Utility theory

Question 1

What is utility in economics?

Answer 1

Utility is the economic welfare or satisfaction obtained from consuming goods and services.

Question 2

Utility is the economic welfare or satisfaction obtained from consuming goods and services.

Answer 2

To maximise utility from their consumption choices.

Question 3

What is total utility (TU)?

Answer 3

The cumulative satisfaction a consumer gains from consuming a certain quantity of a good.

Question 4

Can you give an example of total utility?

Answer 4

Drinking 3 glasses of lemonade provides 18 units of total utility.

Question 5

What is marginal utility (MU)?

Answer 5

The additional satisfaction gained from consuming one extra unit of a good.

Question 6

Can you give an example of marginal utility?

Answer 6

Drinking the 3rd glass of lemonade provides 4 units of marginal utility.

Question 7

What is the key insight about marginal utility?

Answer 7

Marginal utility is highest for the first unit and declines as more units are consumed, following the principle of diminishing marginal utility.

Question 8

What is the law of diminishing marginal utility?

Answer 8

As consumption of a good increases (ceteris paribus), the additional utility derived from each successive unit decreases.

Question 9

How does the lemonade example illustrate diminishing marginal utility?

Answer 9

Marginal utility declines as follows: 8 → 6 → 4 → 2 → 0 → -2.

Question 10

What is the point of satiation?

Answer 10

The point where MU = 0, and total utility is maximised. Beyond this point, MU becomes negative, leading to marginal disutility.

Question 11

What is Adam Smith’s diamonds and water paradox?

Answer 11

• 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.

Question 12

How is the Adam Smith’s diamonds and water paradox resolved?

Answer 12

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.

Question 13

How is marginal utility related to demand?

Answer 13

Consumers choose quantities of goods where MU = Price.

Question 14

What happens when the price rises, according to the relationship between MU and demand?

Answer 14

Consumption decreases to align with MU = Price, reducing the quantity demanded, consistent with the law of demand.

Question 15

What is consumer surplus?

Answer 15

The difference between the total utility a consumer gains and the total amount paid, representing welfare gains from trade.

Question 16

What is opportunity cost in utility theory?

Answer 16

The utility forgone when resources are allocated to one good instead of another.

Question 17

What is indifference curve analysis?

Answer 17

It represents combinations of goods providing equal utility.

Question 18

What is the marginal rate of substitution (MRS)?

Answer 18

The rate at which a consumer is willing to substitute one good for another while maintaining the same utility.

Question 19

What is the difference between cardinal and ordinal utility?

Answer 19

• Cardinal Utility: Utility can be measured (e.g., in units of utility).
• Ordinal Utility: Utility is ranked (preferences are ordered but not quantified).

Question 20

What are the limitations of utility theory?

Answer 20

1. Assumes rationality and perfect information.
2. Difficulty in quantifying utility in real-world contexts.

Question 21

How does behavioral economics challenge traditional utility theory?

Answer 21

It considers psychological biases and irrational behaviors, which traditional utility theory often overlooks.