Utility theory Flashcards
Consumer behaviour -> Individual economic decision making -> Microeconomics
What is utility in economics?
Utility is the economic welfare or satisfaction obtained from consuming goods and services.
Utility is the economic welfare or satisfaction obtained from consuming goods and services.
To maximise utility from their consumption choices.
What is total utility (TU)?
The cumulative satisfaction a consumer gains from consuming a certain quantity of a good.
Can you give an example of total utility?
Drinking 3 glasses of lemonade provides 18 units of total utility.
What is marginal utility (MU)?
The additional satisfaction gained from consuming one extra unit of a good.
Can you give an example of marginal utility?
Drinking the 3rd glass of lemonade provides 4 units of marginal utility.
What is the key insight about marginal utility?
Marginal utility is highest for the first unit and declines as more units are consumed, following the principle of diminishing marginal utility.
What is the law of diminishing marginal utility?
As consumption of a good increases (ceteris paribus), the additional utility derived from each successive unit decreases.
How does the lemonade example illustrate diminishing marginal utility?
Marginal utility declines as follows: 8 → 6 → 4 → 2 → 0 → -2.
What is the point of satiation?
The point where MU = 0, and total utility is maximised. Beyond this point, MU becomes negative, leading to marginal disutility.
What is Adam Smith’s diamonds and water paradox?
- Water: High value in use (essential for life) but low marginal utility due to abundance.
- Diamonds: Low value in use but high marginal utility due to scarcity.
How is the Adam Smith’s diamonds and water paradox resolved?
Value in exchange depends on marginal utility and scarcity, not just practical utility. If water were scarce (e.g., in a desert), its marginal utility—and thus its value—would increase.
How is marginal utility related to demand?
Consumers choose quantities of goods where MU = Price.
What happens when the price rises, according to the relationship between MU and demand?
Consumption decreases to align with MU = Price, reducing the quantity demanded, consistent with the law of demand.
What is consumer surplus?
The difference between the total utility a consumer gains and the total amount paid, representing welfare gains from trade.
What is opportunity cost in utility theory?
The utility forgone when resources are allocated to one good instead of another.
What is indifference curve analysis?
It represents combinations of goods providing equal utility.
What is the marginal rate of substitution (MRS)?
The rate at which a consumer is willing to substitute one good for another while maintaining the same utility.
What is the difference between cardinal and ordinal utility?
- Cardinal Utility: Utility can be measured (e.g., in units of utility).
- Ordinal Utility: Utility is ranked (preferences are ordered but not quantified).
What are the limitations of utility theory?
- Assumes rationality and perfect information.
- Difficulty in quantifying utility in real-world contexts.
How does behavioral economics challenge traditional utility theory?
It considers psychological biases and irrational behaviors, which traditional utility theory often overlooks.
