Category Archives: Micro

Indifference Curves – Mindmap

With a bit more time on my hands I was able to produce a mindmap on Indifference Curves – a topic that students find quite difficult. The mindmap covers all the main features – what is meant by the Income Effect, Substitution Effect and most importantly how they are characterised in Normal, inferior and Giffen goods. Particularly useful for a theoretical essay on utility and consumer choice. You can download a full size copy by clicking here.

Mind Map 13 indifference curves.jpg

A2 Revision – Marginal Utility Theory

With the A2 exam not far away I thought it appropriate to post something on Marginal Utility. This is usually a multiple-choice question and part of an essay.

Consumers buy goods to derive satisfaction, or utility. Each unit purchased gives satisfaction (utility) and Marginal Utility is the satisfaction derived from the consumption of 1 more unit. Under normal circumstances the amount of satisfaction from each unit consumed will fall as more units are consumed e.g. when you finish a run your first drink will give you more satisfaction than your second and your second drink will give you more satisfaction than your third etc. – hence we get diminishing marginal utility see Table below. This is the basis of the normal demand curve, which slopes left to right – downwards.

The theory assumes that the RATIONAL CONSUMER aims to MAXIMISE SATISFACTION (or utility) by equating the MARGINAL UTILITIES yielded by the expenditure of a last money unit (cent or dollar) on each commodity purchased. The consumer is this is EQUILIBRIUM when the following formula is achieved:

  • MU of A   =     MU of B    =     MU of C       Etc.
  • Price of A       Price of B        Price of C

This means that the LAST unit of money spent provides the consumer with the same SATISFACTION (or UTILITY) irrespective of the good on which it is spent.

Examples

A consumer has $35 to spend. Price of X = $10 and Price Y = $5. What combination of X and Y maximize total satisfaction?

Quantity Bought Marginal Utility X Marginal Utility Y
1 30 15
2 20 12
3 15 10
4 9 8

 

  • MU of X   =     MU of Y
  • Price of X       Price of Y
  • 20   =   10
  • 10         5

Here the consumer buys 2X and 3Y

TOTAL UTILITY in this example = 30+20+15+12+10 = 87. (Note that TOTAL UTILITY is otherwise irrelevant to the calculation).

When the PRICE of a good falls, more will be bought (since the M.U. ÷ price formula is disturbed – and a LOWER M.U. {i.e. MORE BOUGHT} will restore equilibrium). Similarly, when the price of a good RISES less will be bought. This emerges from the LAW OF DIMINISHING MARGINAL UTILITY which states that as successful and equal quantities of a good are consumed, total utility increases but at a DIMINISHING RATE (i.e. MARGINAL UTILITY is FALLING – and can eventually become NEGATIVE.

Limitations of marginal utility theory 

  1. Unit of measurement – difficult to find an appropriate unit of measurement of utility.
  2. Habit and impulse – consumer spending on a particular product maybe habit forming or on impulse and therefore does not consider the marginal utility
  3. Enjoyment may increase as consumption increases – in some case utility may increase from further purchases of an item. A collector of memorabilia may obtain greater satisfaction from consuming an additional item – collecting a set of stamps etc
  4. Quality and consistency of successive units of a good – there is the assumption that all goods are homogenous but if successive can of soft drink are not the same then the marginal utility may change and be more or less than the previous one
  5. Other things remain constant – assumes that all factors affecting individuals’ satisfaction remain the same. However over time there maybe changes in income and the quality of other products as well as development of new products.

IGCSE Economics – Co-operatives

Showed this video on co-operatives to my IGCSE Economics (Unit 4 of CIE syllabus) class today and found it most useful in demonstrating the characteristics and examples. Remember the following characteristics about co-operatives:

  • share responsibility for the success or failure of the enterprise
  • work together
  • take decisions together
  • share profits (and losses).
  • The three most commonly found cooperatives are farming, production and retail.

Advantages

  • Limited liability
  • Workers in worker co-operatives take business decisions and share profits.
  • Members of consumer co-operatives enjoy profit dividends or lower prices

Disadvantages

  • Many consumer co-operatives have been forced out of business by larger companies.
  • Worker co-operatives may be badly run.

A2 Revision – Marginal Utility Theory

With the A2 exam not far away I thought it appropriate to post something on Marginal Utility. This is usually a multiple-choice question and part of an essay.

Consumers buy goods to derive satisfaction, or utility. Each unit purchased gives satisfaction (utility) and Marginal Utility is the satisfaction derived from the consumption of 1 more unit. Under normal circumstances the amount of satisfaction from each unit consumed will fall as more units are consumed e.g. when you finish a run your first drink will give you more satisfaction than your second and your second drink will give you more satisfaction than your third etc. – hence we get diminishing marginal utility see Table below. This is the basis of the normal demand curve, which slopes left to right – downwards.

The theory assumes that the RATIONAL CONSUMER aims to MAXIMISE SATISFACTION (or utility) by equating the MARGINAL UTILITIES yielded by the expenditure of a last money unit (cent or dollar) on each commodity purchased. The consumer is this is EQUILIBRIUM when the following formula is achieved:

  • MU of A   =     MU of B    =     MU of C       Etc.
  • Price of A       Price of B        Price of C

This means that the LAST unit of money spent provides the consumer with the same SATISFACTION (or UTILITY) irrespective of the good on which it is spent.

Examples

A consumer has $35 to spend. Price of X = $10 and Price Y = $5. What combination of X and Y maximize total satisfaction?

Quantity Bought Marginal Utility X Marginal Utility Y
1 30 15
2 20 12
3 15 10
4 9 8

 

  • MU of X   =     MU of Y
  • Price of X       Price of Y
  • 20   =   10
  • 10         5

Here the consumer buys 2X and 3Y

TOTAL UTILITY in this example = 30+20+15+12+10 = 87. (Note that TOTAL UTILITY is otherwise irrelevant to the calculation).

When the PRICE of a good falls, more will be bought (since the M.U. ÷ price formula is disturbed – and a LOWER M.U. {i.e. MORE BOUGHT} will restore equilibrium). Similarly, when the price of a good RISES less will be bought. This emerges from the LAW OF DIMINISHING MARGINAL UTILITY which states that as successful and equal quantities of a good are consumed, total utility increases but at a DIMINISHING RATE (i.e. MARGINAL UTILITY is FALLING – and can eventually become NEGATIVE.

Limitations of marginal utility theory 

  1. Unit of measurement – difficult to find an appropriate unit of measurement of utility.
  2. Habit and impulse – consumer spending on a particular product maybe habit forming or on impulse and therefore does not consider the marginal utility
  3. Enjoyment may increase as consumption increases – in some case utility may increase from further purchases of an item. A collector of memorabilia may obtain greater satisfaction from consuming an additional item – collecting a set of stamps etc
  4. Quality and consistency of successive units of a good – there is the assumption that all goods are homogenous but if successive can of soft drink are not the same then the marginal utility may change and be more or less than the previous one
  5. Other things remain constant – assumes that all factors affecting individuals’ satisfaction remain the same. However over time there maybe changes in income and the quality of other products as well as development of new products.

Indifference Curves and Giffen Goods

New to the A2 CIE syllabus is indifference curves and my A2 class recently had a multiple-choice question concerning indifference curves and giffen goods. A giffen good occurs when a rise in price causes higher demand because the income effect outweighs the substitution effect.

Suppose you have a very low income and eat two basic food stuffs rice and meat. Meat is a luxury and is much more expensive than rice. If rice increased in price, your disposable income is effectively reduced significantly therefore, you buy less meat, to compensate for less meat you buy more rice to gain enough calories. Source: www.economicshelp.org

Griffen good and indifference curves

indiff-giffen

  • Good B falls in price – hence budget line moves from: 50 A – 30 B to: 50 A – 60 B.
  • The move from point J to point K is the substitution effect which = +16
  • The move from point K to point L is the income effect which = -20
  • These make up an overall move from point J to point L is the price effect (substitution effect + income effect) = -4

As income effect is negative, substitution effect positive and overall price effect negative Good B is a giffen good.

Summary of income and substitution effects of price changes

sub-income-effect

Go to eLearn Economics for more notes on Indifference Curves.