Marginal Utility

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Consumer’s Behavior Marginal Utility Analysis

Transcript of Marginal Utility

Page 1: Marginal Utility

Consumer’s Behavior

Marginal Utility Analysis

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Learning Objectives

define total utility and marginal utilityunderstand law of diminishing marginal utilitydescribe relationship between total and marginal utilitydemonstrate demand curvedefine marginal utility of moneyillustrate consumer equilibrium

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Two Questions in Consumer’s Behavior

The first one is: why does a consumer demand a good or service.

The second question: how should a consumer spend his limited income on different goods and services

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The problem of a consumer consists of three things:

1. the object

2. the constraints

3. the decision variable44

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Object – To maximize total utility (Satisfaction)

Constraint – Limited Resources (Income)

Decision Variable – The quantity purchased using limited resources

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The principle assumption upon which the theory of consumer behavior and demand is built is:

a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).

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Theories of Consumer Choice

The Cardinal TheoryUtility is measurable in a cardinal sense

The Ordinal TheoryUtility is measurable in an ordinal sense

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What is Utility?Satisfaction, happiness, benefit

What is Util?A unit of measure of utility

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Initial Utility

The utility derived from the first unit of a

commodity is called initial utility. It is always positive.

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Total UtilityThe total satisfaction derived from the consumption of all the units of a commodity. Consumption of “n” units of commodity, then the total utility (TU)

 TUn = U1 + U2 + U3 + ……….. +Un OR TUn =MUn

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TOTAL UTILITY

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Marginal UtilityThe additional satisfaction gained by the consumption of one more unit of something.

 MUn = TUn – TUn-1

OR

The change in total utility (TU) resulting from a one unit change in consumption (X).

MU = TU/ X

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MARGINAL UTILITY

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CALCULATION OF MARGINAL UTILITY

The marginal utility of the 3rd bottle of water = 36 units – 27 units = 9 units.

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Part (a) graphs Total Utility from bottled water.

The figure shows total utility and marginal utility.

GRAPHICAL PRESENTATION OF TOTAL UTILITY AND MARGINAL UTILITY

Each bar shows the extra total utility gains from each additional bottle of water — Marginal Utility.

The blue line is Total Utility curve.

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Part (b) shows how Marginal Utility from bottled water diminishes

The downward sloping blue line is Marginal Utility Curve.

MARGINAL UTILITY

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Marginal utility Positive Marginal Utility

Zero Marginal Utility

Negative Marginal Utility

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Positive Marginal Utility

If, by consuming additional units of a commodity,

total utility increases then the marginal utilities of

these units will be Positive

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Negative Marginal Utility

If the consumption of an additional unit of a

commodity Causes fall in total utility, it means the

marginal utility of that unit is negative

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Zero Marginal UtilityIf the consumption of an additional

unit of a commodity Causes no change in the

total utility, it means the marginal utility of

that unit is negative

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Relationship between Total Utility and Marginal Utility

When marginal utility is positive total utility increases

When marginal utility zero total utility is at maximum. It is also known as ‘point of maximum satisfaction’

When marginal utility is negative total utility diminishes.

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X

X

Total Utility

Marginal Utility

TU

MU

X1 X2

X1 X2

Graphs of Total Utility & Marginal

Utility

X2 is where total utility reaches its maximum. MU is zero. This is the saturation point or satiation point.After that point, TU falls and MU is negative.

X1 is where marginal utility reaches its maximum. This is where we encounter diminishing marginal utility. The slope of TU has reached its maximum; TU has an inflection point here.

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Diminishing Marginal Utility

• Each additional unit of a product contributes less extra utility than the previous unit.

• It is a psychological fact.

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Law of Diminishing Marginal Utility The law of diminishing marginal utility

explains the relation between utility and quantity of a commodity.

when a consumer gets more and more units of a commodity, during a particular time, the utility from the successive units will diminish.

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Assumptions1. Utility is cardinal2. The consumer is rational3. Constant Marginal Utility of Money4. The consumer’s income is limited and constant5. The tastes and preferences of the consumer remain

unchanged6. Diminishing Marginal Utility7. Consumption of reasonable quantity8. Continuous consumption9. No change in Quality

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Utility is CardinalIt is assumed that utility can be measured and a

consumer can express his satisfaction in quantitative terms such as 1, 2, 3, etc.

The Consumer is RationalThe consumer is assumed to be rational who

measures, calculates and compares the utilities of different commodities and aims at maximizing total satisfaction.

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Constant Marginal Utility of Money

As a consumer spends money on the commodity, he is left with lesser money to spend on other commodities.

In this process, the remaining money becomes dearer to the consumer and it increases MU of money for the consumer. But, such an increase in MU of money is ignored.

As MU of a commodity has to be measured in monetary terms, it is assumed that MU of money remains constant.

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The consumer’s income is limited and constant

It is assumed that income of the consumer and prices of the goods which the consumer wishes to purchase remain constant.

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Consumption of reasonable quantity

It is assumed that a reasonable quantity of the commodity is consumed.

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Continuous consumptionIt is assumed that consumption should be a continuous process.

For example, if one ice-cream is consumed in the morning and another in the evening, then the second ice-cream may provide equal or higher satisfaction as compared to the first one.

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No change in Quality

Quality of the commodity consumed is assumed to be uniform.

A second cup of ice-cream with nuts and toppings may give more.

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Independent utilitiesIt is assumed that all the commodities consumed by a consumer are independent.

It means, MU of one commodity has no relation with MU of another commodity.

Further, it is also assumed that one person’s utility is not affected by the utility of any other person.

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Consumer’s Equilibrium – A single commodity

Consumer’s equilibrium leads to a situation where a consumer gets maximum satisfaction out of his limited income

He has no tendency to make any change in his existing expenditure pattern.

The consumer is in equilibrium when the marginal utility of a good(x) is equal to its market price (Px).

MUx = Px

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The consumer is in equilibrium when the

marginal utility of a good(x) is equal to its market price (Px).

MUx = Px

Supposing, if MUP, there can be two possibilities

MU > PMU < P

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Law of Equi - Marginal Utility

• The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one commodity.

• It explains how the consumer spends his limited income on various commodities to get maximum satisfaction.

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Law of Equi - Marginal Utility

The law states that a consumer maximizes his

total utility by distributing his entire income optimally among the various goods

consumed by him.

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ASSUMPTIONS

The consumer is rational so he wants to get maximum satisfaction

Cardinal measurement of utility is possible

Marginal utility of money remains constant

The income of the consumer is given and remain constant

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ASSUMPTIONS

Fashions, tastes and preferences remain constant

Prices of the commodities are given and remain constant

Consumption takes place at a given time period

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Consumer’s Equilibrium – a Several Commodities

When a consumer is consuming several commodities

[suppose there are two goods X and Y] with different prices

simultaneously, he will be in equilibrium at the point

where the utility derived from the last rupee spent on

each is equal.

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The position of consumer’s equilibrium thus can be stated in

following ways

The consumer is in equilibrium when the marginal utility of last rupee spent on each commodity is equal

A consumer will be in equilibrium position where the ratios of marginal utilities of goods to the ratios of corresponding prices for each pair of goods are equal.

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When a consumer is at equilibrium  He maximizes his satisfaction

He spends his entire income

He attains optimum allocation of expenditure

He consumes optimum quantity of each good

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Derivation of the Demand Curve

If the marginal utility is measured in monetary units the demand curve for a good(X) is identical to the positive segment of the Marginal utility curve.

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Derivation of the Demand Curve

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Constancy of the Marginal Utility of Money

This is one of the important assumptions of the marginal utility analysis.

This means, marginal utility of money remains constant throughout when the individual is spending money.

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Constancy of the Marginal Utility of Money

Measurement of marginal utility of goods in terms of money is only possible if the marginal utility of money itself remains constant.

If the marginal utility of money varies, it is not possible to correct measurement of the marginal utility of the good.

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Marginal Utility of Money and Price change

When the price of a good falls – the real income of the consumer rises – the marginal utility of money will fall.

On the other hand, when the price of a good rises – the real income of the consumer falls – the marginal utility of money will rise.

 

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But Marshall ignored this and assumed that marginal

utility of money did not change as a result of price

change. Due to this assumption  Marshall ignored the income effect of the

price change

Marshall could not provide a satisfactory explanation of ‘Giffen Paradox’

Due to this assumption marginal utility curve becomes the demand curve of the good.

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Demerits of Marginal Utility Analysis  Cardinal measurement is unrealistic

Assumption of constant marginal utility of money is not valid.

Cardinal utility analysis does not split up the price effect into substitution and income effect.

Marshall could not explain Giffen Paradox.

Cardinal utility analysis assumes too much and explains little.