MU theory + IC

Question 1

Explain how to derive demand curve using MU theory

Answer 1

• consumption occurs at MU>P
• as MU falls, consumer is unwilling to pay as much for successive units
• so P needs to fall for more consumption to occur
• this explains downward sloping demand curve
• optimal point of consumption is P=MU

Question 2

Is substitution effect positive or negative?

Answer 2

It is always negative

Question 3

How is income effect different for different types of goods

Answer 3

Income effect is negative for inferior goods and giffen goods
positive for normal goods

Question 4

Why is the equilibrium point P=MU important?

Answer 4

• consumption occurs if MU>P
• when MU>P, consumer gains by consuming more until P=MU
• when MU<p></p>

Question 5

Differences between two MU theory and IC

Answer 5

1. MU only consider one product, equi-marginal principle can accommodate two or more products
2. IC incorporate budget constraint but only consider two products, it breaks down change in quantity demanded into substitution effect and income effect
3. IC can accommodate different types of goods, giffen good explain in some cases why demand curve is not downward sloping

Question 6

Assumptions for MU theory

Answer 6

1. consumers are rational, utility maximisers
2. ceteris paribus
3. consumers can attach monetary value of MU
4. MU of money stays constant

Question 7

Criticism for the assumptions of theory

Answer 7

1. consumers are not always rational, instead of attempting to achieve optimal outcome, individuals make decisions based on potential gain and losses that may arise
2. individuals can be ‘nudged’ to take certain actions, e.g. advertising, DMU may not be the case, impulse buying
3. price may not be constant, income can fall and rise (assume limited income)