UTILITY ANALYSIS

Utility is the Power of a Commodity to satisfy human wants. There are two different Approaches to Utility Analysis

1. Cardinal approach to utility analysis 2. Ordinal approach to utility analysis

CARDINAL APPROACH

This School believes that Utility is Measurable and is a Quantifiable entity. Cardinal Approach gives exact measurement by assigning definite numbers such as 1, 2, 3, etc. Assumptions of the Cardinal Marginal Utility
1. 2. 3. 4. Cardinal Measurement of Utility Utilities are Independent Constant Marginal Utility of Money Introspection

TOTAL AND MARGINAL UTILITY

Total Utility is the sum total of the units of utility which an individual derives from the consumption of a commodity during a specified period of time. Marginal Utility is the change in the total utility resulting from a one-unit change in the consumption of a commodity per unit of time. Marginal Utility is the addition made to the total utility by the consumption of the last unit considered just worthwhile. MU = Change in Total Utility Change in Quantity Consumed

Total & Marginal Utility Relationship

Total Utility starts increasing by decreasing ratio while Marginal Utility starts decreasing. When Total Utility is at its maximum point and thereafter starts decreasing, Marginal Utility comes to zero. After the maximum point has been achieved by total utility it starts decreasing which causes marginal utility to become negative.

LAW OF DIMINISHING MARGINAL UTILITY

The German Economist H. Gossen who was first to explain the law said that As the consumer consumes more and more units of a commodity, the utility from the successive units goes on diminishing.

Marshall explains the law as The additional benefit, which a person derives from an increase of his stock of a thing, diminishes with every increase in the stock that he already has.

TOTAL & MARGINAL UTILITY

Units 1 Total utility 10 Marginal utility 10

2
3 4

15
19 22

5 (15-10)
4 3 0 -2 (19-15) (22-19) (23-23) (21-23)

5
6 7

23
23 21

1 (23-22)

DIMINISHING MARGINAL UTILITY FIGURE

LIMITATIONS OF THE LAW

Suitable Units Suitable Time No Change in Consumers Taste Rationality Rare Collections Change in Our & Other Peoples Stock Fashion Not Applicable to Money

APPLICATIONS OF LAW OF DIMINISHING MARGINAL UTILITY

Helps in Taxation Price Determination Household Expenditure Basis of law of Demand Socialists View Consumers Surplus Concept

LAW OF EQUI-MARGINAL UTILITY

It is an extension of the law of Diminishing Marginal Utility to two or more commodities. Given the income of a consumer, the law states that consumer can get maximum satisfaction when the Marginal Utility of the last rupee spent on each commodity yield the same utility. To get maximum satisfaction, consumer will substitute one good for another. It is also called as Law of Substitution, Law of Indifference, or Law of Maximum Satisfaction.

LAW OF EQUI-MARGINAL UTILITY

Under Law of Equi-marginal utility consumer equilibrium can be stated in the following formula.

MUx Px

MUy Py

MUn Pn

EXAMPLE

Suppose consumer is buying two Goods X and Y and marginal utility of them are given as Units of X & Y 1 2 3 4 5 6 MU x 33 30 27 24 21 18 MU y 36 32 28 24 20 16

Suppose the prices of good X & Y are Rs. 3 & Rs.4 respectively and total income is Rs.20. The above table can be reconstructed by dividing the marginal utilities of good X by Rs. 3 and marginal utilities of good y by Rs. 4.

The Resulting Marginal Utility Table

Units of Money 1 MU x Px 11 MU y Py 9

2
3 4 5

10
9 8 7

8
7 6 5

LIMITATIONS OF THE LAW

Rationality Effects of Fashion and Customs Ignorance Indivisible Units Questionable Assumptions

PRACTICAL IMPORTANCE OF THE LAW

Applications to Consumption Applications to Production Applications to Exchange Price Determination Applications to Distribution