Module 2- Utility Concepts

Mr. Deepak Kulkarni

The very concept of utility

Meaning: The quality in a good or service which has the capacity to satisfy the basic purpose which it is meant for i.e the satisfaction of the human wants.

Ex: The satisfaction derived on driving Maruti Sx4 car.

The quality/attributes of the aforesaid car have satisfied a human want.

Features of Utility

1) Subjective in nature:

- concerned with the mental satisfaction of a human mind.

- unique for every individual

Ex: A laptop has utility for an MBA student but it has no utility for a UG student.

2) Relative in nature:

- inconsistency of utility with respect to time and place

Ex: An umbrella has high utility during rainy season but less useful during other seasons.

3) Utility and usefulness:

- are not necessarily inter-related

- commodity having utility may not be useful

Ex: consumption of liquor has no use but it can satisfy the want of an addict.

4) Utility and Morality:

- independent of morality

Ex: Consumption of marijuana is immoral but it can satisfy the want of an addict.

Concepts of utility

1) Initial utility:

- Utility derived upon the consumption of the first unit of the commodity.

- always positive in nature giving the highest amount of satisfaction for the human mind.

Ex: your first bike you brought in the college.

2) Total Utility:

- sum total of the utility derived from different units of a commodity consumed by a household.

- entire amount of satisfaction obtained from consuming various quantities of a commodity.

Formula:

TU=U1+U2+U3+ …….. +Un

Where, TU= Total utility

U1,U2= utilities derived from the consumption of individual units of a commodity

3) Marginal Utility:

- utility derived upon consumption of an additional unit of a commodity.

- change taking place in the total utility by the consumption of an additional unit of a commodity.

Formula:

MU nth = TU n – TU n-1

Where, MU nth= Marginal utility of nth unit

TU n = Total utility of ‘n’ units

TU n-1 = Total utility of ‘n-I’ units

Types of marginal utility

a) Positive Marginal utility

- if total utility increases upon consumption of an additional unit

b) Zero Marginal utility

- if there is no change in the total utility upon consumption of an additional unit

c) Negative Marginal utility

- if there is a fall in total utility as a result of consumption of an additional unit of a commodity.

Relation between Total utility and Marginal utility

Graphical depiction of the relation

assoc files\Total and Marginal utility.xlsx

Interpretation:

1)Total utility increases initially with consumption of additional units

2) Marginal utility continuously decreases

3)Total utility increases as long as MU is positive or zero, is highest when MU is zero, and falls when MU is negative

Law of Diminishing Marginal Utility

Definitions:

1)According to Marshall, “ The additional benefit which a person derives from a stock of a thing diminishes with every increase in the stock that he already has.”

2)According to Samuelson, “As the amount consumed of a good increases, the marginal utility of the goods tends to decrease.”

Explanation of the Law

Diagrammatical representation of the Law

..\assoc files\Total and Marginal utility.xlsx

Reason for decrease in Marginal Utility

1)Intensity of desire in man decreases with continuous consumption of the same good.

2)Satisfaction of man’s needs in degrees

Assumptions of the Law

Other things being equal the law works upon the following assumptions.

1)Utility can be measured in cardinal number system 1 2 3 ….. Etc

2)Consistent income of the consumer

3)Marginal utility of money remains constant.

4)Quality of the units consumed is constant.

5) Commodity is consumed continuously without time lag.

6) Marginal utility of every commodity is constant.

7) Attributes of the units consumed are constant i.e no change in size and quality

8)No change in the tastes and preferences of the consumer

9) Price of the commodity and its substitutes remains constant.

Equimarginal principle.

• This concept was originally associated with the consumption theory and the law is called the “law of marginal utility”.

• This law was applied to the allocation a resources between their alternative uses view to maximizing profit in case of firm carrying out more than one business activity.

• This principle suggests that the available resources should be so allocated between the alternative options that the marginal productivity gains from the various activities are equalised.

• Say if the marginal productivity of three different projects A, B and C are MPa, MPb and MPc then according to this principle MPa=MPb=MPc.

• This principle suggests that a profit maximizing firm , allocate its resources in a proportion such that;

MPa=MPb=MPc……..MPn.• If costs of projects (COP) varies from projects to

projects then resources are allocated in such a way that as shown below:

MPa/COPa=MPb/COPb=MPc/COPc....MPn/COPn

Consumer equillibrium

Equillibrium: A balanced state of any phenomenon

Consumer equillibrium: A point of satisfaction where consumer would be indifferent to any further good consumed.

The Concept2 Constraints:

a) Consumer income

b) Price of the good

Definition

• Consumer Equilibrium When consumers make choices about the quantity of

goods and services to consume, it is presumed that their objective is to maximize total utility. In maximizing total utility, the consumer faces a number of constraints, the most important of which are the consumer's income and the prices of the goods and services that the consumer wishes to consume. The consumer's effort to maximize total utility, subject to these constraints, is referred to as the consumer's problem. The solution to the consumer's problem, which entails decisions about how much the consumer will consume of a number of goods and services, is referred to as consumer equilibrium.

Assume 2 goods are purchased

Good 1 and Good 2

Point of consumer equillibrium would be

MU g1/ P g1 = MU g2/P g2

Illustration

Price of good 1 = AUD 2

Price of good 2 = AUD 1

Budgetary Constraint = AUD 5

Importance of the Law of Equi Marginal Utility

1) Consumer Satisfaction:

- As suggested by the law, if the consumer spends his income in such a way that, the units of money spent on each good yields equal marginal utility for him, this leads to maximum satisfaction

2) Maximum Profit:

- utilize each factor of production in such a way that marginal productivity of each factor is equal leading to max. profit

3) Substitution between commodities:

- consumer substitutes goods with more utility to the one’s giving less utility till marginal utility becomes equal

4) Distribution of national income:

- distribution of national income among factors of production can be done in such a way that every factor gets its share out o national income according to its marginal productivity.

5) Imposition of taxes:

- FM levies taxes in such a way that the marginal sacrifice of each tax payer is equal to ensure least burden on all tax payers.

Criticisms of the Law of equi marginal utility

1) Cardinal measurement of utility is not possible

2) Consumers are not fully rational

3) Shortage of goods having more utility

4) Ignorance of the consumer

5) Influence of fashion, customs and habits

6) Constant income and price

7) Constant marginal utility of money

8) Indivisibility of goods

Indifference Curve

An indifference curve is a locus of all such points which show different combinations of two commodities which yield equal satisfaction to the consumer.

Indifference Schedule

An indifference schedule refers to a schedule that indicates different combinations of two commodities which yield equal satisfaction. A rational consumer places equal importance to each of the combinations.

Indifference map

An indifference is nothing but a diagrammatical representation of the indifference schedule.

Properties of indifference curves

1) Slope downwards from left to right/ has a negative slope:

- the consumer will have to curtail the consumption of one commodity if he wants to consume large quantity of another commodity to maintain the same level of satisfaction.

2) Convex to the point of origin:

- A consumer needs to maintain the balance of the combination to maintain satisfaction levels.

3) Two indifferent curves never intersect:

- each curve represents different levels of satisfaction

4) Indifference curve touches neither x axis nor y axis.

5) Indifference curves need not be perfectly parallel to each other.

6) Indifference curves become more complex incase of more than 2 commodities.

Income, substitution and price effect

1) Income effect:

- the effect on the consumption of two goods caused by a change in income, if the prices of goods remain constant.

- income effect is defined as the effect on the purchases of the consumer caused by a change in income with the price remaining constant.

- Income effect indicates that, other things being equal increase in income increases the satisfaction of the consumer and vice- versa thus resulting in a shift in the equilibrium point.

- The locus of all equilibrium points on the price line is called as the income consumption curve.

ic1

ic3ic2

Substitution Effect

2) Substitution effect shows the change in the quantity of the goods purchased due to the change in the relative prices alone while the real income remains constant.

- if with the change in the price of the goods the money income of the consumer changes in such a way that his real income remains constant, the consumer will substitute cheaper goods for the dearer ones.

Example:

Income of the consumer: Rs. 100

rice : Rs 10 per kg (less nutritious)

wheat : Rs 20 per kg (more nutritious)

Consumption combination:

6 kg of rice and 2 kg of wheat

Crash in the price of wheat to Rs. 10 per kg

New consumption combination:

6kg of wheat and 4 kg of rice.

Consumer will substitute less nutritious rice for more nutritious wheat and the equilibrium of the consumer shifts.

Price Effect

Price effect means change in the consumption of goods when the price of either of the two goods changes, while the price of the other good and the income of the consumer remain constant.