Background to demand

Question 1

Marginal utility theory - Define ‘rational consumer’

Answer 1

A person who weighs up the costs and benefits to them of each additional unit of a good purchased.

Question 2

Marginal utility theory - Define ‘total utility’

Answer 2

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

Question 3

Marginal utility theory - Define ‘marginal utility’

Answer 3

The extra satisfaction gained from consuming one extra unit of a good within a given time period.

Question 4

Marginal utility theory - Define ‘principle of diminishing marginal utility’

Answer 4

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

Question 5

Marginal utility theory - Define ‘consumer surplus’

Answer 5

The excess of what a person would have been prepared to pay for a good (i.e. the utility) over what that person actually pays.

Question 6

Marginal utility theory - Define ‘marginal consumer surplus’

Answer 6

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

Question 7

Marginal utility theory - Define ‘total consumer surplus’

Answer 7

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

Question 8

Marginal utility theory - Define ‘rational consumer behaviour’

Answer 8

The attempt to maximise total consumer surplus.

Question 9

Marginal utility theory - Define ‘equi-marginal principle (in consumption)’

Answer 9

Consumers will maximise total utility from their incomes by consuming that combination of goods where MU_A/MU_B = P_A/P_B. This is the optimal combination of goods to consume and no further gain can be made from switching.

Question 10

Marginal utility theory - Explain the relationship between total utility and marginal utility curves

Answer 10

The MU curve slopes downwards, illustrating the principle of diminishing marginal utility. The TU curve starts at the origin and reaches a peak when marginal utility is zero. Marginal utility can be derived from the TU curve as the slope of the line joining two adjacent quantities on the curve.

Question 11

Marginal utility theory - Discuss the reason why a person’s marginal utility schedule might change

Answer 11

A person’s marginal utility schedule might change due to a change in their consumption of other goods, especially compliments and substitutes, tastes, or other circumstances such as time for leisure.

Question 12

Marginal utility theory - Clarify the water-diamond paradox

Answer 12

Water has a high total utility but low marginal utility due to its abundance, whereas diamonds have a low total utility but high marginal utility due to their scarcity, which is why diamonds are priced higher than water.

Question 13

Marginal utility theory - Explain the derivation of the demand curve according to the one-commodity model

Answer 13

The demand curve for an individual is equal to their MU curve, and diminishing MU implies that each person’s demand curve slopes downwards.

Question 14

Marginal utility theory - Discuss the weaknesses of the one-commodity model

Answer 14

It ignores the effect of MU of one good on changes in consumption in other goods and the dependence of consumption on income, assuming that money itself has a constant MU, which is not the case.

Question 15

Marginal utility theory - Explain why the optimum combination of goods consumed occurs where the marginal utility per £ spent is equal for all goods

Answer 15

This is due to the diminishing MU. If MU_A/MU_B is greater than the ratio of P_A/P_B, consumers can gain utility by consuming more A and less B until equilibrium is met.

Question 16

Marginal utility theory - Explain the derivation of the demand curve according to the multi-commodity model

Answer 16

The quantity of a good demanded satisfies the equation MU_A/MU_B = P_A/P_B for a given income and set of prices, giving a point on the demand curve. Changes in P_A will lead to adjustments in consumption until the equation holds again, providing further points on the demand curve.

Question 17

Timing and cost of benefits - Define ‘exponential discounting’

Answer 17

A method of reducing future benefits and costs to a present value. The discount rate depends on the level of impatience and remains constant in exponential discounting.

Question 18

Timing and cost of benefits - Define ‘present value (in consumption)’

Answer 18

The value a person places today on a good that will not be consumed until some point in the future.

Question 19

Timing and cost of benefits - Explain how a rational consumer can make optimal choices over time

Answer 19

Optimal choices are made by comparing the costs and benefits from consumption today with the discounted costs and benefits from future consumption, using exponential discounting to determine present value.

Question 20

Indifference analysis - Define ‘indifference curve’

Answer 20

A line showing all those combinations of two goods between which a consumer is indifferent, giving the same level of utility.

Question 21

Indifference analysis - Define ‘marginal rate of substitution (between two goods in consumption)’

Answer 21

The amount of one good (Y) that a consumer is prepared to give up in order to obtain one extra unit of another good (X): ΔY/ΔX.

Question 22

Indifference analysis - Define ‘diminishing marginal rate of substitution’

Answer 22

The more a person consumes of good X and the less of good Y, the less additional Y will that person be prepared to give up for an extra unit of X: ΔY/ΔX diminishes.

Question 23

Indifference analysis - Define ‘indifference map’

Answer 23

A graph showing a set of indifference curves, where curves further from the origin represent higher satisfaction levels.

Question 24

Indifference analysis - Define ‘budget line’

Answer 24

A graph showing all possible combinations of two goods that can be purchased at given prices and for a given budget.

Question 25

Indifference analysis - Define ‘price-consumption curve’

Answer 25

A line showing how a person’s optimum level of consumption of two goods changes as the price of one of the goods changes, holding income and the price of the other good constant.

Question 26

Indifference analysis - Define ‘income effect of a price change’

Answer 26

The portion of the change in quantity demanded resulting from the change in real income, holding relative prices constant.

Question 27

Indifference analysis - Define ‘substitution effect of a price change’

Answer 27

The portion of the change in quantity demanded resulting from the change in the relative price of the good, holding real income constant.

Question 28

Indifference analysis - Describe the main benefit of indifference analysis over marginal utility theory

Answer 28

Indifference analysis does not require utility to be measured in an absolute sense, focusing instead on how a rational consumer chooses between goods.

Question 29

Indifference analysis - Explain why an indifference curve is convex to the origin

Answer 29

The convexity reflects the principle of diminishing marginal rate of substitution; as a consumer substitutes good X for good Y, each additional unit of X will provide less additional satisfaction, so the consumer will give up less of Y for each subsequent unit of X.