Theory of consumer Behaviour Chapter 2

Question 1

What is law of demand?

Answer 1

The inverse relationship between price of a commodity and quantity demand is referred to as Law of demand.

Question 2

What is demand

Answer 2

The ability to pay as well the willingness and desire to pay is called demand.

Question 2

What cannot be explained by law of demand?

Answer 2

Why people buy more when price of a commodity increases or why people buy less when the price of a commodity decreases.

For this there is three schools of thought for this purpose
Cardinal utility analysis
Ordinal Utility analysis
revealed preference theory.

Question 3

What is utility?

Answer 3

It is the power or capacity of a commodity to satisfy a want.
The benefit or satisfaction from a commodity, the commodity is said to have a utility.

Question 4

Who coined the term utility?

Answer 4

W.S Jevons.

Question 5

Who developed Cardinal Utility theory?

Answer 5

By classical economists.
Gossen,
William Stanley Jevons,
Leon Walras
Karl Menger
Alfred Marshall later made significant refinements

Question 6

What is cardinal utility theory?

Answer 6

Cardinal Utility theory states that utility is measurable just like height, weight and temperature.
Utility is measurable cardinally or quantitatively

Question 7

Other Names for cardinal utility theory?
Think Alfred Marshall?

Answer 7

Neo-classical utility theory
Marshallian utility theory

Question 8

Compare assumption of cardinal utility theory vs its limitations?

Answer 8

(Check the numbers) Rest read page 26 and 27

Assumptions/features
1. Utility is measurable in numerical terms
2. Utilities are independent of substitutes or complements(depends on the commodity itself)
3. The marginal utility of money remains constant
4. Man is rational

5. Utility gained from successive units of a commodity goes on diminishing.(law of diminishing marginal utility)

Limitations.
1.Utility is a psychological concept hence cannot be measured cardinally.
2.This assumption is wrong it depends on availability of substitutes and complements
3.This is not true. The law of diminishing marginal utility does not apply on money.
4. Incorrect. No consumers compare utility and disutility of each unit of commodity while buying it.

5. Unable to explain the existence of Giffen Goods.
6. Does not study income effect, substitution effect and price effect.

Question 9

What is marginal utility?

Answer 9

The utility derived from consuming the additional unit of a commodity.

Question 10

What is total utility?

Answer 10

Utility derived from consuming all units of a commodity.

Question 11

What is law of diminishing marginal utility?

Answer 11

When a consumer consumes the more of the same commodity, each successive units give lesser and lesser satisfaction.

the more of the same commodity is consumed the total utility from a commodity increases at a diminishing rate and may become negative.

Question 12

What is negative utility called?

Answer 12

Disutility

Question 13

Read Page 28 for graph on diminishing marginal utility.
Basically when consuming a commodity continuously the total utility diminishes and marginal utility diminishes at higher rate.

The graph is like a wave originating from 0 and moving along x axis.

Y= total/marginal utility
x= units of the same commodity (usually mangoes)

Answer 13

From starting of page 28 to page 29.
Also read relationship between marginal utility and total utility.(till there)

Question 14

Assumptions of the marginal utility law?
(What are the assumptions of the marginal utility law after learning about the graph?)
(These are assumption we make before drawing the graph)

Answer 14

1. The units of commodity are identical or homogenous
2. Consumer tastes remain constant/unchanged. (as they need to consume the same commodity for this shit to work)
3. There is no time interval between two units of a commodity. The consumption is continuous.
4. The units of the commodity are normal sized (not too small or large)

5.The price of the goods and the income of the consumer must remain constant.

6.The law assumes that utility is measurable in terms of money

Question 15

Limitations of the law of diminishing marginal utility?

Answer 15

1.It does not apply to antique goods and rare collectibles that increase satisfaction while having more possessions.
(E.g. Stamps, coin collection, old paintings and art)

2. It does not hold good on the consumption of liquor.
   (the more someone drinks the more he likes)

3.It does not apply to a miser.
(spends less saves more)

4.Law does not apply to money. Marginal utility of money never falls to zero.

5. The law fails when there is a higher number of consumer for a commodity
6. There are cases where a certain commodity can provide increasing marginal utility for a certain period of time.
   (A man watching TV for the first time)

Question 16

Practical importance of diminishing marginal utility law?
Application of the diminishing marginal utility law?

Answer 16

1. Helpful In taxation: The principle of increasing taxation is also based on the Law of Diminishing Marginal Utility. The rate of taxes increases on a person’s income as their income increases because the marginal utility of money falls to the rise of income of the person.
   (basically they (gov) think that with increase in income the satisfaction from that money decreases (bullshit).

2.Basis of the policy of equal distribution of wealth: Capitalism increase inequalities of wealth. To balance this government levy higher taxes on the rich and use the money to provide free education, medical aid etc. to the less fortunate people.

3.Helpful in regulating daily expenditure: When we buy more of the same commodity, the marginal utility decreases and puts a stop to further expenditure.

4.Determination of market prices: Price of a commodity must fall when its supply increases.

5.Helpful to the monopolist: It allows monopolists to charge different prices to different types of people with different incomes in order to make maximum profit.

6.Basis of economic laws: These laws are all derived from the law of diminishing marginal utility.

Law of Consumer Surplus
Law of Equi-Marginal Utility
Elasticity of demand
etc.

Question 17

Who developed theory of consumer surplus?

Answer 17

It was developed by the french engineer economist
A.J Dupuit. But Marshall again refined it.

Question 18

What all comes under cardinal utility approach?

Answer 18

Anything quantifiable

Question 19

What is consumer surplus?

Answer 19

A consumer surplus happens when the price that consumers pay for a product or service is less than the price they’re willing to pay. It’s a measure of the additional benefit that consumers receive because they’re paying less for something than what they were willing to pay.

Consumer surplus is a concept in which a consumer is willing to pay more amount for a commodity or a service (usually paper, salt, matchbox, etc) and if the said commodity or service is acquired for its orginal price or lower price the consumer gets extra or surplus satisfaction over and above the price we pay or were willing to pay.

Question 20

Formulae for consumer surplus?

Answer 20

Consumer surplus =
the price we were willing to pay - the price we actually paid
or
Total utility - total amount spent

Total utility - Market price * quantity purchased

Question 21

How is total amount spent calculated? (even babies know this)

Answer 21

Total amount spent = Market price * quantity purchased

Question 22

How is total utility calculated?

Answer 22

It is the sum of all marginal utility of a commodity.

Question 23

Assumptions of Theory of Consumer surplus?
Things we assume (may or may not be true but it is required to prove the hypothesis)?

Answer 23

1.Utility can be measured (lol no)

2.The marginal utility of money remains constant. (similar to assumption of cardinal utility)

3.The commodity has no substitute. (Similar to CUT)

4.The taste, income fashion of the consumer remains constant. (Similar to DMU)

5.The utility of a commodity depends upon the quantity of that commodity alone.

6. This theory is applicable only if the law of DMU is valid.

Question 24

Limitations of the Consumer surplus law?

Answer 24

1. Marginal utility of money cannot remain constant for most goods.

2.It is imaginary i.e. it is hypothetical.

3.It cannot be measured. (lol)

4.It does not apply to necessaries of life: It does not apply to vast range of necessary goods like salt, match box, bread and kerosene.

If we pay 1000 dollars for a glass of water in a desert and it actually cost 10 outside. When in desert does the consumer surplus become 990 (1000-10). Therefore it is immeasurable and unlimited.

5. Consumer surplus of two people cannot be compared because there is change in income, wealth, tastes etc.
6. It neglects the income effect.

income effect = The change in demand of goods/service due to the change in purchasing power of a consumer.

Question 25

Practical importance of consumer surplus?

Answer 25

1.Importance to the government in imposing taxes

2.Importance to the monopolist in fixing price of his products. High price for those who get larger consumer surplus and lower price for those who get lower consumer surplus.

3. It helps in comparing standard of living. Places where money income is same but other factors differ.

4.Importance in International trade: Consumer surplus is helpful in measuring the benefits from international trade.
If foreign goods are cheaper than domestic ones the higher consumer surplus can be obtained from foreign goods.

5.Importance in measuring value-in-use and value-in-exchange:
Goods like salt, match box, have great value in use and goods like radio, refrigerator, jewelry etc have more value in exchange and have small consumer surplus.

Question 26

Concept of ordinality?

Answer 26

The number 2 is twice than that of number 1. Number 9 is thrice than that of number 3 and so on.

Ice cream has more utility than chocolate.

Question 27

Why did modern economist debunk Cardinal utility approach?

Answer 27

They believed that utility is psychological concept and impossible to measure quantitatively.

Question 28

Who created ordinal utility approach?

Answer 28

Edgeworth -creator
Prof. J.R. Hicks and RGD Allen - perfecter/refiner

Question 29

What is ordinal utility approach?

Answer 29

The concept of ordinal utility states that the level of satisfaction a consumer obtains after consuming various commodities cannot be measured in numbers but can be arranged in the order of preference.

Question 30

Other names of ordinal utility approach?

Answer 30

Indifference curve analysis.
Ordinal Utility analysis

Question 31

What is indifference curve?

Answer 31

It is defined as a curve which shows the the number of alternative combinations of two or more goods which yield the same level of satisfaction.

Question 32

Why is it called “Indifference curve”?

Answer 32

When all combinations of two or more goods give the same level of satisfaction, the consumer may choose one from the list of pairs, and will be “indifferent” to the other pairs in the list .

Question 33

Assumptions of indifference curve?

Answer 33

1.The consumer is rational.

2.Consumer purchases a group of combination of two goods

3.Consumer has full knowledge about the market conditions

4.Utility cannot be measured cardinally but can be expressed ordinally.

5. Marginal utility of money does not remain constant .
6. The consumer is consistent in his choices

Question 34

Other names of Indifference curve?

Answer 34

Iso-utility curve

Question 35

What is Marginal rate of Substitution?

Answer 35

It is the RATE at which consumer substitutes one commodity for another.

Question 36

Marginal rate of substitution formulae?

Answer 36

MRSao = ^o/^a
o = oranges and a = apples.

Trick: the bottom part (^a) is diminishing from a larger number and is on X axis.

Question 37

Why does Diminishing MRS happen?

Answer 37

The consumer must reduce the consumption of one commodity when he increases the consumption of another to get the same level of satisfaction.

His intensity for one commodity increases and other decreases.

The goods are never prefect substitutes of each other in the satisfaction of a particular want

If they were MRS will be constant.

Question 38

Properties of Indifference curve?

Answer 38

1.Indifference curve slopes downwards from left to right.
THIS IS BECAUSE OF THE PRICIPLE OF DIMNISHING MARGINAL RATE OF SUBSTITUTION.

2.The indifference curve is convex to the point of origin.
THIS IS BECAUSE OF THE PRICIPLE OF DIMNISHING MARGINAL RATE OF SUBSTITUTION.

3.The indifference curve has a negative slope. This is because when the amount of one commodity increased, the other commodity must be reduced, in order to maintain the same level of satisfaction.(see graph in master class io)

4.Two indifference curves cannot intersect each other intersect each other. If they intersect each other, there is a common point between two curves. This further means that the same combination sometimes give more, sometimes less, and sometimes equal satisfaction. This is unscientific.
(graph is just two ICs intersecting which is wrong)

5.The higher ICs represent higher level of satisfaction than lower ICs.

6.ICs may not be parallel because rate of substitution in different IC schedules are not necessarily equal.
(graph is basically just some parallel ICs)

7.Straight line ICs indicate that two goods are perfect substitutes. (graph is three lines drawn like a demand curve)

8.ICs will be rectangular when two goods are non-substitutable. (graph is just x and y axis drawn multiple times inside each other)

9.A consumer has generally a list of indifference curve rather than just one. It is a set of indifference curves that is ranked in the order of the consumer’s preference.

A set of indifference curves is known as an indifference map.

Question 39

What is indifference map?

Answer 39

A set of indifference curves is known as an indifference map.

Question 40

What does a higher indifference curve mean?

Answer 40

A higher indifference curve means a higher level of satisfaction.

Question 41

Application of indifference curve ?

Answer 41

1.Helpful in production function:
Iso-quants is similar to indifference curve, it uses two factors (usually capital and labor) to find the optimum level of production. In short, IC is used to find out producers equilibrium.

2.Helpful in Exchange of commodities between two individuals
(As in the individuals can exchange commodities to find which one gives maximum satisfaction)

3.Useful In International Trade: It is helpful in determining the rate at which commodities of one country will/can be exchanged by commodities of another.

4.Useful in Taxation: It helps govt. to choose direct or indirect tax.
(Direct tax: On the individuals income)
(Indirect tax: On goods and services)

5.Useful In public finance: The famous law of maximum social advantage can be explained by the way of ICs.

Read this (Maximim social advantage is when Marginal utility of expenditure is equal or above to the marginal disutility of taxation. Basically satisfaction of expenditure should be equal to or above the dissatisfaction of taxation)

6. Helpful to government in deciding rationing and subsidies.

7.Useful in Investment management: Security analysis and portfolio management.

8.Helps measure consumer surplus.

Question 42

Iso-quants

Answer 42

An isoquant in economics is a curve that, when plotted on a graph, shows all the combinations of two factors that produce a given output. Often used in manufacturing, with capital and labor as the two factors, isoquants can show the optimal combination of inputs that will produce the maximum output at minimum cost.

Question 43

Criticisms of Indifference curve analysis?

Answer 43

1.Old wine in new bottle: The logic is that of Marshal but terms are simply different.

While Hicks used ‘preference’ in place of ‘utility’.
ordinal in place of cardinal.
and MRS in place of DMU.

2.Deals with only two goods: In real life consumers spend his income on more than two goods. When taking more than two goods in an indifference analysis the indifference map becomes complicated.

3.Wrong assumption of rationality: Consumers can be irrational and thoughtless when spending his/her money. Therefore the assumption that a consumer behaves rationally is wrong.

4.Ignores the market behavior: Since the focus of IC analysis is one two goods it does not explain much on market changes and prices of other goods.

5.Unrealistic assumption of perfect competition: Unrealistic assumption of perfect competition and homogeneity of goods. But in real life consumer is confronted with monopolistic competition and differentiated products.

6.Micro economic in character: It deals only with the choice and equilibrium of an individual customer. It is not the group equilibrium or group choice.

7. All commodities are not divisible

Question 44

Who criticized the indifference curve analysis?

Answer 44

Prof. Amstrong, Frank Knight

Question 45

Difference between utility analysis and indifferent analysis?

Answer 45

Refer to classmaster.io

Question 46

What is budget line or price line?

Answer 46

The maximum number of two commodities that a consumer can buy with the income he allocated for it . This maximum points can be represented using a graph which forms a straight line from y to x axis.

(the graph is like the demand line but touches both points of x and y axis ◣)

Question 47

Other name for price line?

Answer 47

Price-income line
Outlay line
Resource line
Price opportunity line
Expenditure line

Question 48

Consumers Equilibrium ? (Refer to pic) Read pg 42?

Answer 48

Three indifference curves of two commodity (x and Y) are drawn along with the price/budget line AB.
The three ICs are
IC1, IC2, IC3 (that are drawn almost parallel)
The budget line AB touches IC1 at point C and F.
The budget line AB is tangent to IC2 and the point of contact is E.
The budget line AB does not touch IC3 because it is above the line.

The point of contact which provides the highest level of satisfaction is called the consumers equilibrium.
That is E of IC2.

(because the IC1 touches at point C and F but it is a lower level IC and cannot provide maximum satisfaction)
(IC3 is above the income level i.e. above the budget line therefore not applicable)

Then you can find the amount of commodity X and Y that you need. (do it yourself)