Economics Marginal Utility Questions Long
Marginal utility theory is a fundamental concept in economics that explains how individuals make decisions regarding the allocation of their limited resources. It helps to understand the income effect and substitution effect, which are two important concepts in consumer behavior.
The income effect refers to the change in consumption patterns resulting from a change in income, while keeping prices constant. According to marginal utility theory, as income increases, individuals can afford to consume more goods and services. This leads to an increase in their overall utility or satisfaction. The income effect can be further divided into two sub-effects: the income effect of a normal good and the income effect of an inferior good.
For a normal good, as income increases, the individual's purchasing power increases, allowing them to consume more of the good. This leads to a positive income effect, where the individual's overall utility increases. For example, if a person's income increases, they may choose to buy a higher quality or more expensive brand of a product, leading to an increase in their satisfaction.
On the other hand, for an inferior good, as income increases, the individual's preference for the good decreases. This is because as income rises, individuals tend to substitute inferior goods with higher-quality alternatives. This results in a negative income effect, where the individual's overall utility decreases. For instance, if a person's income increases, they may choose to switch from consuming generic brands to more expensive and higher-quality brands, reducing their satisfaction from consuming the inferior good.
The substitution effect, on the other hand, refers to the change in consumption patterns resulting from a change in the relative prices of goods, while keeping income constant. According to marginal utility theory, individuals will substitute goods that have become relatively more expensive with goods that have become relatively cheaper. This is because individuals aim to maximize their utility by allocating their limited resources efficiently.
When the price of a good increases, individuals tend to consume less of that good and more of other goods that are relatively cheaper. This is known as the substitution effect. For example, if the price of apples increases, individuals may choose to consume more oranges, which have become relatively cheaper, to maintain their overall utility.
In summary, marginal utility theory explains the income effect as the change in consumption patterns resulting from a change in income, while keeping prices constant. It shows that as income increases, individuals can afford to consume more of normal goods, leading to a positive income effect, while their preference for inferior goods decreases, resulting in a negative income effect. The substitution effect, on the other hand, explains the change in consumption patterns resulting from a change in relative prices, while keeping income constant. It shows that individuals tend to substitute goods that have become relatively more expensive with goods that have become relatively cheaper to maximize their utility.