This chapter explains how a rational consumer chooses the bundle of goods that gives maximum satisfaction within her budget. Two approaches are studied. The cardinal utility approach measures satisfaction in numbers (utils) and uses the law of diminishing marginal utility — as more of a good is consumed, the extra utility from each additional unit falls; a consumer is in equilibrium where the marginal utility per rupee is equal across goods. The ordinal utility approach ranks preferences using indifference curves, each showing bundles giving the same satisfaction. Indifference curves slope downward, are convex to the origin, and do not intersect; their slope is the marginal rate of substitution, the rate at which the consumer trades one good for another while staying equally satisfied. The budget line shows all bundles a consumer can just afford given prices and income; its slope is the ratio of prices. The consumer is in equilibrium where the budget line is tangent to the highest attainable indifference curve. From this, the demand curve is derived, showing how quantity demanded varies inversely with price (the law of demand). The chapter also covers the market demand curve, normal and inferior goods, substitutes and complements, movements along versus shifts of the demand curve, and price elasticity of demand, \(e_d = \dfrac{\%\,\Delta Q}{\%\,\Delta P}\), and its link to expenditure.
Key terms
Utility
The satisfaction a consumer derives from consuming a good or service.
Marginal rate of substitution
The amount of one good a consumer gives up to gain one more unit of another, staying equally satisfied.
Indifference curve
A curve showing all bundles of two goods that yield the same level of satisfaction.
Budget line
A line showing all combinations of two goods a consumer can just afford with given income and prices.
Law of demand
Other things equal, quantity demanded falls as price rises and rises as price falls.
Price elasticity of demand
The responsiveness of quantity demanded to a change in price, \(e_d=\dfrac{\%\,\Delta Q}{\%\,\Delta P}\).
Extra questions & answers
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The law of diminishing marginal utility states that as consumption of a good increases:
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