Consumption and Consumer Behaviour
Domain 3 tests utility analysis and demand: the cardinal approach (TU, MU, diminishing marginal utility, equi-marginal utility), the ordinal approach (indifference curves, MRS, budget line), the law of demand and elasticity with its measurement.
Cardinal utility
- TU is total satisfaction; MU is the addition to TU from one more unit: MU = change in TU / change in Q.
- Law of diminishing marginal utility: as consumption rises, MU falls. TU rises while MU is positive, is maximum when MU = 0, and falls when MU is negative.
- Equi-marginal utility: a consumer maximises satisfaction when MUx/Px = MUy/Py, so that the last rupee spent on each good yields equal satisfaction.
Ordinal utility
- An indifference curve shows combinations giving equal satisfaction. Properties: downward sloping, convex to the origin (diminishing MRS), never intersecting, higher curve means higher satisfaction.
- Budget line: slope = Px/Py. Equilibrium occurs where MRSxy = Px/Py, with the indifference curve tangent to the budget line.
Demand and elasticity
- Law of demand: price and quantity demanded move inversely, other things equal.
- Price elasticity = percentage change in quantity / percentage change in price. Total outlay method: if price falls and total revenue rises, demand is elastic; if revenue falls, inelastic; if unchanged, unitary.
Worked example
Price falls from Rs 10 to Rs 8; quantity rises from 100 to 140. Total outlay rises from 1,000 to 1,120, so demand is elastic. Check: percentage change in quantity = 40 percent, in price = 20 percent, so e = 2.
Traps
- Saying TU falls as soon as MU falls; TU falls only when MU turns negative.
- Drawing intersecting indifference curves.
- Confusing elasticity with slope; slope and elasticity are different measures.
- Ignoring exceptions to the law of demand: Giffen goods, Veblen goods, speculation.