1 Chapter No 4 Utility Analysis:

2 The term utility has been coin (invent, create) by Jevons of United Kingdom. According to him every matter (goods or services) possesses the characteristics of satisfying human want. Utility, therefore, can be defined as want satisfying power of an article (piece, item). In the words of M.M Bobber “Utility is the power of a commodity or service to satisfy human want”.

3 Conti… For example, thirst quenching quality of water, hunger satisfying power of loaves(bread), writing quality of pen is said to be the utility. It has no physical or material existence. It depend upon the mental make up of the customer. Utility and satisfaction: Some older economist could not distinguish between utility and satisfaction; and they stated that satisfaction of wants is utility.

4 Conti… We will explain the difference between utility and satisfaction below: In order to explain this we should know how our want is satisfied. It has the following stages: 1.First of all we feel a want; 2.Then we decide which commodity possesses this utility mean which possesses the power to satisfy that want;

5 Conti…. 3. After that we consume the commodity; 4. As a result of consumption, our want is satisfy. Thus we can say the relation ship between the two is of means and end. Utility is mean; satisfaction is end because satisfaction is secured through utility ( a commodity possessing utility). So we can say utility is the want satisfying power of a commodity.

6 There are three concept of utility: 1.Initial utility: 2.Marginal Utility: 3.Total Utility: 1. Initial Utility: The utility derived from the first unit of a commodity is called initial utility. Utility of the first bread is called initial utility. It is always positive.

7 Conti… 2. Marginal Utility: Marginal Utility means the addition made to the total utility by the marginal unit. Suppose four loaves of bread gives =30 units of utility, while the three loaves had given =26 units, the addition made by the fourth loaf is 30-26=4. there for the marginal utility of fourth loaf is equal to 4.

8 Conti… 3) Total Utility: the total utility derived by a person from the total number of units of a commodity consumed by a person is called total utility. In simple words, if a person consumes four loaves of bread, than the total amount of utility will be equal to the sum total of the utility derived from the 1 st, 2 nd, 3 rd,4 th, loaf.

9 Following is the relationship between marginal and total utility: i.When marginal utility is positive total utility is positive. ii.When marginal utility is zero total utility is maximum. It is also known ‘point of satisfaction’. iii.When marginal utility is negative total utility diminishes.

10 Units of good Marginal Total consumed: Utility Utility

11 Conti…. The above schedule clearly shows that up to the 3 rd unit of the goods consumed marginal utility is positive and total utility is increasing. At the 4 th unit of the commodity marginal utility is zero and total utility is maximum. This point is known as point of full satisfaction. At 5 th and 6 th unit of commodity marginal utility is negative and total utility is diminishing.

12 diagram Y X Y MU TU Max TU Zero MU +ve MU -ve MU Marginal & Total Utility Units of Commodity

13 In this diagram, along x-axis are measured units of commodity and along y-axis the utility is measured. MU curve is marginal utility curve and TU curve total utility curve. Up to the consumption of 3 rd unit the total utility is increasing but marginal utility is diminishing though positive. At the 4 th unit the marginal is zero and the total utility is maximum. This point is called maximum satisfaction point.

14 Conti…. And beyond the 4 th unit the total utility is diminishing and the marginal utility is negative.

15 1) The Cardinal Measurement of Utility: The Utility analysis considers utility a cardinal concept. Which means utility is a quantifiable entity (body, unit). It means a person can express the satisfaction derived from the consumption of a commodity in quantitative terms. It tell us whether utility from a unit of commodity is 100 or 90 or anything else.

16 Conti…. 2) Independent Utility: The utility which a consumer get from commodity depends upon the amount of that product only. It is not related to the amount of other commodities purchased by a consumer. Further, it is also assumed that one person’s utility is not affected by the utility of other persons. That’s why we can say utility is independent.

17 Conti…. 3) Constant Marginal Utility of Money: when a person purchases more of good, the amount with him must diminish and marginal utility of money must increase. But this variation in marginal utility of money has been ignored and it is assumed to remain constant.

18 Conti…. 4) Introspection (to study the mind of a person): The marginal utility analysis assumes that from one’s own experience (judging what happens in one’s own mind) it is possible to draw inference (conclusion, supposition) about another person.

19 The law of Diminishing Marginal Utility explains the relation between utility and quantity of a commodity. It is a psychological fact that when a consumer gets more and more units of a commodity, during a particular time, the utility from the successive units will diminish.

20 “It states that other things remain constant as more and more units of a commodity (like a cup of tea) are continuously consumed, marginal utility derived from every successive unit must diminish, and may even become zero or negative.

21 Cup of Tea Marginal Utility

22 The table shows us the relationship between the six cup of tea and marginal utility that we derived from that. When the consumer use 2 cup of tea marginal utility goes down according to the law. As the consumer consume 5 th unit marginal utility become zero. This is the point of full satisfaction. After this as he consume 6 th cup marginal utility goes in negative.

23 Conti… ve MU Zero MU Max Satisfaction MU Curve MU Utility Cup of Tea

24 Along OX we measured cup of tea consumed by individual and along OY axis we measured Marginal Utility. When the consumer consumed 1 st cup of tea he derived 8 unit of utility. Up to consumption of 4 th cup of tea the marginal utility decrease to 2 unit as he consume 5 th unit marginal utility become zero and this is the point of maximum satisfaction as he further consume another unit the marginal utility goes down in negative -2. this shows that as we consume a commodity more and more the marginal utility goes down, which is call law of diminishing marginal utility.

25 1.Utility can be measured in cardinal (Basic, Fundamental) number: 2.Marginal Utility of money remain constant: 3.Marginal Utility of every commodity is independent: 4.Every unit of the commodity being used is of same quality and size: the size and quality of the commodity will be same for example, the second toast is well buttered then the first one, then it will give greater utility to a

26 consumer in comparison to the first one, which is unbuttered. 5. There is continues consumption of the commodity. If there is any interval between the consumption of the various units of a commodity the law will not hold good. For example, A cup of tea in the morning and another in the evening may not be subject to the law of diminishing marginal utility.

27 6. Suitable and proper quality of the commodity is consumed: for example, water should be in glasses and not in drops or in teaspoon. If a person is thirsty we give water in teaspoon, the marginal from every additional teaspoon of water will increase instead of decreasing. 7. There is no change in the income of the consumer: the income of the consumer will not change, if income increase or decrease it will affect the law.

28 9. There is no change in the fashion, taste and habits of the consumer. If there is a change in fashion, taste or habit of the consumer it will affect the law. 10. The good and person should be normal: the consumer should be an economic man who act rationally, mean the person should be normal, like the person should not drunk, because than the law will not work. Also the product will be a normal product. If they are

29 11.rare commodities like diamond jewel or hobby goods like sport goods, so here the law doesn’t apply.

30 Sometimes,it appears that the law of diminishing utility does not apply to the following conditions. However, if we deeply think we find that such doubt arises because the assumptions and conditions of the law are ignored. Otherwise the law is universally applicable. 1. knowledge: If a person acquires more and more knowledge, his appetite for knowledge increases. Utility of further study rises. However if a person reads the same book again and again without much interval, marginal utility will certainly fall. 2.Wealth and money: Some people argue that since money can be used to purchase every good, marginal utility of money does not fall. Similarly, to a miser each addition in his wealth gives more utility. However money and wealth are no exception. If income of a person increases and he becomes rich, he is ready to spend more and more money on a commodity, which he previously thought not worthwhile.

31 3. Drugs and narcotics: If a person is addicted to smoking, drinking or drugs, the more he uses these, the greater urge he feels. But in this case too, we should remember that if he goes on using the commodity without any break, his desire for more will diminish. 4. Rare articles : Someone may feel that the people who are collecting rare articles of historical importance, get increasing satisfaction with every addition to their collection. But it is not true. Suppose a person has two coins of emperor Akbar’s period in his possession. Now if he gets a third of the same type, he will not be as much pleased as he felt on finding the first coin. 5. Articles of fashion: if some articles are purchased just out of fashion or to show one’s wealth the marginal utility may increase instead of decreasing. But in this case too, the law applies provided we consider only one commodity. A person certainly lose interest in a commodity if he gets more and more of it.

32 This is a basic law of economics with great practical importance. 1.It explains why demand curve falls from left to right: When people get more quantity of a commodity, its marginal utility falls. It does not appear to them as attractive as before. Thus, they purchase additional quantity only when price is lowered. 2.It provides basis for progressive taxation: Progressive tax means that rate of tax is higher for richer people. When income of a person increases marginal utility of money falls. If the person with high income has to pay tax at the same rate as a poor person, he feels less burden. Therefore to do justice, rate of tax should be higher for the rich people.

33 3. Redistribution of wealth: The socialists advocate equal distribution of wealth on the ground that marginal utility of money for the rich is lower than for the poor. They say that if some wealth is taken away from the rich and distributed among the poor, total utility of the community increases. 4. It explains how a consumer gets maximum utility: In order to get maximum possible utility out of his income, a consumer should spend the amount in such a way that per rupee marginal utility of all commodities purchased becomes equal.

34 Law of equi-marginal utility is the 2 nd important law of utility analysis. This law was first presented by a French engineer H.H.Gossen. This law points out how a consumer can get maximum satisfaction out of given expenditure on different goods. “This law states that in order to get maximum satisfaction, a consumer should spend his limited income on different commodities in such a way that the last rupee spent on each commodity yields him equal marginal utility”.

35 RupeeMU of applesMU of bananas 1 st 2 nd 3 rd 4 th 5 th

36 The law can be illustrated with the help of the table. Suppose a person has got AFS 5 which he wants to spend on Apples and Bananas. Let us suppose the price of both the goods is A.1 per unit. Marginal utilities which he expects to derive from each rupee spent on both these goods is in the previous table. The consumer will proceed to spend each rupee in that use from which he gets maximum satisfaction. Thus, he would spend his first rupee on apples, for it gives him the highest utility. The second rupee will again be spend on apple, the third on banana, the fourth on apple and so on. When he has spent the whole amount of AFS 5., he will find that he has spent AFS 3. on apples and AFS 2. on bananas. We can say that the marginal utility of the last rupee spent on every commodity is the same. By so arranging his expenditure, the purchaser derives 37 units of total utility, which is the maximum.

loss 2 Gain MU Utility units of money

38 The law has many limitations. It is difficult to apply in practical problems due to the following reasons: 1.The income of consumers, prices of goods and tastes are always changing. The consumer can act according to this principle only when he constantly makes calculations. But human beings are not calculating machines. 2.Indivisible goods : many goods are not divisible into smaller units. Thus, it becomes impossible to substitute a little of one commodity for another. For example, a cars indivisible. It cannot be purchased in parts. 3.Custom and fashion: Some times people purchase goods just out of fashion or custom. They do not care to equalize marginal utilities.

39 4. Time problem: Many goods last for very long periods. It is difficult to compare their utilities : e.g. It is difficult to compare utility of a table lamp with that of chicken roast which is consumed up in no time. 5.Utility in not measurable: This principle has very weak basis. Utility is not measurable. So it is difficult to compare utilities to find maximum utility. It is not possible to add or subtract utilities.

40 Law of equi-marginal utility is of great significance. Some of the applications of the law are in the following fields. 1.Consumption: every consumer wants to get maximum satisfaction from his expenditure. If a consumer spends his income according to the law, he can get maximum satisfaction. 2.Production: every producer aims at earning maximum profit. To achieve this objective he must utilize different factors of productions i.e. land, labor, capital etc., in such a way the marginal productive of each factor is equal. For this purpose the producer has to substitute sometimes labor for machinery or at other times machinery for labor till marginal the marginal productivity of each is equal.

41 3.Price determination: The principle of equi marginal utility has important bearing on the determination of the price. When there is scarcity of a commodity, the law of substitution comes to our aid. We start substituting the less scarce or cheaper goods for the more scare and costly goods. The scarcity of the later goods thus reduced and their prices come down. On the other hand demand for higher priced goods decreases and their prices come down. 4.International trade : A country follows the principle of substitution in international trade. It exports a commodity which has lower marginal utility and imports a commodity which has higher marginal utility.This substitution continues till marginal utilities becomes equal.

42 5. Distribution of assets: This law also helps the individuals to distribute his assets among alternative forms, such as cash, bank deposits, bonds, stock and shares or property etc. According to this law the investment should be made in different forms of assets in such a way that last unit of money invested in each form should yield equal marginal utility. Thus,he will derive almost equal psychological benefit from all forms of assets and thereby, enjoy maximum satisfaction.