Podcast Beta
Questions and Answers
What is the reason why Irish peasants purchased more potatoes as prices increased during the potato famine?
The income effect always exceeds the substitution effect.
False
What is the term for a special type of inferior good whose positive income effects outweigh the negative substitution effect?
Giffen good
As consumption increases, the marginal utility of a commodity falls rapidly, making demand _______________.
Signup and view all the answers
Match the following commodities with their corresponding demand elasticity:
Signup and view all the answers
What is the reason why consumers pay high prices for diamonds?
Signup and view all the answers
The law of diminishing marginal utility applies to water but not to diamonds.
Signup and view all the answers
What is the principle that states that consumers will allocate their budget such that the marginal utility per pound spent is equal for all commodities?
Signup and view all the answers
The price of diamonds is high due to _______________ supply.
Signup and view all the answers
What is the term for the apparent contradiction between the high price of diamonds and the low price of water?
Signup and view all the answers
Study Notes
Utility Theory
- Limited Income: Individuals have limited money income, which means they must make choices about how to allocate their income.
- Opportunity Cost: Buying one good involves going without something else, and consumers weigh up the opportunity costs to obtain maximum satisfaction.
Utility and Marginal Utility
- Total Utility: The total satisfaction a person derives from consuming a certain number of units of a product within a given time period.
- Marginal Utility: The change in satisfaction resulting from a one-unit change in the consumption of a product within a given period of time.
- Marginal Utility Formula: Marginal Utility = Change in Total Utility / Change in Number of Units Consumed
- Utility is Subjective: Utility cannot be measured and varies from person to person, place to place, and over time.
Law of Diminishing Marginal Utility
- Definition: The law states that the more a consumer has of a given commodity, the smaller the satisfaction gained from consuming each extra unit.
- Graphical Representation: Figure 5.1 shows the relationship between Total Utility and Marginal Utility, with Marginal Utility decreasing as the quantity consumed increases.
Marginal Utility and Demand Curve
- Rational Consumer: A consumer will continue consuming a good as long as Marginal Utility is greater than or equal to the price.
- Individual's Demand Curve: The demand curve is the same as the Marginal Utility curve, and the consumer will buy more of a good if the price falls.
- Consumer's Surplus: The difference between the maximum amount a consumer is willing to pay and the market price, represented by the area below the demand curve and above the market price.
Utility-Maximizing Choice
- Rational Consumer: A consumer will allocate their expenditure to maximize total utility by comparing the marginal utility per euro spent on different goods.
- Equi-Marginal Principle: A consumer will buy goods up to the point where the Marginal Utility per euro spent is equal for all goods.
Substitution and Income Effects
- Substitution Effect: The change in consumption of a good associated with a change in its own price, leading to an increase in consumption of a cheaper good and a decrease in consumption of a more expensive good.
- Income Effect: The change in consumption of a good associated with a change in real income, leading to an increase in consumption of a normal good and a decrease in consumption of an inferior good.
- Price Elasticity of Demand: The bigger the income and substitution effects, the higher the price elasticity of demand.
Giffen Goods
- Definition: A Giffen good is a type of inferior good for which an increase in price leads to an increase in quantity demanded.
- Characteristics: Giffen goods have a high percentage of expenditure and few close substitutes, leading to a strong income effect that outweighs the substitution effect.
Relationship between Marginal Utility and Price Elasticity of Demand
- Inelastic Demand: A good with a rapidly decreasing Marginal Utility has an inelastic demand, meaning a small percentage change in price leads to a small percentage change in quantity demanded.
- Elastic Demand: A good with a slowly decreasing Marginal Utility has an elastic demand, meaning a small percentage change in price leads to a large percentage change in quantity demanded.
The Paradox of Value
- Total Utility vs. Marginal Utility: Total utility refers to the total satisfaction derived from a good, while marginal utility refers to the additional satisfaction derived from one more unit of the good.
- Diamonds and Water: Diamonds have a high marginal utility and a high price, while water has a low marginal utility and a low price. The marginal utility per pound spent is equal for both goods.
- Demand and Supply: The price of diamonds is high due to low supply, and the price of water is low due to high supply.
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Description
Learn about utility theory in economics, where individuals weigh opportunity costs to obtain maximum satisfaction from their expenditure. Understand how consumers make rational decisions considering relative costs and benefits.
