2.1.1. Consumer Behaviour

Question 1

Summary

Answer 1

• Individual Demand Theory
• Rational Economic Decision Making and Economic Incentives
• Utility Theory
• Hypothesis of Diminishing Marginal Utility
• Utility Maximisation
• Importance of the Margin when making choice

Question 2

1. Individual Demand Theory

Answer 2

• Individual Demand Curve: shows how much of a good / service the consumer plans to demand at different possible prices
• Law of Demand: as a good’s price falls, the demand for it will increase. (inverse relationship between P and Q)
• Shift in Demand Curve: change in the conditions of demand
  (Conditions: income, preference, price of substitute / complimentary goods)
• Movement along: contraction of extension of demand caused by change in price.

Question 3

2. Rational Economic Decision Making and Economic Incentives

Answer 3

• Traditional theory assumes consumers always act rationally
• Rational behaviour: is acting in the pursuit of self-interest (maximisation of welfare /utility)
• Given this assumption: change in price of any good / change in the conditions of demand alter economic incentives.

Question 4

3. Utility Theory

Answer 4

Utility: satisfaction an individual gains from consuming a good or service.
Marginal Utility: additional welfare, satisfaction or pleasure gained from consuming one extra unit of good.

In rational economic decision making: we attempt to maximise utility.

(Draw diagram of relationship between total utility and marginal utility)

Question 5

4. Hypothesis of Diminishing Marginal Utility

Answer 5

• Law of Diminishing Marginal Utility: marginal utility derived from a good / service diminishes for each additional unit consumed.

This can be seen in Adam Smith’s ‘Diamonds and Water Paradox’

• In most countries, water is cheap (despite it’s essentiality)
• Diamonds are expensive (despite their uselessness)
• Smith: this can be explained through marginal utility and scarcity
• Water is plentiful (people can consume it to the point at which the MU they gain from it is low)
• Diamonds are scarce, meaning that the MU gained from adding one more diamond to a person’s collection is higher.

Question 6

5. Utility Maximisation

Answer 6

• Demand Theory: household’s objectives are to maximise utility obtained from goods and services consumed.
• If all goods were free, consumers would maximise utility by obtaining all goods which yield utility, up to the point of satiation.
• Satiation: no more utility can be gained from consuming extra units of a good.

Maximisation is Subject to Constraints

• The problem of scarcity means consumers face a number of constraints which restrict the choices they make in the marketplace.
  1. Limited Income: income spent on one good cannot be spent on another
  2. Given Set of Prices: Consumer cannot (on their own) determine prices faced.
  3. Budget Constrain: Limited Income + Price Faced = a budget constrain on consumers’ freedom of action in the market place
• Opportunity Costs: consumer can only purchase more of one good by giving up consumption of another
  4. Limited Time Available: impossible to consume more than one good at a time.

Question 7

6. Importance of the Margin when making choices

Answer 7

• The ‘margin’ is a key concept of traditional Economic Theory
• Rational consumers choose between goods and services in such a way as to try to maximise total utility derived from consumption
• Along with prices that must be paid, marginal utilities gained from consumption of the last unit of each good determine the combination of goods the consumer must choose in order to maximise total utility .
• Utility maximising consumer will choose to consume a good up to the point at which marginal utility = opportunity cost.