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UTILITY ANALYSISUTILITY ANALYSIS

UtilityUtility isis thethe PowerPower ofof aa CommodityCommodity toto satisfysatisfyhumanhuman wantswants..

ThereThere areare twotwo differentdifferent ApproachesApproaches toto UtilityUtilityAnalysisAnalysis

1.1. CardinalCardinal approachapproach toto utilityutility analysisanalysis

2.2. OrdinalOrdinal approachapproach toto utilityutility analysisanalysis

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CARDINAL APPROACHCARDINAL APPROACH

ThisThis SchoolSchool believesbelieves thatthat UtilityUtility isis MeasurableMeasurableandand isis aa QuantifiableQuantifiable entityentity..

CardinalCardinal ApproachApproach givesgives exactexact measurementmeasurement byby

assigningassigning definitedefinite numbersnumbers suchsuch asas 11,, 22,, 33,, etcetc..

Assumptions of the Cardinal Marginal UtilityAssumptions of the Cardinal Marginal Utility

1.1. CardinalCardinal MeasurementMeasurement ofof UtilityUtility2.2. UtilitiesUtilities areare IndependentIndependent

3.3. ConstantConstant MarginalMarginal UtilityUtility ofof MoneyMoney

4.4. IntrospectionIntrospection

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TOTAL AND MARGINAL UTILITYTOTAL AND MARGINAL UTILITY

TotalTotal UtilityUtility isis thethe sumsum totaltotal ofof thethe unitsunits ofof utilityutility whichwhichanan individualindividual derivesderives fromfrom thethe consumptionconsumption ofof aacommoditycommodity duringduring aa specifiedspecified periodperiod ofof timetime..

Marginal

Marginal UtilityUtility isis thethe changechange inin thethe totaltotal utilityutilityresultingresulting fromfrom aa oneone--unitunit changechange inin thethe consumptionconsumption ofof

aa commoditycommodity perper unitunit ofof timetime..

Marginal

Marginal UtilityUtility isis thethe additionaddition mademade toto thethe totaltotal utilityutilityby by thethe consumptionconsumption ofof thethe lastlast unitunit consideredconsidered justjust

worthwhileworthwhile..

MUMU == ChangeChange inin TotalTotal UtilityUtility

ChangeChange inin QuantityQuantity ConsumedConsumed

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Total & Marginal Utility RelationshipTotal & Marginal Utility Relationship

TotalTotal UtilityUtility startsstarts increasingincreasing byby decreasingdecreasing rateratewhilewhile MarginalMarginal UtilityUtility startsstarts decreasingdecreasing..

WhenWhen TotalTotal UtilityUtility isis atat itsits maximummaximum pointpoint andandthereafterthereafter startsstarts decreasing,decreasing, MarginalMarginal UtilityUtilitycomescomes toto zerozero..

AfterAfter thethe maximummaximum pointpoint hashas beenbeen achievedachieved bybytotaltotal utilityutility itit startsstarts decreasingdecreasing whichwhich causescausesmarginalmarginal utilityutility toto becomebecome negativenegative..

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LAW OF DIMINISHING MARGINALLAW OF DIMINISHING MARGINAL

UTILITYUTILITY

TheThe GermanGerman EconomistEconomist HH.. GossenGossen whowho waswas firstfirst toto

explainexplain thethe lawlaw saidsaid thatthat AsAs thethe consumerconsumer consumesconsumes

moremore andand moremore unitsunits of of aa commodity,commodity, thethe utilityutility fromfrom

thethe successivesuccessive unitsunits goesgoes onon diminishingdiminishing..

MarshallMarshall explainsexplains thethe lawlaw asas TheThe additionaladditional benefit,benefit,

whichwhich aa personperson derivesderives fromfrom anan increaseincrease of of hishis stockstock ofof

aa thing,thing, diminishesdiminishes withwith everyevery increaseincrease inin thethe stockstock thatthathehe alreadyalready hashas..

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TOTAL & MARGINAL UTILITYTOTAL & MARGINAL UTILITY

UnitsUnits Total utility Total utility Marginal utilityMarginal utility

11 1010 1010

22 1515 5 (155 (15--10)10)33 1919 4 (194 (19--15)15)

44 2222 3 (223 (22--19)19)

55 2323 1 (231 (23--22)22)66 2323 0 (230 (23--23)23)

77 2121 --2 (212 (21--23)23)

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DIMINISHING MARGINAL UTILITY

FIGURE

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LIMITATIONS OF THE LAWLIMITATIONS OF THE LAW

Homogeneous UnitsHomogeneous Units Suitable TimeSuitable Time

No Change in Consumers TasteNo Change in Consumers Taste

RationalityRationality Price of the substitute goodsPrice of the substitute goods

FashionFashion

Not Applicable to MoneyNot Applicable to Money

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LAW OF EQUILAW OF EQUI--MARGINAL UTILITYMARGINAL UTILITY

ItIt isis anan extensionextension ofof thethe lawlaw ofofD

iminishingD

iminishing MarginalMarginalUtilityUtility toto twotwo oror moremore commoditiescommodities..

GivenGiven thethe incomeincome ofof aa consumer,consumer, thethe lawlaw statesstates thatthat

consumerconsumer cancan getget maximummaximum satisfactionsatisfaction whenwhen thetheMarginalMarginal UtilityUtility ofof thethe lastlast rupeerupee spentspent onon eacheachcommoditycommodity yieldyield thethe samesame utilityutility..

ToTo getget maximummaximum satisfaction,satisfaction, consumerconsumer willwill substitutesubstituteoneone goodgood forfor anotheranother..

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LAW OF EQUILAW OF EQUI--MARGINAL UTILITYMARGINAL UTILITY

UnderUnder LawLaw ofof EquiEqui--marginalmarginal utilityutility consumerconsumer

equilibriumequilibrium cancan bebe statedstated inin thethe followingfollowing formulaformula..

MUMUxx == MUMUyy

PxPx PyPy

IfIf therther areare moremore thanthan twotwo goodsgoods then,then,

MUMUxx == MUMUyy == MUMUnn ==

PxPx PyPy PnPn

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EXAMPLEEXAMPLE SupposeSuppose consumerconsumer isis buying buying twotwo GoodsGoods XX andand YY andand

marginalmarginal utilityutility ofof themthem areare givengiven asas

SupposeSuppose thethe pricesprices ofof goodgood XX && YY areare RsRs.. 22 && RsRs..33respectivelyrespectively andand totaltotal incomeincome isis RsRs..2424.. TheThe aboveabove tabletablecancan bebe reconstructedreconstructed byby dividingdividing thethe marginalmarginal utilitiesutilities ofof

goodgood XX byby RsRs.. 22 andand marginalmarginal utilitiesutilities ofof goodgood yy byby RsRs.. 33..

Units of X & YUnits of X & Y MU xMU x MU yMU y

11 2020 2424

22 1818 2121

33 1616 1818

44 1414 1515

55 1212 1212

66 1010 99

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The Resulting Marginal Utility TableThe Resulting Marginal Utility Table

Units of MoneyUnits of Money MU xMU x

P xP x

MU yMU y

P yP y

11 1010 88

22 99 77

33 88 66

44 77 55

55 66 44

66 55 33

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LIMITATIONS OF THE LAWLIMITATIONS OF THE LAW

RationalityRationality

Effects of Fashion and CustomsEffects of Fashion and Customs

IgnoranceIgnorance

Indivisible UnitsIndivisible Units

Questionable AssumptionsQuestionable Assumptions