Unit 7, Utility, Indifference Curve Theory, and Externalities, Costs and Benefits flashcards

utility

the satisfaction received from consumption

law of diminishing marginal utility

as consumption of a good or service increases, the additional satisfaction gained from each additional unit consumed decreases.

total utility

the total satisfaction received from consumption

marginal utility

the additional utility derived from the consumption of one more unit of a good or service

equi-marginal principle

consumers maximise their utility where their marginal valuation for each product consumed is the same, MUa/Pa = MUb/Pb = MUc/Pc…

assumptions of the equi-marginal principle

consumers have limited incomes, consumers will always behave in a rational manner, consumers seek to maximise their utility

derivation of the individual demand curve

As the price of one good changes, income and the prices of other goods remain the same, leading to consumer equilibrium shifting and resulting in different quantities demanded by the consumer at various price levels, which will then give that individual’s demand curve

limitations of marginal utility theory

assumes that consumers are capable of putting their wants in rank order and assigning a value from their consumption, assumes that consumers act and behave in a rational way to maximise utility with purchasing decisions

indifference curve

a graph that shows different combinations of two goods that provide the same level of satisfaction to a consumer, reflecting their preferences and trade-offs between the goods.

Indifference curve intersection

Indifference curves cannot cross each other as this would be where a consumer is being irrational in the choices made, higher indifference curve = higher level of satisfaction

marginal rate of subsitution

the rate at which a consumer is willing to substitute one good for another, graphically represented by the slope of the indifference curve

budget line

a graph that shows the combinations of two goods that can be purchased with given income and given prices

substitution effect

where, following a price change, a consumer will substitute the cheaper good for the one that is now relatively more expensive

income effect

where, following a change in the price of a good, a consumer has a change in real income and will change the quantity of this good that they consume

Optimal consumer choice (indifference curve theory)

A consumer’s choice is optimal at the point where the budget line is a tangent to the highest indifference curve.

Giffen good

A type of inferior good where the quantity demanded falls as price falls and the quantity demanded increases as price increases. This phenomenon occurs because the income effect outweighs the substitution effect, leading consumers to buy more despite higher prices.

economic efficiency

where scarce resources are used in the most efficient way to produce maximum output

productive efficiency

when a firm is producing at the lowest possible cost; occurs at bottom of average cost curve

allocative efficiency

when firms are producing those goods and services most wanted by consumers; where price is equal to marginal cost;

marginal cost

the addition to total cost when making one extra unit of output

average cost

the total cost per unit of output, calculated by dividing total cost by the quantity produced.

pareto optimality

where it is impossible to make someone better off without making someone else worse off

dynamic efficiency

when resources are allocated efficiently over time, achieved when a firm meets the changing needs of its market by introducing new production processes in response to competitive pressures

market failure

when a free market fails to make the best use of scarce resources, when the interaction of demand and supply in a market fails to lead to productive and/or allocative efficiency

externality

where the actions of a producer or consumer give rise to side effects on third-parties not directly involved in the action

negative externality

where the side effects of an action have a negative impact that imposes costs on third parties

positive externality

where the side effects of an action have a positive impact that provides benefits to third parties

private costs (PC)

those costs that are incurred by a consumer or by the firm that produces a good or service

private benefits (PB)

those benefits that accrue to the consumer or to the firm that produces a good or service

external costs (EC)

those costs paid for by a third party not involved in the action

external benefits (EB)

those benefits that are received by a third party not involved in the action

social costs (SC)

the total costs of a particular action

social benefits (SB)

the total benefits of a particular action

negative production externalities

costs to third parties as a result of the actions of producers, MSC > MPC

positive production externalities

benefits to third parties as a result of the production of goods and services, MSC < MPC

negative consumption externalities

costs to third parties as a result of the consumption of goods and services, MSB < MPB

positive consumption externalities

the benefits to third parties as a consequence as the consumption of goods and services, MSB > MPB

asymmetric information

where one party has more or better information than another in a business transaction

adverse selection

when sellers have information that buyers do not have on product quality or when buyers have information that sellers do not have on product quality

moral hazard

the temptation to take risks when some other party is covering these risks

cost-benefit analysis

a method of decision-making that takes into account the costs and benefits involved

shadow price

a price that is applied when there is no established market price available

difference between cost-benefit analysis and private sector methods of appraisal

cost-benefit analysis seeks to include all costs and benefits, not just private ones, and often has to provide a shadow price

stages of cost-benefit analysis

identification of all relevant costs and benefits; putting a monetary value on all relevant costs and benefits; forecasting future costs and benefits (where appropriate); decision making - the interpretation of the results from cost-benefit analysis

benefit:cost ratio

net benefits as a proportion of net costs; projects with the highest benefit:cost ratio are most likely to be carried out

limitations of the indifference curve model

Consumers have to choose from many more goods than just two, assumes that consumers express their wants and needs in terms of indifference rather than preference or rank order, assumes that consumers acts rationally