Title 1. A2 Economics - Notes.pdf ✅

A2 / MICRO — [NOTES] — CHAPTER 1 AATIK TASNEEM | O/A-LEVEL | BUSINESS & ECONOMICS | 0304 1122845 2 Lecture 2 1. Marginal utility and derivation of an individual demand schedule If marginal utility were measured in terms of money then the MU curve would be the persons demand curve. A rational consumer will tend to maximize their utility from consumption and in order to do so will try to consume at a point where marginal utility equals price. As long this is maintained the individual demand curve would be the same as the marginal utility curve. MU = P In order to understand this let’s look at the diagram below: - MU > P: If the marginal utility is greater than the price of the product the consumer would tend to increase the consumption of the product because the benefit or marginal utility is higher than the asking price. - MU < P: If marginal utility is less than the price of the product the consumer would tend to decrease consumption of the product because the benefit or marginal utility of the product is lower than the asking price.
A2 / MICRO — [NOTES] — CHAPTER 1 AATIK TASNEEM | O/A-LEVEL | BUSINESS & ECONOMICS | 0304 1122845 3 2. LAW OF EQUI-MARGINAL UTILITY In diminishing marginal utility, we were only looking at the impact of a price change on one good. The marginal theory can also be used to explain how the consumers will allocate expenditure across all goods. This is called the equi-marginal principle. The quantity chosen of one good affects the demand for the other, given a limited budget to spend it is not a simple question of setting MU=P, as decision of one good affects the position of the MU curve for other goods due to the linkage of budget constraint. Definition | Equi-Marginal Principle: A rational consumer is in equilibrium when he spends his fixed income on different goods with given prices in such a way that MU of the last unit of money spent on each good is equal. &'( )( = &'* )* Situation 1: Price of Product X Falls If the price of Product X falls the equation would be structured as follows: &'( )( > &'* )* This shows that the last unit of money spend on X is greater than Y. Hence the consumer would tend to consume more of X. However the law of diminishing marginal utility would come in and with every unit consumed the MUx will fall until the equality is restored. Note: This also explains the reasons that when Priceâ Quantity Demandedá Situation 2: Price of Product Y Falls If the price of Product Y falls the equation would be structured as follows: &'( )( < &'* )* This shows that the last unit of money spend on Y is greater than X. Hence the consumer would tend to consume more of Y. However the law of diminishing marginal utility would come in and with every unit consumed the MUy will fall until the equality is restored. Consumer strategy to maximize utility Situation 1 Situation 2 Situation 3 &'( )( > &'* )* - Consume More X - Consumer Less Y &'( )( < &'* )* - Consumer More Y - Consumer Less X &'( )( = &'* )* - Quantity X unchanged - Quantity Y unchanged Limitation of Marginal Utility Theory Factor Description 1. Utility cannot be measured It is difficult to measure utility because there is no method to do that. Further utility can neither be added not it can be compared physically. 2. Ceteris paribus In reality things don’t remain constant and consumer preference, incomes, etc. changes with time. This can lead to new consumption habits which might have an impact on consumer satisfaction 3. For some goods utility goes up For some goods an increase in consumption actually leads to an increase in utility. Examples include money, collections, land in some cases an owning a collection tends to increase value. 4. Durable Goods This is difficult to apply to durable goods as they are not continuously used. Specially for diminishing marginal utility this law is important. 5. Consistency of goods The assumption holds that all the goods are similar in nature, however that might not be true. Example: If the consumer is eating an apple, the quality might be different in successive units and depending on that the utility may be more or less than the previous one. 6. Consumers are not rational Sometimes consumers are not rational as they buy goods on basis of impulse or even indulge in conspicuous consumption. Hence they are not basing their decision on marginal utility.