Consumer Theory, Utility and Indifference Analysis
This domain tests why demand curves slope downwards. Questions ask you to distinguish total from marginal utility, apply the equi-marginal principle, manipulate indifference curves and budget lines, and separate income from substitution effects.
Utility
- Cardinal utility assumes measurable satisfaction; ordinal utility only requires ranking, which is the basis of indifference analysis.
- Total utility rises while marginal utility is positive and peaks where marginal utility is zero; negative marginal utility reduces total utility.
- Law of diminishing marginal utility: successive units consumed in a period yield less extra satisfaction.
Equi-marginal principle
- A consumer maximises satisfaction when marginal utility per unit of money is equal across goods: MU of rice divided by price of rice equals MU of beans divided by price of beans.
- If one ratio is higher, spending shifts towards that good until the ratios equalise.
Indifference curves and the budget line
- An indifference curve shows combinations giving equal satisfaction. Curves slope downwards, are convex because the marginal rate of substitution diminishes, never cross, and higher curves represent higher satisfaction.
- The budget line has slope equal to the price ratio and intercepts equal to income divided by each price.
- Optimum: tangency where the marginal rate of substitution equals the price ratio. Corner solutions occur with perfect substitutes.
- A price fall rotates the budget line outwards and produces an income and a substitution effect; for a Giffen good the negative income effect outweighs the substitution effect and demand rises when price rises.
- Consumer surplus is the area below the demand curve and above price, measuring the gain from exchange.
Worked example
A student has 6,000 XAF, rice costs 500 XAF per kg and beans 1,000 XAF per kg. At 4 kg of rice and 4 kg of beans the purchase is exactly affordable. Suppose the marginal utility of the last kg of rice is 120 and of beans 240.
- Utility per franc of rice = 120/500 = 0.24.
- Utility per franc of beans = 240/1,000 = 0.24.
- The ratios are equal, so this bundle is the equilibrium; shifting a franc either way lowers total utility. If the bean figure had been 300, its ratio would be 0.30, and the student should spend more on beans and less on rice.
Traps that cost marks
- Treating maximum total utility as the point where marginal utility is at its maximum; it is where marginal utility is zero.
- Saying indifference curves shift when income changes: the budget line shifts, the map stays.
- Claiming every inferior good is a Giffen good.
- Using income divided by the price ratio instead of the price ratio itself as the slope of the budget line.