utility cardinal theory in economics.ppt

1. Concept of Utility
Dr. Arifa Saeed

2.  "The power of a commodity or service to satisfy human want".
 Utility is thus the satisfaction which is derived by the consumer by
consuming the goods.
For example, cloth has a utility for us because we can wear it. Pen has a
utility who can write with it. The utility is subjective in nature. It differs
from person to person. The utility of a bottle of wine is zero for a person
who is non drinker while it has a very high utility for a drinker.
Utility is defined as

3. “The additional benefit which a person derives from a given increase of his
stock of anything diminishes with the growth of the stock that he has.”
In this statement of the law, the word “Additional” is very important. It is
only additional (marginal) benefit which decrease and not the total benefit
Marshall states the law:

4. Two types of utility theory:
1. Law of Diminishing Marginal utility
2. Law of Equi Marginal utility
UTILIY THEORY

5. The term marginal refers to the effects of a small change in
consumption.
'Marginal considerations are considerations which concern a slight
increase or reduction of the stock of anything which we possess.’
MARGINAL UTILITY

6.  The sum total of satisfaction which a consumer receives by consuming
the various unity of the commodity.
 (The more unit of a commodity he consumes, the greater will be his
total utility)
TOTAL UTILITY

7.  1. INITIAL UTILITY
 2. TOTAL UTILITY
 3. MAGINAL UTILITY
MEASUREMENT OF UTILITY

8. LAW OF DIMINIDHING MARGINAL UTILITY
 The law of diminishing marginal utility describes a familiar and
fundamental tendency of human behavior.
 “The law of diminishing marginal utility states that, “as a consumer
consumes more and more units of a specific commodity, utility from the
successive units goes on diminishing”.

9. Assumptions of the Law:-
These assumptions are –
 Various units of goods are homogenous.
 There is no time gap between consumption of the different units.
 Consumer is rational
(So aims at maximization of utility of the product)
 Tastes, preferences, and fashion remain unchanged.
 Consumers posses perfect knowledge of the price in the market
 No price change
 It assumes Law of marginal diminishing Utility
 Utilities of different commodities are independent of each other

10. Law based upon three facts:
The law of diminishing utility is based upon three facts.
 Firstly
The wants of a man are unlimited but single want can be satisfied. As a man gets more
and more units of a commodity, the desire of his want for that good goes on falling. A
point is reached when the consumer no longer wants any more units of that good,
 Secondly
Different goods are not perfect substitutes for each other in the satisfaction of various
particular wants.
 Thirdly
There is no change in the tastes of the consumers.

11. Example
 Explanation of the Law:
 Suppose a person is thirsty and the price of water is zero. He takes one
glass of water which gives him great satisfaction. We can say the first
glass of water has great utility for him.
 He then takes second glass of water. The utility of the second glass of
water is less than that of first glass of water. The utility declines because
the edge of his thirst has been blunted to a great extent.
 If he drinks third glass of water, the utility of the third glass will be less
than that of second and so on. The utility goes on diminishing with the
consumption of every successive glass of water till it drops down to zero.

12. It is the position of consumer’s equilibrium or maximum satisfaction.
If the consumer is forced further to take a glass of water, it leads to
disutility causing total utility-to decline. The marginal utility will become
negative. A rational consumer will stop taking water at the point at
which marginal utility becomes negative even if the good is free.
In short, when a good is free, a consumer increases consumption of a good
so long its additional units provide him positive marginal utility.

13. The following table will make the law of diminishing marginal
utility more clear.
Units Total Utility Marginal Utility
1st glass 20 20
2nd glass 32 12
3rd glass 40 8
4th glass 42 2
5th glass 42 0
6th glass 39 –3

14. From the above table,
It is clear that in a given span of time :-
 The first glass of water to a thirsty man gives 20 units of utility.
 When he takes second glass of water, the marginal utility goes down to 12 units.
 When he consumes fifth glass of water, the marginal utility drops down to zero
and if the consumption of water is forced further from this point, the utility
changes into disutility (–3).
 Here it may be noted that the utility of the successive units consumed
diminishes not because they are of inferior in quality than that of others. We
assume that all the units of a commodity consumed are exactly alike.

15. The graph will make the law of diminishing
marginal utility more clear.

16. In the above figure,
OX we measure units of a commodity consumed and OY is shown the marginal utility derived
from them. The marginal utility of the first glass of water is called initial utility. It is equal to
20 units. The MU of the 5th glass of water is zero. It is called the satiety point. The MU of the
6th glass of water is negative –3.
Tie MU curve here lies below the OX axis. The utility curve MM falls from left down to the
right showing that the marginal utility of the success units of glasses of water is falling.
 When a good is scarce and so priced the consumer will increase the consumption of a
commodity up to the extent where his marginal utility for the good equals the price which he
has to pay, i.e. Mu = P.

17. Limitations of the law
 Case of intoxicants.
(Consumption of liquor defies the law for a short period. The more a person drinks, the more he
likes it)
 Application to money.
(The law equally holds good for money. It is true that more money the man has the more greedy)
 Rare collections.
(If there are only two diamonds in the world, the possession of 2nd diamond will push up the
marginal utility.)
Example: collection of the rare stamps and coins
 Utility is subjective
 Cardinal measurement of utility is not possible
 Every commodity is not an independent commodity
 Marginal utility can’t be estimated for all commodities
 Doesn’t explain Giffen paradox

18.  Initial Utility:
It is the utility of the initial or the first unit. In the table given on the previous page, the initial utility is 15.
 Total Utility:
Look at column 3 of the table. It gives the total utility at earn step. For example, if you consume one
‘rasgulla’, the total utility is 15; if you consume two, the total utility is 28, and so on.
 Zero Utility:
When the consumption of a unit of a commodity makes no addition to the total utility, then it is the point
of zero utility. In our table, the total utility, after the 6th unit is consumed, is 52. At the seventh also it is
52. Thus, the seventh ‘rasgulla results’ in no increase whatsoever. This is the point o’ zero utility, it is thus
seen that the total utility is maximum when the marginal utility is zero.
 Negative Utility:
If the consumption of a commodity is carried to excess, then instead of giving any satisfaction, it may
cause dissatisfaction. The utility in such cases is negative. In the table given above the marginal utility of
the 8th and the 9th units is negative
CLASSIFICATIONS OF UTILITY

19.  1. Utility has no Ethical or Moral Significance:
 2. Utility is Psychological
 3. Utility is always Individual and Relative
 4. Utility is not Necessarily Equated with Usefulness
 5. Utility cannot be Measured Objectively
 6. Utility Depends on the Intensity of Want
 7. Utility is Different from Pleasure
 8. Utility is also Distinct from Satisfaction
Characteristics of Utility:

20.  1. Form Utility: This utility is created by changing the form or shape of the materials. For example—
A cabinet turned out from steel furniture made of wood and so on. Basically, from utility is created
by the manufacturing of goods.
 2. Place Utility: This utility is created by transporting goods from one place to another. Thus, in
marketing goods from the factory to the market place, place utility is created. Similarly, when food-
grains are shifted from farms to the city market by the grain merchants, place utility is created.
 3. Time Utility: Storing, hoarding and preserving certain goods over a period of time may lead to the
creation of time utility for such goods e.g., by hoarding or storing food-grains at the time of a
bumper harvest and releasing their stocks for sale at the time of scarcity, traders derive the
advantage of time utility and thereby fetch higher prices for food-grains. Utility of a commodity is
always more at the time of scarcity. Trading essentially involves the creation of time utility.
 4. Service Utility: This utility is created in rendering personal services to the customers by various
professionals, such as lawyers, doctors, teachers, bankers, actors etc.
Types of utility

21.  The Cardinal Utility approach is propounded by neo-classical economists,
who believe that utility is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers, such as 1,2,3, and so on.
 And to do so, they have introduced a hypothetical unit called
as “Utils” meaning the units of utility. Here, one Util is equivalent to one
rupee and the utility of money remains constant.
CARDINAL UTILITY

22. With the above basic premises, the founders of cardinal utility analysis have
developed two laws which occupy an important place in economic theory
and have several applications and uses.
These two laws are:
 Law of Diminishing Marginal Utility; and
 Law of Equi-Marginal Utility.
The two laws

23. Marshall who has been a famous exponent of the cardinal utility analysis has
stated the law of diminishing marginal utility as follows:
Law of Diminishing Marginal Utility

25.  Dissimilar Units
 Very Small Units
 Too Long an Interval
 Rare Collections
 Abnormal Persons
 Change in another Person’s Stock
 Changes in Income, Habits and Tastes
Limitations or Exceptions

26. Law of Equi-Marginal Utility

27. Background
 The law of equi marginal utility was presented in 19th century by an Australian
economists H. H. Gossen. It is also known as law of maximum satisfaction or law of
substitution or Gossen's second law.
 A consumer has number of wants.
 He tries to spend limited income on different things in such a way that marginal utility
of all things is equal.
 When he buys several things with given money income he equalizes marginal utilities
of all such things.
 The law of equi marginal utility is an extension of the law of equi marginal utility.
 The consumer can get maximum utility by allocating income among commodities in
such a way that last dollar spent on each item provides the same marginal utility.

28. Definition
 "A person can get maximum utility with his given income when
it is spent on different commodities in such a way that the
marginal utility of money spent on each item is equal".
 It is clear that consumer can get maximum utility from the
expenditure of his limited income. He should purchase such
amount of each commodity that the last unit of money spend
on each item provides same marginal utility.

29. Assumptions
 There is no change in the prices of the goods.
 The income of consumer is fixed.
 The marginal utility of money is constant.
 Consumer has perfect knowledge of utility obtained from goods.
 Consumer is normal person so he tries to seek maximum satisfaction.
 The utility is measurable in cardinal terms.
 Consumer has many wants.
 The goods have substitutes.

30. Explanation
 The law of substitution can be explained with the help of an
example. Suppose consumer has six dollars that he wants to
spend on apples and bananas in order to obtain maximum total
utility. The following table shows marginal utility (MU) of
spending additional dollars of income on apples and bananas:

31. Schedule
Money (Units) MU of apples MU of bananas
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3

32. Schedule
 The above schedule shows that consumer can spend six dollars in different ways:
 $1 on apples and $5 on bananas. The total utility he can get is:
[(10) + (8+7+6+5+4)] = 40.
 $2 on apples and $4 on bananas. The total utility he can get is:
[(10+9) + (8+7+6+5)] = 45.
 $3 on apples and $3 on bananas. The total utility he can get is:
[(10+9+8) + (8+7+6)] = 48.
 $4 on apples and $2 on bananas. This way the total utility is:
[(10+9+8+7) + (8+7)] = 49.
 $5 on apples and $1 on bananas. The total utility he can get is:
[(10+9+8+7+6) + (8)] = 48.
 Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4 on
apples and $2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7 is also satisfied. Any
other allocation of the last dollar shall give less total utility to the consumer.

33. Diagram

34. Limitations
 The law is not applicable in case of knowledge. Reading of books provides
more satisfaction and knowledge to the scholar. Different books provide
variety of knowledge and satisfaction.
 The law is not applicable in case of indivisible goods. The consumer is unable
to divide the goods to adjust units of utility derived from consumption of
goods.
 There is no measurement of utility. It is psychological concept. It is not
possible to express it into quantitative form.
 The law does not hold well in case fashion and customs. The people like to
spend money on birthdays, marriages and deaths.

35. Limitations…
 The does not hold well in case of very low income. The maximization of utility
is not possible due to low income.
 The law is not applicable in case of durable goods. The calculation of marginal
utility of durable goods is impossible.
 The law fails when goods of choice are not available. The consumer is bound to
use commodity, which provides low utility due to non availability of goods
having high utility.
 There are certain lazy consumers. They do not care for maximum utility. The
law fails to operate in case of laziness of consumers. They go on consuming
goods with comparing utility.

36. Limitations…
 It does not work when there are frequent prices changes. The consumer
is unable to calculate utility of different commodities. Changing price
levels create confusion in the minds of consumers.
 There may be unlimited resources. The does not work due to unlimited
resources. There is no need to change the direction of expenditure from
one item to another when there are gifts of nature.

37. Importance
 The law of equi marginal utility is helpful in the field of production. The
producer has limited resources. He uses limited resources to purchase
production factors. He tries to equalize marginal utility of all factors. He
wishes to get maximum output and profit.
 National income is distributed among factors of production according to this
law. An entrepreneur can pay factors of production equal to marginal product
measured in money terms. He will substitute one factor for another until
marginal productivity of all factors is equal to prices of their services.
 The law is used in the field of exchange. The people like to exchange a
commodity having low utility with a commodity having high utility. There is
maximum benefit from exchange of commodities. The law is helpful in
exchange of wealth, trade, import and export.

38. Importance…
 The law is applicable in consumption. A rational consumer tries to get
maximum satisfaction when he spends his limited resources on various
things. He tries to equalize weighted marginal utility of all the things.
 The law is applicable in public finance. The government can spend its
revenue to get maximum social advantage. The marginal utility of each
dollar spent in one sector must be equal to marginal utility derived from all
other sectors.
 The law is useful for workers in allocating the time between work and rest.
They can compare the marginal utility of work and the marginal utility of rest.
They can decide working hours and rest hours.

39. Importance…
 The law holds well in case of saving and spending. The consumer can
make choice between present wants and future wants. He can feel that
a dollar saved has greater utility than a dollar spent, he can save more
and spend less. He will substitute saving and spending till marginal
utility of a dollar spent and a dollar saved are equal.
 The law is helpful in prices. Due to scarcity of commodity its prices go
up. The law tells us to use substitute commodity, which is less scarce.
The result is that the price of commodity comes down.