Micro Economics 46

Micro Economics 47
CHOICE AND UTILITY THEORY
Utility is the satisfaction gained by consumers from consumption of goods and
services, or it can also be defined as the ability of a good to provide satisfaction to its
consumer.
According to the theory of utility, consumers use satisfaction level as the basis to make
consumption choices and evaluate goods based on satisfaction. asically, there are t!o
approaches of utility theory analysis namely, the cardinal approach and ordinal
approach. "hrough cardinal approach, it is assumed that utility can be measured !ith
utile as the unit of measurement. #or e$ample, eating a piece of durian gives % utils,
!hile eating a piece of rambutan !ill give & util.
Mean!hile, the ordinal approach, assumes that level of satisfaction cannot be
measured. #or instance, eating durian gives more satisfaction compared to eating
rambutan. 'n this condition, the measurement unit of satisfaction is not given. "he
level of satisfaction is determined by means of comparison only.
Cardinal Measurement of Utility
(ardinal utility theory is a method !hich assumes that
satisfaction can be measured using the unit of )util*.
Marginal utility analysis assumes in the first place that
utility can be measured and the e$act measurement can be
given by assigning definite numbers such as &, %, % etc.
"hat is, it is assumed that utility is a +uantifiable entity. "his means that a person can
e$press the satisfaction derived from the consumption of a commodity in +uantitative
terms.
#or instance, eating a piece of cake !ill give , utils, !hile eating biscuits !ill only
give 4 utils. "his reflects that a cake gives t!o-times the utility compared to biscuits.
Utility level is normally reflected by the !illingness of a person to pay based on the
value of money. "he higher the price !illing to be paid, the higher the level of
satisfaction gained.
Ordinal utility theory states that !hile the utility of a
particular good or service cannot be measured using a
numerical scale bearing economic meaning in and of itself,
pairs of alternative bundles .combinations/ of goods can be
ordered such that one is considered by an individual to be
Ordinal utility
Utility is measurable in the
ordinal sense if the utility
numbers we assign to
objects have no meaning
other than to represent
the ranking of these goods
in terms of a persons
preferences.
Cardinal utility
Utility is said to be
measurable in the cardinal
sense if not only the utility
numbers assigned to
bundles but also their
diferences are
meaningful.
Micro Economics 4,
!orse than, e+ual to, or better than the other. "his contrasts !ith cardinal
utility theory, !hich generally treats utility as something !hose numerical value is
meaningful in its o!n right. "he concept !as first introduced by 0areto in &126.
According to the ordinal utility theory, the benefit or satisfaction gained by consumers
cannot be measured in +uantitative form, but in terms of comparison to the
consumption of other goods.
"he ordinal utility emphasi3e on ordering4rank bundles of goods. "he cardinal utility
emphasi3e on the si3e of the difference bet!een t!o bundles of goods. (hristopher
0appas
5hen discussing cardinal vs. ordinal, it is helpful to look at !hat the !ords mean. "he
distinguishing factor here is bet!een cardinal and ordinal numbers. (ardinal numbers
are &, %, 67 ordinal numbers, &st, %nd, 6rd. 8ome crucial differences follo! from that.
5hereas mathematical operations can be performed on cardinal numbers, they cannot
be performed on ordinal numbers. 9o!, !hen talking about cardinal utility, it is an
attempt to ::measure the utility of various alternatives. 5hen talking about ordinal
utility, it is the ::ranking of alternatives.:::: (ardinal utility is, ho!ever, an erroneous
concept. 't is impossible to ;measure; utility. 0eople can only say ;' prefer A to ;,
but cannot meaningfully say ;' prefer A %.< times more than ; or something to that
effect.
Total Utility and Marginal Utility
"here are t!o basic concepts of utility, namely, total utility and marginal utility. "otal
Utility ."U/ is the total satisfaction gained from a given level of consumption of a
good. Marginal utility .MU/ is the increase in total utility !hen consumption increases
by & unit.
"able 6.& sho!s the relationship bet!een the consumption of goods !ith total utility
and marginal utility. =bserve that total utility for the first unit is &2 utils. 5hen
consumption level is increased to % units, total utility increases to %% utils, and so on.
As you already kno!, marginal is addition. "he formula for marginal utility is as
follo!s>
Micro Economics 41
"herefore, marginal utility for the first unit is e+uivalent to the total utility of that unit.
As !e can see from "able 4.&, MU for the first unit is &2 utils !hile for the second
unit is &% or .%% - &2/ utils, and so on.
Table .!" Total Utility and #arginal Utility
5hen !e sum up marginal utility up to < consumption levels, !e !ill obtain 6, utiles,
that is, e+uivalent to the total utility of the unit.
#igure> 6.&> "otal Utility and Marginal Utility
#igure 6.& is the illustration of total utility and marginal utility derived from "able 6.&.
=bserve that marginal utility is e+uivalent to the gradient of total utility at each unit of
consumption. "otal utility reaches ma$imum !hen marginal utility is 3ero.
Micro Economics <2
Relationshi !et"een #Marginal Utility$% #Total Utility$ and #A&erage Utility$
"he relation among marginal utility, total utility and average utility can be understood
by a careful study of "able 6.% and #ig. 6.%. 't is clear from this table and figure that
initially the total utility curve slopes up!ards to the right.
"his indicates that the total utility !ill rise !ith consumption of additional units of the
commodity. ?o!ever, the increase in total utility is not constant, but falls steadily. 'n
other !ords, the total utility rises at a falling rate. "his is sho!n by corresponding
do!n!ard or negative slope of the marginal utility curve. 'n the present e$ample, this
happens upto 6 units of the commodity.
5hen the total utility reaches its
ma$imum value, marginal utility
becomes 3ero. efore this point,
though marginal utility falls, it
al!ays remains positive. 'n our
e$ample, this happens, !hen the
consumer consumes si$th unit of
the commodity. 't is called the
point of satiety. "he total utility
stops rising at this stage.
Micro Economics <&
5hen consumption is e$panded beyond the point of satiety, the total utility starts
falling because marginal utility turns negative. 'n the present e$ample, the consumer
gets negative marginal utilities of @s. % and @s. 4, !hen he decides to consume
seventh and eighth units of the commodity respectively.
'ig( )(*+ Relation among MU% TU and AU
"he relationship bet!een total utility and marginal utility can also be verified
mathematically by using the concept of slope. 5e kno! that the slope of the total
utility curve at each point indicates the marginal utility derived from the
corresponding level of consumption. "his has been sho!n in #ig. 6.6.
#ig. 6.6> Marginal Utility though
8lope of "otal Utility
'n #ig. 6.6, four points )A*, )* )(*
and )A* are considered on the total
utility curve. "he slopes at these
points are measured by the slopes
of the tangents dra!n at these
points. "he slope of the total utility
curve at point )A* is A#4E#, !hile the slope of the total utility curve at point )* is
?4B?. 8ince A#4E# C ?4B?, marginal utility for the unit corresponding to point
)A* is greater than for the unit corresponding to point )*.
"hus, initially, marginal utility falls, as total utility rises at diminishing rate. #urther, at
ma$imum point )(* on the total utility curve, the tangent is parallel to D-a$is. 8o, its
slope is 3ero. "herefore, marginal utility is 3ero, !hen total utility is ma$imum. Again,
slope of the tangent after point )(* becomes negative .e.g., point )A* in the figure/.
"his sho!s that marginal utility turns negative, after total utility reaches its ma$imum
point.
Unlike marginal utility, average utility is al!ays positive, since it is a ratio of t!o non-
negative values. 8o, the graph of average utility al!ays remains above D-a$is. 5hen
Micro Economics <%
average utility attains ma$imum value, it is e+ual to marginal utility. Eike marginal
utility curve, average utility curve is also do!n!ard sloping.
La" of Diminishing Marginal Utility
Utility refers to the amount of satisfaction a person gets from consumption of a certain
item. And marginal utility refers to the addition made to total utility7 !e get after
consuming one more unit.
An individual:s !ants are unlimited in number yet each individual:s !ant is satiable.
ecause of this, the more !e have a commodity, the less !e !ant to have more of it.
"his la! state that as the amount consumed of a commodity increases, the utility
derived by the consumer from the additional units, i.e marginal utility goes on
decreasing.
Ea! of diminishing marginal utility means that the marginal utility obtained from the
consumption of additional unit !ill start to decrease after a certain level of
consumption !hen the amount consumed increases.
"he la! of diminishing marginal utility e$plains the do!n!ard sloping demand curve.
Definition
According to Marshall, F"he additional benefit a person derives from a given increase
of his stock of a thing diminishes !ith every increase in the stock that he already hasG
Assumtions+
All the units of a commodity must be same in all respects
"he unit of the good must be standard
"here should be no change in taste during the process of consumption
"here must be continuity in consumption
"here should be no change in the price of the substitute goods
E,lanation+
As more and more +uantity of a commodity is consumed, the intensity if desire
decreases and also the utility derived from the additional unit.
8uppose a person eats read. And &st unit of bread gives him ma$imum satisfaction.
5hen he !ill eat %nd bread his total satisfaction !ould increase. ut the utility added
Micro Economics <6
by %nd bread .MU/ is less than the &st bread. ?is "otal utility and marginal utility can
be put in the form of a follo!ing schedule.
"able> 6.6> Aiminishing Marginal Utility
0lotting the above data on a graph gives
#igure> 6.4> Aiminishing Marginal Utility
?ere, from the MU curve
!e can see that MU is
declinig as consumer
consumes more of the
commodity.
5hen "U is ma$imum,
MU is Hero.
After that, "U starts
declining and MU
becomes negative.