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Utility analysis by Dr. ruchi jain

The document discusses the utility analysis, defining utility as both a psychological and economic concept centered on the satisfaction derived from consuming goods. It elaborates on total utility and marginal utility, explaining key principles such as the law of diminishing marginal utility and the law of equi-marginal utility. Furthermore, it addresses assumptions, measurement methods, and limitations of utility, while highlighting its significance in consumer behavior and economic theories.

Economy & Finance◦
Related topics:
Managerial Economics• Business Economics•
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UTILITY ANALYSIS Dr. Ruchi Jain
Content Utility Approach: Meaning and Definition of Utility. Characteristics of Utility. Measurement of Utility. Total Utility and Marginal Utility. Law of Diminishing Marginal Utility, Law of Equi-Marginal utility, Limitations of Utility approach Law of Consumer surplus (Marshall’s version)
What is Utility?  Product angle: Want satisfying property of any product (absolute).  Consumer angle: The psychological feeling of satisfaction or happiness or well being or benefit derived by the consumer by the consumption of certain units of a good or service at a certain point of time (subjective)
Utility can be measured in two ways: ➢ Cardinal Utility: Assigning numerical values to the amount of satisfaction.(cardinal numbers are those definite numbers which can be added or subtracted.) ➢ Ordinal Utility: Not assigning numerical values to the amount of satisfaction but indicating the order of preferences, that is, what is
In twentieth century Marshall and Pigou elaborated Cardinal Utility Analysis. Fisher has used the term ‘util’ as a measure of Utility.
MEANING OF UTILITY In the words of Hibbdon , “Utility is the Quality of a good to satisfy a want.” Thus we can say that wants satisfying power of a commodity is called utility.
FEATURES OF UTILITY  UTILITY IS SUBJECTIVE: It is subjective because it deals with the mental satisfaction of a man.Eg. Medical books re not useful for commerce students.  UTILITY IS RELATIVE: Utility of a commodity never remains the same.it varies across the time and place. E.g. Cooler has utility in the summer but not during winter.  UTILITY IS NOT ESSENTIALLY USEFUL:A commodity having utility need not be useful. Liquor and cigarette are not useful, but to satisfy the want of an addict then they gave utility for him.  UTILITY IS INDEPENDENT OF MORALITY: Utility has nothing to do with morality.eg. Use of opium, liquor
FEATURES OF UTILITY  UTILITY CAN BE MEASURED: Marshall assumes cardinal measurement of utility.’Utils’  UTILITY DEPENDS ON THE INTENSITY OF WANT: A want which is unsatisfied and greatly intense will imply a high utility for commodity concerned to a person.  UTILITY IS CONCERNED WITH CONSUMER GOODS NOT WITH PRODUCTIVE GOODS: eg.atta in restaurants (productive goods) does not give direct satisfaction to customers, at home (consumer good)  UTILITY HAS NO PHYSICAL SHAPE: It is psychological concept and differs from person to person , place to place ad time to time.  UTILITY DOES NOT DEPEND ON ACTUAL CONSUMPTION:the utility starts the moment when he consumer thinks of buying a commodity and the satisfaction is derived after the consumption of the commodity.
Assumptions  Rational consumer  Cardinal utility-Measured in cardinal numbers 1,2,3,4,5 etc.  Independent Utility: it is assumed that the utility that a consumer gets from a commodity depends upon the quantity of that commodity itself.it is not affected by the utility derived from other goods.  Marginal Utility of money is constant  Divisibility  Diminishing marginal utility  Total Utility Depends on quantities of Individual Commodities: if there are ‘n’ commodities in the bundle with n1,n2,…nn quantities the total utility is U=f(n1,n2,…nn )
Utility is of two types: ➢Total Utility ➢Marginal Utility
Total Utility ➢ Sum of utility derived by consumer from multiple units Consumed at a point or over a period of time ➢ Example: A consumer consumes 3 units of X and derives utility u1, u2, u3 and u4 ➢ Total Utility Ux= u1 + u2 + u3 ➢ TUx= f(Qx) ➢ TU= ∑MU
Total Utility  The total satisfaction of wants & needs obtained from the consumption of goods & services  Based on the presumption that the amount of utility generated from the consumption of a good can be explicitly measures  Hypothetical measure is util  TOTAL UTILITY: It is the sum total of utility derived from the consumption of all units of a commodity.
MARGINAL UTILITY Marginal means change.  It refers to the additional utility obtained due to the consumption of an additional unit of a commodity. The change in total utility (∆TU) derived from one additional unit of consumption (∆X) MU = ∆ TU/ ∆ X MU= TUn- Tun-1 Marginal utility can be (i) positive (ii) zero (iii) negative.
Total Utility (TU) and Marginal Utility (MU) Ice-creams Consumed Total Utility (TUx) Marginal Utility (MUx) 1 20 20 2 36 16 3 46 10 4 50 4 5 50 0 6 44 -6
➢ The first column is showing the unit of a commodity. Second column of the above table gives and individuals hypothetical total utility (tu) from consuming various alternative quantities of commodity X . There it is noted that, as the individual consumes more unit of X, Tux increases. ➢ The Third column of the table is showing the individuals marginal Utility for commodity X. each value of column three is obtain by subtracting two successive value of column two. For example, If the individuals consumption of X goes from 1 unit to 2 units, the (Tux ) goes from 20 to 36 utilities, giving a MUx of 16. Similarly if the consumption of X rises from 2 units to 3 units, the (Tux) rises from 36 to 46, giving a MUx from 16 to 10. From the table we can see that as this individuals consumption more Units of X, MUx falls
Total Utility and Marginal Utility curve
TU is maximum Saturation point TU Y X Y X 0 0 MU +ve MU = 0 MU (–)ve MU
➢ In Fig, units of ice-cream, are shown along the X-axis and TU and MU are measured along the Y-axis. MU is positive and TU is increasing till the 4th ice-cream. After consuming the 5th ice-cream, MU is zero and TU is maximum. ➢ This point is known as the point of satiety or the stage of maximum satisfaction. After consuming the 6th icecream, ➢ MU is negative (known as disutility) and total utility starts diminishing. Disutility is the opposite of utility. It refers to loss of satisfaction due to consumption of too much of a thing
RELATION BETWEEN TOTAL UTILITY AND MARGINAL UTILITY ➢ Total utility is increasing at increasing rate so long as marginal utility is positive. ➢ Total utility becomes maximum when marginal utility is zero. ➢ Total utility starts declining when marginal utility is negative.
Significance of the difference between Total Utility and marginal Utility  Paradox of Value or The Diamond – Water Paradox-Total utility of Water is more and marginal Utility of Diamond is more. Value/Price is according to marginal utility.  Consumer’s surplus- Customer willing to pay according to total utility but actually pays according to marginal utility. Difference between two is Consumer Surplus.
LAW OF DIMINISHING MARGINAL UTILITY:  LAW OF DIMINISHING MARGINAL UTILITY: It stated that as the consumer goes on consuming more and more amount of commodity the marginal utility of the commodity goes on declining becomes zero and finally becomes negative.  As we go on consuming more and more amount of commodity. The marginal utility derived from it is declining becomes zero and negative.
LAWS OF UTILITY ANALYSIS UTILITY ANALYSIS LAW OF DIMINISHING MARGINAL UTILITY LAW OF EQUI-MARGINAL UTILITY
LAW OF DIMINISHING MARGINAL UTILITY It states that as the consumer goes on consuming more and more amount of commodity the marginal utility of the commodity goes on declining becomes zero and finally becomes negative. E.g. If you are set to buy ,say, fountain pens at and given time, then as the number of pens with you goes on increasing, the marginal utility from each successive pen will go on decreasing.
 “As the quantity consumed of a commodity  goes on increasing, the utility derived from  each successive unit goes on diminishing,  consumption of all other commodities  remaining the same” When the changes in  consumption are infinitely small, marginal  utility is the derivative of total utility.  MU = dTU/dX
ASSUMPTIONS Utility can be measures in the cardinal number system. Marginal utility of money remains constant. Marginal utility of every commodity is independent. Every unit of the commodity being used is of same quality and size. There is a continuous consumption of the commodity. Suitable quantity of the commodity is consumed. There is no change in the income of consumer, price of the commodity and its substitutes. There is no change in the tastes, character, fashion and habits of consumer.
Example • As an example assume you have one ice cream • 1 Ice Cream you feel Ecstatic
You have a second Ice cream 2nd Ice Cream, u still feel Ecstatic
You have a Third Ice cream 3 rd Ice Cream, u feel very happy
You have a Fourth Ice cream 4th Ice Cream, u feel happy
You have a Fifth Ice cream 5th Ice Cream, u still feel happy
You have a Sixth Ice cream 6th Ice Cream You are not so Happy
You have a Seventh Ice cream 7th Ice Cream You are not so Happy
You have a Eighth Ice cream 8th Ice Cream You fall sick.
The following table will make the law of diminishing marginal utility more clear Units Total Utility Marginal Utility 1st ice cream 20 20 2nd ice cream 32 12 3rd ice cream 40 8 4th ice cream 44 4 5th ice cream 45 1 6th ice cream 45 0 7TH ice cream 42 -3 8th ice cream 40 -2
 It is evident from the table and diagram that first cup of ice cream yield 30 utils thus higher satisfaction and with consumption of more and more units of ice cream, MU from each successive unit goes on diminishing. 1 2 4 53 6 4 3 2 1 O -1 B Y A +ve -ve X C QUANTITY UTILITY M.U. CURVE Point of saturation Zero M.U.
We can say that the law of diminishing utility, like other laws of Economics, is simply a statement of tendency. It holds good, provided other factors remain constant.
EXCEPTIONS  Curious and Rare Things: Law does not these things. Those persons who collect old and rare coins ,postage stamps etc derive increasing marginal utility as the stock of these rare articles goes on increasing.  Misers: It seems as if the law does not apply to misers, who are out to acquire more and more of wealth. Their desire for money seems to be insatiable.  Good Book or Poem: Reading a good book or listening to a melodious song or beautiful poem again and again, one gets more utility than before so these also exceptions to this law.  Drunkards: When drunkards takes more and more pegs of liquor his desire to have more of it goes on increasing.  Initial units: when the initial units of a commodity are used in less than the appropriate quantity, then MU from the additional units goes on increasing.
CAUSES OF ITS APPLICATIONS Commodities are Imperfect Substitutes: tea in place of coffee and coffee in place of tea cannot be used to unlimited extent. Satiability of Particular Wants: Alternative Uses: Each and every commodities have more than one uses. E.g. electricity
LIMITATIONS OF THE LAW  Suitable units:- It is assumed that the commodity is taken in suitable units.  Suitable time:-It is further assumed that the commodity is taken within a certain time, otherwise law will not apply.  No change in consumer’s tastes:-Another assumption is that the character of the consumers does not change.  Normal persons:- The law of diminising marginal utility applies to normal persons and not to eccentric or abnormal persons like misers.
 Constant income:-it is also essential that the income remains the same. Any change in income will falsify the law.  Rare collections:- In case of rare collections ,the law does not hold good.  Fashion:- Further, fashion utility depends on fashion too.
IMPORTANCE OF THE LAW  Basis of the Laws of Consumption: Law of diminishing marginal utility is the basis of all laws of consumption.(1) Law of equi -marginal utility.(2)Law of demand and (3) Concept of Consumer’s Surplus.  Variety in Production and Consumption: It is because of the operation of law of diminishing marginal utility. Continuous consumption of one commodity will yield less and less M.U. to the consumer. So the producers will have to produce different varieties of goods.  Basis of progressive taxation : In this direct taxes come.  Advantage to the consumer: Due to law of diminishing M.U a consumer always buys till that point where P=M.U.  Difference between Value-in Use and Value-in- Exchange.  Price Determination  Basis of re– distribution.
Derivation of Demand Curve with the help of Law of Diminishing Marginal Utility  The price that a consumer pays for a commodity is equal to its marginal utility. As a consumer goes on purchasing more and more units of a commodity, its marginal utility goes on diminishing.
M1 M2 M3 P1 P2 P3 -ve M.U. QUANTITY Q1 Q2Q3Q1 Q2 Q3 DEMAND CURVE
CRITICISM  Cardinal measurement of utility is not possible: It cannot be measured in cardinal numbers because it is subjective concept.  Every commodity is not independent commodity: Example – Car and Petrol.  Marginal Utility cannot be estimated in all conditions.  Unrealistic Assumptions.  Marginal utility of money is not constant.
Law of Equi Marginal Utility  Second law of Gossen  This law points out how a consumer can get maximum satisfaction out of his expenditure on different goods.  Marshall called it law of equi marginal utility.  The law states that in order to get maximum satisfaction, a consumer should spend his limited income on different commodities in such a way that the last rupee spent on each commodity yields him equal marginal utility.  According to the law of equi marginal Utility , other things being equal , a consumer maximising his utility will spend his income among different goods in such a manner that the utility derived from the last unit of money spent on each good is equal.
• According to samuelson , “ A consumer gets maximum satisfaction when the ratio of marginal utilities of all commodities and their price is equal.” • MU1 = MU2 = MU3 ________ ________ ______ P1 P2 P3 If prices of the commodities are equal , the maximum satisfaction to the consumer can be indicated in the following equation: MU1 = MU2 = MU3 Here, MU1 Mu2 and MU3 refers to the marginal utility of first, second and third commodity and P1,P2 and P3 refers to price of first, second and third commodity.
ASSUMPTIONS Cardinal measurement of utility is possible.  Consumer is relation , that is, he wants maximum satisfaction from his income.  Income of the consumer remains constant. Income of the consumer is fixed and constant.  Marginal Utility of money remains constant.  Prices of the commodities remain constant.  Commodity is divisible into small units. Its means that the consumer can spend his income in small units of money , say , one rupee.  Consumption takes places at a given time period.
IMPORTANCE OF THE LAW Consumption  Production  Exchange  Distribution  Public Finance  Distribution of Income between Saving and Consumption  Optimum Distribution of Commodities  Distribution of Assets
CRITICISM OF THE LAW  Consumer are not fully rational  Consumer is not Calculating  Shortage of Goods  Influence of Fashion, Customs and Habits  Ignorance of the Consumer  Indivisibility of Goods  Constant Income and Price  Cardinal Measurement of Utility of Money  Complementary Goods
COMSMER’S EQUILIBRIUM  Consumer’s equilibrium refers to a situation wherein a consumer gets maximum satisfaction out of his limited income and he has no tendency to make any change in his existing expenditure.  In the words of TIBER SCITOVOSKY “A consumer is in equilibrium when he regards his actual behaviour as the best possible under the circumstances and feels no urge to change his behaviour as long as circumstances remain unchanged”
ASSUMPTIONS  Consumer is assumed to be rational.  Marginal utility of Money is Constant.  Fixed price and Income.  Tastes are constant.  Perfect knowledge  Independent utility  Cardinal Utility
Determination of Consumer’s Equilibrium  A single commodity with one use.  A single commodity with several uses.  Several commodities.
Single commodity with one use- When a consumer buys a commodity, he pays a price for it. For each unit of the commodity he makes a sacrifice in terms of price. In returns he gets some utility from each unit. By the law of diminishing marginal utility, the utility of each successive unit goes on diminishing as more and more units of a commodity are consumed. The utility of money paid in terms of price of each unit of commodity remains constant. A rational consumer will consume the commodity upto a point where the MU of the final unit of the commodity is equal to the MU of money (in terms of price) paid for it. The consumer will get maximum satisfaction and will be in equilibrium. (where MU =price)
Consumer’s Equilibrium in case of one commodity with one use Unit of ‘x’ (1) M.U. of ‘x’ (2) Utility of ‘x’ sacrificed in terms of Price of ‘x’ (3) surplus( 2-3) 1 50 20 30 2 40 20 20 3 30 20 10 4 20 20 0 5 10 20 -10
A single Commodity with several Uses-  In case of a single commodity with several uses, a consumer will be in equilibrium when he distributes different uses in such a way that he gets equal marginal utility from each use.  MU (A) use= MU (B) Use
Consumer’s equilibrium in case of Single Commodity with Several uses Quantity of Oil (in litres ) M.U. of Oil in stoves M.U. of Oil in Lantern 1 10 8 2 8 6 3 6 4 4 4 2 5 2 1
SEVERAL COMMODITIES- When a consumer spends his fixed income on more than one commodity, he compares the marginal utilities of different commodities with a view to getting maximum satisfaction. He spends a unit of money on that commodities which gives him more M.U. The consumer stops the purchase of a commodity when its M.U becomes less than M.U of another commodity. He will then shift his purchase to other commodity. He arrives at a situation where the last unit of money spent on different commodities yields him equal M.U. This will be the position of his equilibrium. A consumer will have mo desire to make any change in this position, as he gets maximum satisfaction.
Consumer’s Equilibrium- Several Commodities Rupee Spent M.U. of X Commodity M.U. of Y Commodity 1 12 10 2 10 8 3 8 6 4 6 4 5 4 2
Criticism of Cardinal Utility Analysis  Utility is Subjective.  Cardinal measurement of utility is not possible.  Every commodity is not an independent commodity.  Marginal utility cannot be estimated in all conditions.  Marginal utility of money does not remain constant .  No division of Price effect between Income Effect and Substitution Effect.  Utility analysis breaks down in an under- developed Planned Economy.  Consumer is regarded as a computer.
Consumer Surplus Consumer Surplus - the difference between the price buyers pay for a good and the maximum amount they would have paid for the good. Example: • I’m willing to pay Rs.6 for a case of orange • Orange is on sale for Rs.5 a case • Consumer surplus = Rs.1
Consumer Surplus The difference between what a consumer is willing to pay for an addition unit of a good and the market price that he/she actually pays is referred to as “consumer surplus”. The area between the demand curve and the price (line) measures the total consumer surplus.
Consumer Surplus S D Q P 0 Rs5 31 2 Rs.9 Rs.7 This is the Consumer Surplus for the second case of Orange
Consumer Surplus Here is the generally accepted method of finding the total Consumer Surplus in a market
Consumer Surplus S D Q P 0 Q* P* The area of this triangle is the total Consumer Surplus
THE END