Module 4 - Consumer Demand And Uncertainty

Question 1

Total utility

Answer 1

The total satisfaction a consumer gets from the consumption of all the units of a good consumed within a given time period.

Question 2

Marginal utility

Answer 2

The extra satisfaction gained from consuming one extra unit of a good within a given time period (assuming that the consumption of other goods is held constant). In money terms, it is what you are willing to pay for one more unit of good.

Question 3

Principle of diminishing marginal utility

Answer 3

The more of a product a person consumes over a given period of time, the less will be the additional utility gained from one more unit.

As more unit of good are consumed, additional units will provide less additional satisfaction than previous units.

Question 4

Marginal consumer surplus

Answer 4

The excess of utility from the consumption of one more unit of good (MU) over the price paid: MCS = MU - P.

The difference between the maximum amount that you are willing to pay for one more unit of a good (i.e. your marginal utility) and what you are actually charged (i.e. the price).

Question 5

Total consumer surplus

Answer 5

The excess of a person’s total utility from the consumption of a good (TU) over the amount that the person spends on it (TE) : TCS = TU-TE.

It is the sum of all the marginal consumer surpluses you have obtained from all the units of a good you have consumed. It is the difference between the total utility from all the units and your expenditure on them.

Question 6

Rational consumer behaviour

Answer 6

The attempt to maximise total consumer surplus.

If MU > P, the consumer should buy more. Total consumer surplus is maximised where MU = P, i.e. people should consume a good up to the point where MU = P.

Question 7

How is demand curve related to marginal utility

Answer 7

Provided that consumers are rational and maximise consumer surplus, then the demand curve for an individual consumer corresponds to her marginal utility curve measured in money. The principle of diminishing marginal utility then implies that the individual’s demand curve will slope downwards.
The market demand curve is simply the horizontal sum of all the individual demand curves and so will also slope downwards. Its slope reflects the price elasticity of demand and supply the marginal utility of the good.

Question 8

Weaknesses of the one-commodity version of marginal utility theory

Answer 8

Although the theory is fairly realistic, it ignores:

1. The interdependence of changes in consumption of different goods
2. The dependence of consumption on income.

Question 9

Consumer durable

Answer 9

A consumer good that lasts a period of time, during which the consumer can continue gaining utility from it.

The further into the future you look, the less certain you will be of its costs and benefits to you.

Question 10

Expected value

Answer 10

The average value of a variable after many repetitions: in other words, the sum of the value of a variable on each occasion divided by the number of occasions.

Question 11

Diminishing marginal utility of income

Answer 11

Where each additional pound earned yields less additional utility than the previous pound.

It refers to the situation in which an individual gains less additional utility from each extra pound of income.

Question 12

Spreading risks

Answer 12

The more policies an insurance company issues and the more independent the risks of claims from these policies are, the more predictable will be the number of claims.

Question 13

Independent risks

Answer 13

Where two risky events are unconnected. The occurrence of one will not affect the likelihood of the occurrence of the other.

Question 14

Law of large numbers

Answer 14

The larger the number of events of a particular type, the more predictable will be their average or expected outcome.

Question 15

Diversification

Answer 15

Where a firm expands into new types of business.

In the example of insurance companies it is a way of spreading their risks by offering more types of insurance like car, house, life, health etc. The more type it offers, the greater is likely to be the independence of the risks.

Question 16

Adverse selection
(self selection / anti selection)

Answer 16

A market process whereby either buyers, sellers or products with certain unobservable characteristics (e.g. high risk or low quality) are more likely to enter the market at the current market price. The process can have a negative impact on economic efficiency and causes some potentially profitable markets to collapse.

Adverse selection describes the fact that people who know that they are particularly bad risks are more inclined to take out insurance than those who know that they are good risks.

Question 17

Moral hazard

Answer 17

Following a deal, there is an increased likelihood that one party will engage in problematic behaviour to the detriment of another.

Moral hazard describes the fact that a policyholder may, because they have insurance, act in a way that makes the insured event more likely.
Moral hazard makes insurance more expensive. It may even push the price of insurance above the maximum premium that a person is prepared to pay.

Question 18

Differences between risk-neutral, risk-loving and risk-averse behaviour

Answer 18

Risk neutral: a person who chooses the option with the highest expected value and therefor is indifferent between accepting or rejecting a fair gamble.

Risk averse: a person that will never choose a gamble if it has the same expected value as the pay off from not taking a gamble. A person who dislikes risk and will always reject a fair gamble.

Risk loving: a person who will always choose gamble if it had the same expected value as the pay off from not taking the gamble. A person who likes risk and will always accept a fair gamble.

Question 19

Shapes of the curves showing marginal and total utility as functions of income

Answer 19

Upward sloping: as the marginal utility of income is positive.
Concave: as the marginal utility of income decreases with income.

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Question 21

How can an insurance company deal with adverse selection

Answer 21

1. Screening: the person or party who is uninformed about the relevant characteristics of the other parties asks for information.
2. Signalling: the person or party who is informed about the relevant characteristics to take action to reveal it to the uninformed person or party.

Question 22

How can an insurance company deal with moral hazard

Answer 22

• Uninformed party to devote more resources to monitoring the actions and behaviour of the informed party.
• Change the term of the terms of the deal so that the party with the unobservable actions has an incentive to behave in ways which are in the interests of the uninformed party.

The insurer can monitor customers’ behaviour (expensive) or change the terms of insurance so that the customer still suffers some sort of penalty if the insured event occurs. (insured limit, excess, nod)

Question 23

Feasible insurance contract

Answer 23

An insurance contract is feasible if the minimum premium that the insurer is prepared to charge is less than the maximum amount that a potential policyholder is prepared to pay.

Question 24

How can a system of insurance increase expected utility

Answer 24

Of the insured: because people are risk averse, the feeling they of certainty they get from having insurance gives them extra utility. The system of insurance can reduce the financial impact of uncertain future events.

Of the insurer: insurance is mutually beneficial, the insurance companies are usually better off in terms of total utility if the insurance is taken out.

Question 25

Maximum premium that an individual is prepared to pay for insurance

Answer 25

Maximum premium: P
Random loss: X
Initial level of wealth: a

E[U(a-X)] = U(a-P)

Question 26

Minimum premium the insurer is willing to charge for insurance

Answer 26

Minimum insurance premium: Q
Potential loss: Y
Initial wealth of insurer: a

E[U(a + Q - Y)] = U(a)