A Level Economics Chapter 2 Price System and Microeconomy

Law of diminishing marginal utility

Each extra unit consumed adds less to total utility than the previous unit consumed.
Equi-marginal principle
The consumer equilibrium is the consumption bundle where total utility is a maximum.

In considering the consumer equilibrium a number of assumptions are made, namely that the
individual:
a) has a limited income;
b) acts in a rational manner;
c) aims to maximise his or her total utility subject to the income constraint.

The above equation states that the consumer equilibrium is where the marginal utility from the
last penny spent on product x exactly equals the marginal utility from the last penny spent on
product y equals the utility from the last penny spent on product n, thereby taking into account
all of the products the individual consumes.
Deviation to demand curve
It is possible to use marginal utility as a means of deriving a demand curve.

If the price of product y were to fall to 2.00, the consumer would reduce consumption of
product x by 1 unit and raise consumption of product y by 3 units, hence consuming 3 of
product x and 5 of product y. (refer to table 4.20)
The individual consumes 3 of product x and 5 of product y given an income of 16.00,
with the consumer obtaining total utility of 324 utils.

Indifference curve
Lines representing different combinations of commodities that yield a constant level of utility or
satisfaction to the consumer.
1. They are convex to the origin, i.e. bent towards the origin

2. It is possible to produce an indifference map (see Figure 4.4(a)). There are an infinite
number of indifference curves although only three are shown in the figure, and a move to
an indifference curve further from the origin, say from IC1 to IC2 represents an increase
in the level of utility or satisfaction. This is because indifference curves further from the
origin represent consumption bundles containing more of both products, which can be
expected to mean higher utility or satisfaction.
3. Indifference curves cannot cross for this would suggest inconsistent or irrational
consumer behaviour. For example, suppose we have the following consumer ranking of
three bundles of products x and y, with the respective bundles shown as A, B and C in
Figure 4.4(b).
A>B
B>C
Then, via consistent consumer behaviour, we can say:
A>C
Budget Line
Describes the various combinations of two (or more) products that can be purchased if the
whole household income is spent on these products.
Consumer Equilibrium
Slope of budget line = slope of indifference curve
Point E = Maximum Utility

1. A change of income

An increase in income, assuming the price of the two products remains unchanged, will
lead to a parallel shift in the budget line to the right, allowing the consumer to buy more
of both products.
This can be seen in Figure 4.7 where the budget line shifts from AB to CD, thus allowing
the consumer to move onto a higher indifference curve IC2 with a new equilibrium of E2.
The line through the equilibrium positions is called the incomeconsumption curve and it
shows how the consumption of the two products responds to an income change.
If there had been a fall in income the budget line would have shifted parallel and to the
left.

*Income-consumption curve - Shows how the quantity consumed of two products changes as the
income changes, assuming no change in relative prices. A line which joins the set of tangency
points between budget lines and highest attainable indifference curves.
2. A change in price
In Figure 4.8 the initial budget line is AB and the consumer is in equilibrium at E1, where
the budget line is tangential to the indifference curve.
Following a fall in the price of product x the budget line pivots to AC, thus allowing the
consumer to move onto a higher indifference curve (IC2) resulting in a new equilibrium
of E2.
A line that joins all of the points of consumer equilibrium is called the price
consumption curve.
In Figure 4.8 there has been a fall in the price of product x, but if the price had risen then
the budget line would have pivoted again from point A but become steeper.
Substitution effect
The additional amount of a product purchased as a result of its price being cheaper
relative to other substitutes in consumption.
As the price of product x falls it becomes cheaper relative to product y and for this reason
the consumer will substitute product x for product y.
It will always be the case that the consumer will substitute towards the product which has
become relatively cheaper.

Income effect
The additional purchasing power resulting from a fall in price of one or more products in
the consumption bundle.
As the price of product x falls it also means that the consumer has more money to spend
on other products. It can be said that the consumers real income has increased since it
costs less to buy a given quantity of goods.
Steps:
1. Shifting a line back, parallel to the new budget line AC, until it is tangential to the
original indifference curve with the consumer obtaining the same level of utility as that
prior to the price change.
2. This is represented by line AC which is tangential to the original indifference curve at b.
3. Restore the level of income by shifting the budget line in parallel fashion from AC back
to AC.
4. Point b to point c represents the income effect, allowing the consumer to reach a higher
indifference curve IC2 and consume more of product x, i.e. a move from X2 to X3.
5. Figure 4.9 above applicable to Normal Goods.

Inferior Good
Cheap but poor quality substitutes for other goods. As real incomes rise above a certain
threshold, consumers tend to substitute more expensive but better quality alternatives for
certain products.

The income effect is negative, unlike the previous example, and this means a movement from b
to c with less being consumed, X2 to X3.
Although the income effect is negative, in this case it is not sufficient to outweigh the
substitution effect, which means that overall there is still more of the product demanded as the
consumer has moved from X1 to X3.

In other words, the demand curve for product x is still downward sloping.

It is possible, however, for the negative income effect to be sufficiently large to outweigh the
substitution effect.

Giffen Good

A Giffen good refers to a situation where the substitution effect is outweighed by the negative
income effect.

The total effect of a price change reveals that the total quantity of the product demanded falls
(X1 to X3) as the price of the product falls.
 In this situation the demand curve is upward sloping from left to right (a positive slope) and
this special type of demand curve relates to a type of product which is referred to as a Giffen
good.