INSTITUTE OF PROFESSIONAL EDUCATION AND RESEARCH

REPORT ON EQUIMARGINAL UTILITY

(MANAGERIAL ECONOMICS)

Submitted to :Prof. A.K Sharan

Submitted by :Himanshu Singh Shekhawat

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Concept of utility
In economics, utility is a measure of relative satisfaction. In other words, it is a term referring to the total satisfaction received by a consumer from consuming a good or service. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one's utility. Utility is often modeled to be affected by consumption of various goods and services, possession of wealth and spending of leisure time.

Concept of marginal utility

The marginal utility of a good or service is the utility gained (or lost) from an increase (or decrease) in the consumption of that good or service. Economists sometimes speak of a law of diminishing marginal utility, meaning that the first unit of consumption of a good or service yields more utility than the second and subsequent units. Concept of diminishing marginal utlity "The law of diminishing marginal utility is at the heart of the explanation of numerous economic phenomena, including time preference and the value of goods.The law says, first, that the marginal utility of each (homogenous) unit decreases as the supply of units increases (and vice versa); second, that the marginal utility of a larger-sized unit is greater than the marginal utility of a smaller-sized unit (and vice versa). The first law denotes the law of diminishing marginal utility, the second law the law of increasing total utility "The law of diminishing marginal utility is at the heart of the explanation of numerous economic phenomena, including time preference and the value of goods.The law says, first, that the marginal utility of each (homogenous) unit decreases as the supply of units increases (and vice versa); second, that the marginal utility of a larger-sized unit is greater than the marginal utility of a smaller-sized unit (and vice versa). The first law denotes the law of diminishing marginal utility, the second law the law of increasing total utility

Concept of equi marginal utility

The equi marginal was associated with consumption theory and law of equi-marginal utility. The law of marginal utility states that a utility maximizing consumer distributes his consumption expenditure between various goods and services he/she consumes in such a way that the marginal utility derived from each unit of expenditure maximizes a consumer s total utility The law of equi-marginal principle was over time applied by business managers to allocation of resources between their alternative uses with a view to maximizing profit in case of firm carries out more than one business activity. This suggests that the available resources (inputs) should be so allocated between the alternative options that the marginal productivity gains (MP) from the various activities are equalized.

Explanation
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As we know, every consumer has unlimited wants. However, the income this disposal at any time is limited. The consumer is, therefore, faced with a choice among many commodities that he can and would like to pay. He, therefore, consciously or unconsciously compress the satisfaction which he obtains from the purchase of the commodity and the price which he pays for it. If he thinks the utility of the commodity is greater or at-least equal to the loss of utility of money price, he buys that commodity.

As he buys more and more of that commodity, the utility of the successive units begins to diminish. He stops further purchase of the commodity at a point where the marginal utility of the commodity and its price are just equal. If he pushes the purchase further from his point of equilibrium, then the marginal utility of the commodity will be less than that of price and the household will be loser. A consumer will be in equilibrium with a single commodity symbolically:

MUx = Px

A prudent consumer in order to get the maximum satisfaction from his limited means compares not only the utility of a particular commodity and the price but also the utility of the other commodities which he can buy with his scarce resources. If he finds that a particular expenditure in one use is yielding less utility than that of other, he will tie to transfer a unit of expenditure from the commodity yielding less marginal utility. The consumer will reach his equilibrium position when it will not be possible for him to increase the total utility by uses. The position of equilibrium will be reached when the marginal utility of each good is in proportion to its price and the ratio of the prices of all goods is equal to the ratio of their marginal utilities.

The consumer will maximize total utility from his income when the utility from the last rupee spent on each good is the same.

MUa / Pa = MUb / Pb = MUc = Pc = MUn = Pn

Here: (a), (b), (c). (n) are various goods consumed It may here be noted that when a consumer is in equilibrium there is no way to increase utility by reallocating his given money income.

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The doctrine of equi-marginal utility can be explained by taking an example. Suppose a person has Rs.5 with him which he wishes to spend on two commodities, tea and cigarettes. The marginal utility derived from both these commodities is as under:

Units of Money 1 2 3 4 5 Rs.5

MU of Tea 10 8 6 4 2 Total Utility = 30

MU of Cigarettes 12 10 8 6 3 Total Utility = 39

A rational consumer would like to get maximum satisfaction from Rs. 5.00. He can spend this money in three ways. (1) (2) (3) Rs. 5.00 may be spent on tea only Rs. 5.00 may be utilized for the purchase of cigarettes only. Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes.

If the prudent consumer spends Rs. 5.00 on the purchase of tea, he gets 30 utility. If he spends Rs. 5.00 on the purchase of cigarettes, the total utility derived is 39 which is higher than tea. In order to make the best of the limited resources, he adjusts his expenditure. (1) By spending Rs. 4.00 on tea and Rs. 1.00 on cigarettes, he gets 40 utility (10+8+6+4+12=40). (2) By spending Rs. 3.00 oa tea and Rs. 2.00 on cigarettes, he derives 46 Utility (10+8+6+12+10=46). (3) By spending Rs. 2.00 on tea and Rs. 3.00 on cigarettes, he gets 48 utility (10+8+12+10+8=48). (4) By spending Rs. 1.00 on tea and Rs. 4.00 on cigarettes, he gets 46 utility (10+12+10+8+6=46). The sensible consumer will spend Rs. 2.00 on tea and Rs. 3.00 on cigarettes and will get the maximum satisfaction. When he spends Rs. 2.00 on tea and Rs. 3.00 on cigarettes, the marginal utility derived from both these commodities is equal to 8. When the marginal utilities of the two
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commodities are equalized, the total utility is then maximum i.e., 48 as is clear from the schedule given above.

Application Of Law Of Equi-Marginal Utility The law of equi-marginal utility has wide applications in almost all spheres of man's economic behavior. It is not merely a law of economics, it is a law of logic itself. The applications of this law of substitution in diversified fields of Economics are stated below. 1. Consumption In the field of consumption, the law tells us as to how should a consumer spend his money to secure maximum utility. The law not only explains the number of units of various commodities to be purchased by the consumer, it also helps the consumer in allocating income of the consumer into multiple uses of the same commodity. Further, the decision regarding the proportion of income to be spent and the proportion to be saved too depends upon this law. The distribution of budget between consumption and saving is the best in which the utility derived from the marginal unit of saving is equal to the utility derived from the marginal unit of consumption. 2. Production The law of equi-marginal returns is also important to the producer to maximize his returns. The producer combines the various factors of production in such a manner that marginal returns from the different factors of production are equalized. The producer continues to substitute one factor for the other, till this objective is achieved. Through this, the producer ensures the optimal combination of j the factors of production and is said to be in equilibrium. Here, marginal productivities of all the _ factors of production are proportional to their respective prices. If there are 'n' factors of production, the following condition will be satisfied in the equilibrium:

MP1 / P1 = MP2 / P2 = MP3 / P3 = . = MPN / PN Where MP1, MP2, MP3,.., MPN are the marginal products of various factors and P1, P2, P3,.PN are their respective prices. In the case of inequality in the above equation, the producer will substitute the factor which gives him more productivity for the factor which gives him less productivity. This process of substitution will continue, till the ratios for the factors become equal. The producer pays remuneration to the factors according to their marginal productivities. This is explained in detail under the theory of distribution. When the prices of different commodities are equal, the condition of equilibrium reduces to MP1 = MP2=MP3 = ........ MPN

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3. Exchange The law of substitution is also applicable in the field of exchange, whether the exchange is of a good for a good, or of a good in exchange for money. Under barter system, where goods are exchanged for goods, the process of exchange continues, till the utility derived from the extra unit of the commodity consumed, becomes equal to the utility lost from the extra unit of the commodity sacrificed by the consumer. This condition is true for both the parties taking part in exchange. When a consumer purchases a commodity for money, the process of exchange is in no way] different from the case, which has been discussed under consumption in this sub-section. 4. Distribution and Price Determination We know that production is the result of joint efforts of different factors of production (i.e., land, labor, capital and entrepreneur. Their share in the production process (rent, wages, interest and profits) is determined according to the principle of marginal productivity. The producer will employ various factors of production till the point, where the cost of employing each one of them equals their marginal productivity (or marginal revenue resulting from their use). The law has an important bearing in the determination of value on the basis of their relative scarcity. More scarce goods command higher prices and vice-versa. 5. Public Finance The modern state is a welfare state, which undertakes various schemes for enhancing social welfare. The Government can realize the objective of public finance to achieve maximum social advantage through the law of substitution. The use of this law in the field of public finance is clear from the following two points: (i) The welfare state has to push up public expenditure in various directions upto the point, such that the marginal utilities are equal in all of them to ensure maximum social benefit. (ii) The rates of taxation should be devised in such a way that marginal sacrifice of all tax payers is equal. 6. Savings A prudent will try to distribute his limited means between his present and future uses so as to have equal marginal utility just equal to the loss in utility for not saving it for the future, he will spend that instead of saving it for the future consumption. This is how he gets maximum satisfaction from his income which enables him to save effectively for the future

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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 diminish 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 purchase of goods. 3. Utility is cardinally measurable4. Every consumer is rational in the purchase of goods-The consumer is rational who wants to wants to obtain maximum satisfaction. 5. Consumers income is given 6. Consumption is done in a fixed time 7. The law is based on the law of diminishing marginal utility LIMITATIONS OF THE LAW Imperfect knowledge Effect on 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 knows 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. 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. Indivisible units: If the unit of expenditure is not divisible, then again the law may become inoperative. Freedom of choice: If there is no perfect freedom between various alternatives, the operation of law may be impeded. No Fixed Accounting Period:There is no definite budget period in the case of individuals. Even if there is a fixed accounting period, the application of this principle is rendered difficult by the varying degrees of durability of the goods consumed. A durable goods is available for consumption in several succeeding accounting periods. It is not, therefore, easy to bring it into the account of income and expenditure of a particular accounting period to see if satisfaction has been maximized during that period. Questionable Assumptions- In the theory of consumers equilibrium, the basic criticism of the law of Equi-marginal utility is that it rests on some questionable assumptions. For example, we assume that utilities can be added and compared; that during successive purchases, the marginal
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utility of money to the consumer remains constant .The modem economists criticize both these assumptions. The indifference curve approach to the theory of consumers equilibrium is based on this basic criticism of the Marshallian analysis.

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