Analyzing Major Economic Processes - Essay Example

The ultimate result may be as follows: If the change caused by the income effect is greater than by the substitution effect, more of X would be consumed; otherwise – consumption of X would decrease or stay at the same level.

Risk-averse individuals are better off with the purchase of insurance because they prefer certain losses to uncertain ones of the same scale. Given that the marginal utility of wealth is diminishing they are ready to give up a certain and reasonable amount of money in the form of insurance premium to avoid the chance of large and uncertain loss. Thus, it is in their interest to buy insurance because of the certainty it provides.

According to the expected utility model, the individuals tend to undertake actions that increase the expected utility value (U), which can be expressed as the function of the income (Y). If the probability of the accident resulting in the loss of X is indicated as P and assuming that the insurance company in the case of an accident will pay the amount equal to X, the expected utility for an individual who does not buy insurance is equal to: U1 = (1-P) x U(Y) + P x U (Y-X);

If insurance is purchased and the insurance premium is equal to I the expected utility can be expressed as: U2 = (1-P) x U(Y-I) + P x U (Y – I –X+X);

If the insurance premium I is fair, i.e. I = P x X, then the consumer would benefit by purchasing insurance (U2 > U1). 

If per unit tax on a good is imposed and the tax revenue is then used to offset the decrease in consumer surplus the consumers still would be worse off than before the introduction of the tax. It happens because the consumer bears an excessive burden which is equal to the difference between the value of equivalent variation (compensation that allows the customer to achieve the same level of utility as before tax, graphically – the vertical distance between pre-and post-tax indifference curves) and tax revenue that the government can use to offset the effect of tax (graphically - the vertical distance between corresponding budget constraint lines).

It may be beneficial for the companies offering service or good A to introduce a choice of price and service options to target the groups of customers with different levels of income and needs. The optimal bundle of service A and all the other goods will vary depending on the budget constraint and marginal utility of A for a certain group. Introducing several variations A1, A2,…., An (from low price – low service to higher-priced advanced products) would allow the company to appeal to very price-sensitive customers as well as to those, for whom additional service has higher marginal value than the extra price charged for it.