UTILITY ANALYSIS

SARBJEET KAURLecturer in Economics

• Meaning of Utility • Types of Utility • Law of DMU• Law of Equi-Marginal Utility

• Utility Means want Satisfying power of a Good/ Commodity

• Utility is Subjective• Utility is Relative• Utility is Independent of Morality

Types of Utility

• Total Utility• Marginal Utility• Total utility – the satisfaction a person

receives from consuming a specific quantity of a good.

• Marginal utility – the increments to total utility from changes in consumption.

Cardinal and ordinal utility

cardinal utility : Utility is measured in Numeric terms like I,2,,3

Ordinal Utility: ordinal utility captures only ranking and not strength of preferences.

Law of Diminishing Marginal Utility

The law says, first, that the marginal utility of each (homogenous) unit decreases as the supply of units increases (and vice versa);

“The additional benefit which a person derives from a given stock of a thing diminish with every increase in the stock that he already has”

Marshall

Assumption

• Utility is cardinally measured• MU of Money is constant• MU of every commodity is Independent• No Change in income of consumer• No change in Price of a commodity• No change in Taste and habits

No. of cup Cakes MU

First 4

Second 3

Third 2

Fourth 1

Fifth 0

Sixth -1

Exceptions:1. Curious and rare Things2. Misers3. Good Books or Poem4. Drunkards

Importance of DMU

• Basis of law of Consumption• Variety in production and Consumption• Difference between Value in Use and

Exchange• Advantage to consumer• Basis of Redistribution

Law of Equi Marginal UtilityAccording to this, a consumer is in equilibrium when he distributes his given

money income among various goods in such a way that marginal utility derived from the last rupee spent on each good is the same.

• Assumptions The main assumptions of the law of equi-marginal utility are as under: (1) Independent utilities. The marginal utilities of different commodities are

independent of each other and diminishes with more and more purchases.(2) Constant marginal utility of money. The marginal utility of money remains

constant to the consumer as he spends more and more of it on the purchases of goods.

(3) Utility is cardinally measurable.(4) Every consumer is rational in the purchase of goods.(5) Limited money income. A consumer has limited amount of money income

to spend

• lgebraically, this is when; MUa / Pa = MUb / Pb

= MUc = Pc = MUn = Pn • Here (a), (b), (c)…. (n) are various goods

consumed

Rs Spent MU Of Mangoes MU oF Milk

1 12 10

2 10 8

3 8 6

4 6 4

5 4 2

• Limitations of the Law• (i) Effect of fashions and customs. The law of equi-marginal utility may

become inoperative if people forced by fashions and customs spend money on the purchase of those commodities which they clearly know yield less utility but they cannot transfer the unit of money from the less advantageous uses to the more advantageous uses because they are forced by the customs of the country.

• (ii) Ignorance or Carelessness. Sometimes people due to their ignorance of price or carelessness to weigh the utility of the purchased commodity do not obtain the maximum advantage by equating the marginal utility in all the uses.

• (iii) Indivisible Units. If the unit of expenditure is not divisible, then again the law may become inoperative.

• (iv) Freedom to Choose. If there is no perfect freedom between various alternatives, the operation of law may be impeded;

• Importance of the law• The Law of equi-marginal utility is of great practical importance. The

application of the principle of substitution extends over almost every field of economic enquiry. Every consumer consciously or unconsciously trying to get the maximum satisfaction from his limited resources acts upon this principle of substitution. Same is the case with the producer. In the field of exchange and in theory of distribution too, this law plays a vital role. In short, despite its limitation, the law of maximum satisfaction is meaningful general statement of how consumers behave.

• In addition to its application to consumption, it applies equally to the theory of production and theory of distribution. In the theory of production, it is applied on the substitution of various factors of production to the point where marginal return from all the factors are equal.

Derivation of the Demand Curve in Terms of Utility Analysis:• Dr. Alfred Marshal was of the view that the law of demand and so the

demand curve can be derived with the help of utility analysis. He explained the derivation of law of demand (i) in the case of a single commodity and (ii) in the case of two or more than two commodities. In the utility analysis of demand, the following assumptions are made:

Assumptions• Utility is cardinally measurable.• Utilities of different commodities are independent.• The marginal utility of money to the consumer remains constant.• Utility gained from the successive units of a commodity diminishes.•

Derivation of Demand Curve in the Case of a Single Commodity (Law of Diminishing Marginal Utility):

the MUx is negatively slopped. It shows that as the consumer acquires larger quantities of good x, its marginal utility diminishes. Consequently at diminishing price, the quantity demanded of the good x increases as is shown in fig. 2.4 (b). At X1, quantity the marginal utility of a good is MU1. This is equal to P1 by definition. The consumer here demands OX1 quantity of the commodity at P1 price. In the same way X2 quantity of the good is equal to P2. Here at P2 price, the consumer will buy OX2 quantity of commodity. At X3 quantity the marginal utility is MU3, which is equal to P3. At P3, the consumer will buy OX3 quantity and so on.

Derivation of the Demand Curve in the Case of Two or More than Two Commodities (Law of Equi-marginal Utility):