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Utility Theory

Dr. Kishor Bhanushali


Faculty – Economics
IBS-Ahmedabad
Utility
By utility we mean then extent of
satisfaction obtain from the consumption
of goods and services preferred by the
consumer
Place, Form, Time utility
Cardinalist approach & Ordinalist
approach
Total utility received from the good is the
total satisfaction enjoyed from the
consumption of that good
Marginal utility
Law of diminishing marginal utility
Marginal Utility Analysis
Marginal utility analysis explains the
consumers’ demand for a commodity
and derives the law of demand which
shows an inverse relationship
between quantity demanded and the
price of the commodity
Utility Function
∆TU
MUx =
∆X
∆TU
MUy =
∆y
Numerical
Marginal utilities for good A and B are
600 and 900, and the price of good B
is Rs. 120. If the consumer is in
equilibrium, the price of good A
is____
Price of good A = Rs. 80
Basic Assumptions
Cardinal measurement of utility
Utilities are independent (additive)
Constant marginal utility of money
Introspection
Law of Diminishing Marginal Utility
The additional benefits which a person derives
from a given increase in his stock of a think
diminishes with every increase in the stock of
what he already has
Units Total Utility Marginal Utility
1 20 20
2 38 18
3 53 15
4 64 11
5 70 6
6 70 0
7 62 -8
8 46 -16
TU Total Utility

0 Q

Marginal Utility

MU

0 Q
Why ?
1. Even though human wants are unlimited, yet
particular want can almost be fully satisfied.
Hence when consumer consumes more and
more of a commodity, his want is satisfied and
he does not desire further increment of the
commodity
2. Goods are imperfect substitutes for one
another. Different commodities satisfy different
wants. When a consumer goes on consuming a
commodity, the marginal utility falls as his want
is satisfied. But if the commodity could be
substituted for other commodities, it would
have satisfied other wants. Hence its marginal
utility would not have decreased even though
its quantity increases.
Limitations

Suitable units
Suitable time
Normal persons
Rare collections
Not applicable to money
Consumer’s Equilibrium
(One commodity)
Consumer will purchase the successive
units of a commodity till marginal
utility of the commodity becomes
equal to price
The equality between marginal utility
and price indicates the position of
consumer’s equilibrium when only
one commodity is being purchased
and consumed
Equilibrium Conditions
(More than one commodities)
For a rational consumer, utility gets
maximized only when he chooses that
bundle of goods from the available
alternatives, which gives him highest level
of satisfaction
Consumer allocates his total income is
purchasing of various goods in such a
manner that he acquires the same level of
marginal utility per rupee he spends on
every good
MU1 = MU2 = MU3 = …….MUn = Mum
P1 P2 P3 Pn
Diagrammatic Representation
MU

Loss
Gain
MUa MUb

A a a’ B
O b b’
Why Demand Curve Slopes Downward ?
When the price of the good falls, the
consumer buys more of the good so as to
equate the marginal utility to lower price.
A price falls, consumer can afford to buy
more. He is able and willing to buy more
because things being cheaper, his real income
increases
When the commodity become cheaper, it
tends to be substituted wholly or partly for
other commodities.
A commodity tends to put to more uses or
less urgent uses when it becomes cheaper
Old buyer buy more and new buyer enter the
market
Substitute and Complementary Goods

Substitute goods are those that


serves the same purpose to the
consumer
Complementary goods are those
whose demand pattern are so related
to each other that an increase in the
price of the first good will cause a
decrease in the demand for the other
good
Derivation of Market Demand
Market Demand is nothing but
horizontal summation of the quantity
demanded by different individual at
each prices
Quantity demanded at each market
price is the summation of the
individual demands of all customers
at that price.
Types of Demand
Direct and derived demand
Domestic and Industrial demand
Autonomous and induced demand
Perishable and durable goods’ demand
New and replacement demand
Final and intermediate good demand
Individual and market demand
Total market and segmented market
demand
Short run and long run demand
Company and industry demand
The Paradox of Value
Items of great values e.g. water, air etc. are often
sold at negligible prices or are costless, where as
items like jewelry with very little use to mankind are
sold at exorbitant prices.
Paradox of value deals basically with the reason why
consumer pay zero or very less amount of money for
certain items with very high benefits.
Diamond-Water Paradox: Adam Smith
The relative abundance of water in most places brings
its marginal utility very close to zero. On the contrary,
due to scarcity of diamond all over the world its
marginal utility is always maintained at very high
level.
So the willingness of the consumer to sacrifice more
units of money in the case of diamond is solely
contributed to its availability constraints which is
manifested through higher marginal utility.
Water – Diamond Paradox

Water
Diamond

Price W Price D
MU MU

P
MU
MU

0 W 0 D
Consumer Surplus
First introduced by Marshall
Consumer surplus measures the difference
between what a person is prepared to pay for a
commodity and the amount he actually pay.

Price
& A
MU p1
p2

P N
r1 r2
B

0
q1 q2 Q Quantity
Application of the Consumer Surplus
The concept of consumer surplus is
useful in designing various
government policies and programs
It is used to evaluate the effects of
various policies on consumers
Application of Consumer Surplus
Price

D Producer Surplus

A Dead Weight Loss


P1

Loss in consumer
B surplus = P1ABP0
P0 Producers surplus =
E
P1P0EA
Dead weight loss = AEB
D’

0 Q1 Q0 Quantity
Numerical
Consumption TU TU TU
Cheese Fish Meat
1 70 80 160

2 130 160 290


3 170 210 410
4 205 250 510
5 230 285 590
6 250 315 650
7 260 335 680

Monthly Budget = Rs. 340


Price of Cheese = Rs 20
Price of Fish = Rs 40
Price of Meat = Rs 50
Numerical
Consum MU MU/P MU MU/P MU MU/p
ption Cheese Cheese Fish Fish Meat Meat
1

2 60 3 80 2 130 2.6

3 40 2 50 1.25 120 2.4

4 35 1.75 40 1 100 2

5 25 1.21 35 0.875 80 1.6

6 20 1 30 0.75 60 1.20

7 10 0.5 20 0.50 30 0.6

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