference curve must be analyzed. The increase in price of an inferior good will cause the budget line to pivot inwards to the left since people are less capable of affording the same quantity of goods, so they’ll demand less. The overall total effect value is low since inferior goods are inelastic demand, people are not highly sensitive towards a price change, so a slight increase in price will barely decrease the Q.D since it takes a low proportion out of their incomes.
Regarding substitution effect, it is negative because any rational consumer will seek a cheaper alternative over this specific inferior good, so demand is likely to decrease. This increase in price also indicates that purchasing power has become weaker, and real incomes have decreased, so according to YED, people are going to demand inferior goods more since they are still relatively cheaper and take a low % from income. However, overall, the substitution effect is stronger, so quantity demanded will decrease.
By tracking the quantities demanded at different prices, the demand curve can be derived to show the relationship between utility, price and quantity demanded. The demand curve is downward sloping since there’s an inverse relationship between the variables, and it is vertical since inferior goods are inelastic demand.
What are Giffen goods?
They are goods that are highly inferior to the point that the income effect exceeds substitution effect. Even if there is a price increase, quantity demanded will increase as well.
Demand curve is upward sloping
