1. Define and explain the relationship between total utility, marginal utility, and the law of diminishing marginal utility.
The law of diminishing marginal utility states that beyond a certain quantity, additional units of a specific good will yield declining amounts of extra satisfaction to a consumer.
2. Describe how rational consumers maximize utility by comparing the marginal utility-to-price ratios of all the products they could possibly purchase.
The utility-maximization model assumes that the typical consumer is rational and acts on the basis of well-defined preferences. Because income is limited and goods have prices, the consumer cannot purchase all the goods and services he or she might want. The consumer therefore selects the attainable combination of goods that maximizes his or her utility or satisfaction.
A consumer's utility is maximized when income is allocated so that the last dollar spent on each product purchased yields the same amount of extra satisfaction. Algebraically, the utility-maximizing rule is fulfilled when
The Marginal Utility of product A divided by the price of product A equals the Marginal Utility of product B divided by the price of product B.
and the consumer's total income is spent.
3. Explain how a demand curve can be derived by observing the outcomes of price changes in the utility-maximization model.
The utility-maximizing rule and the demand curve are logically consistent. Because marginal utility declines, a lower price is needed to induce the consumer to buy more of a particular product.
4. Discuss how the utility-maximization model helps highlight the income and substitution effects of a price change.
The utility-maximization model illuminates the income and substitution effects of a price change. The income effect implies that a decline in the price of a product increases the consumer's real income and enables the consumer to buy more of that product with a fixed money income. The substitution effect implies that a lower price makes a product relatively more attractive and therefore increases the consumer's willingness to substitute it for other products.
5. Give examples of several real-world phenomena that can be explained by applying the theory of consumer behavior.
The theory of consumer behavior can explain many real world phenomena, including the rapid adoption of popular consumer goods like the iPad that feature disruptive technologies, the over consumption of products like health care that have artificially low prices, and why people often prefer gifts of cash to receiving particular items or objects of the same monetary value as gifts.