Micro Economics

Scarcity and choice

Robbins Definition of Economics:

Lionel Robbins claiming his definition Economics precise, scientific and superior, defines Economics book
Nature and Significance of Economics Science' (Published in 1932):
"A science which studies human behavior as a relationship between ends and scarce means which have alternative
uses".
Marshalls definition of economics remained an article of faith with all economists from 1830 to 1932. However,
with the publication of Robbins book 'Nature and Significance of Economic Science' (1932), there developed a
fresh controversy in regard to the definition of economics. Lionel Robbins, after criticizing the definitions given
by the Classical and Neo-classical economists, gave his own definition of Economics. According to him:
Firstly, the definition of Economics given by him is superior to that of others because it does not contain any
reference of the term material or welfare. Secondly, it applies as much to the case of an isolated individual as to
the complicated net working of society. Thirdly, it raises the status of Economics to that of Science. Fourthly, it
makes Economics a positive science which deals only with facts, It forbids the economists to pass any value
judgment of what is good or bad, right or wrong, etc.

This definition is based on the following five pillars:

Main Pillars of Robbins's Definition:

(i) The Human wants or ends are unlimited: Human wants referred to as ends by Robbins are unlimited. They
increase in quantity and quality over a period of time. They vary among individuals and overtime for the same
individual. It is not possible to find a person who will say that his wants for goods and services have been
completely satisfied. This is because of the fact that when one want is satisfied, it is replaced by another and there
is then no end to it.
(ii) The ends or wants vary in importance: The ends or wants are of varying importance. They are ranked in
order of importance as: (a) necessaries (b) comforts and (c) luxuries. Man generally satisfies his urgent wants first
and less urgent afterwards in order of their importance.
(iii) Scarcity of resources: Resources are the inputs used in the production of things which we need. The
resources (Land, labor, capital and entrepreneurship) at the disposal of man are scarce. They are not found in as
much quantity as we need them. Scarcity means that we do not and cannot have enough income or wealth to
satisfy our every desire. Scarcity exists because human wants always exceed what can be produced with limited
resources and time that Nature makes available to man at any one time. Scarcity is a fact of life. It occurs among
the poor and among the rich. The richest person on earth faces scarcity because he too cannot satisfy all his wants
with the limited time available to him.
(iv) According to Robbins: the unlimited ends and the scarce resources provide a foundation to the field of
Economics. Since the human wants are innumerable and the means to satisfy them are scarce or limited in supply,
therefore, an economic problem arises. If all the things were freely available to satisfy the unlimited human wants,
there would not have arisen any scarcity, hence no economic goods, no need to economic and no economic
problem. Scarcity, thus, can be defined as the excess of human wants over what can be actually produced in the
economy.
(v) Economic resources have alternative uses: The fourth important proposition of Robbins definition is that the
scarce resources available to satisfy human wants have alternative uses. They can be put to one use at one time.
For instance, if a piece of land is used for the production of sugarcane, it cannot be utilized for the growth of
another crop at the same time. Man, therefore, has to choose the best way of utilizing the scarce resources which
have alternative uses. The scarcity resources and choices are the key problems confronting every society.
The choices to be made by it are:

What goods shall be produced and in what quantity?

How should the various goods and services be produced?
How should the goods and services be distributed?

Summing up the foundation of economic science according to Robbins, is based on satisfaction of human wants
with scare resources which have alternative uses.

Merits of Robbins's Definition of Economics:

There are many admirers of Robbins definition. It has the following merits:
(i) Status of a positive science: Robbins tries to make economics a more exact science. According to him,
economics has nothing to do with ends. They may be noble or ignoble, material or non-material. Economics is not
concerned with them as such.
(ii) An analytical definition: Robbins definition makes study of economics analytical. It studies the particular
aspect of human behavior which is imposed by the influence of scarcity.
(iii) A universal definition: Robbins definition is applicable everywhere. It is concerned with unlimited wants
and limited resources which is the problem facing every economy socialistic or capitalistic.
(iv) Clear on the nature and scope of economics: Robbins definition serves to specify the nature, scope and
subject matter of economics. According to him, an economic problem is characterized by the possibility of
exercising choice between ends an which have alternative uses.
(v) Valuation is the central problem: According to Robbins, valuation is the central problem of economics.
Wherever the ends are unlimited and the resources scare, they give rise to an economic problem Marshalls
definition does not identity this valuation process.

Criticism on Robbins Definition of Economics or Demerits:

Robbins definition of economics has been bitterly criticized by eminent writers Hicks, Longe, Durbin, Frazer, etc.,
on the following grounds:
(i) Reduced economics merely to a theory of value: Robbinss definition restricts the scope of economics by
treating it as a positive Science only while in reality it is both a positive and a normative science.
(ii) Scope of economic has been widened: Robbinss definition has widened the scope of economics by covering
the whole of economic life, while it is concerned with that part of human life which is connected with the market
price.
(iii) Economics has become a colorless science: Robbinss made economics colorless, impersonal and abstract. It
is in fact a definition of economics for economist only.
(iv) Study of economic growth: The study of economic growth process remains outside the scope of economics
while it is through economic growth that living standards improve.
Summing up: The definition of economics given by Robbins has doubt certain flaws. However, it is more
comprehensive in describing the problem of resource utilization.

Comparison of Marshal and Robbins definition

Marshalls Definition of Economics:

The neo-classical school led by Dr. Alfred Marshall gave economics a respectable place among social sciences.
He was the first economist who lifted economics from the bad repute it had fallen. Dr. Alfred Marshall (1842 1924) in his book, 'Principles of Economics' defined Economics as:

Study of mankind in the ordinary business of life; it examines that part of individual and social actions
which is closely connected with the attainment and with the use of material requisites of well being.

This definition clearly states that Economics is on the one side a study of wealth and on the other and more
important side a part of the study of man. Marshalls followers like Pigou, Cannon and Baveridge(the Neoclassical writers) have also defined Economics as:

Study of causes of material welfare.

For example, according to Cannon, the aim of Political Economy is the explanation of the general causes en
which the material welfare of the human being depends.

Characteristics:

The definitions given by Welfare School of Economists have the following main features of Economics as
Material Welfare:

(i) Wealth is not the be all and the end all of human activities: Economics does not regard wealth as the be all
and the end all of the human activities. It is only a mean to the fulfillment of an end which is human welfare.
Welfare and not wealth is; therefore, of primary importance to man.

(ii) Study of an ordinary man: Economics is a study of an ordinary man who lives in free society. A person who
is cut away from the society is not the subject of study of Economics.

(iii) It does not study all activities of man: Economics does not study all the activities of man. It is concerned
with those actions which can be brought directly or indirectly with the measuring rod of money.

(iv) Study of material welfare: Economics is concerned with the ways in which man applies his knowledge,
skill to the gifts of Nature for the satisfaction of his material welfare.

For a long time, the definition of Economics given by Alfred Marshall was generally accepted. It enlarged the
scope of economics by taking emphasis that its studies wealth and man rather than wealth alone.

However, Marshalls definition was criticized by Lionel Robbins. He in his book Essay on the Nature and
Significance of Economic Science gave a critical review of the welfare definitions of economics. These
criticisms are summed as under:

Robbins's Criticism:

(i) Narrows down the scope of economics: According to Robbins, the use of the word Material in the
definition of Economics considerably narrows down the scope of Economics. There are many things in the world
which are not material but they are very useful for promoting human welfare. For example, the services of
doctors, lawyers, teachers, dancers, engineers, professors, etc., satisfy our wants and are scarce in supply. If we
exclude these services and include only material goods, then the sphere of economics study will be very much
restricted.

(ii) Relation between economics and welfare: The second objection raised by Robbins on welfare definition is
on the establishment of relation between Economics and Welfare. According to him, there are many activities
which do not promote human welfare, but they are regarded economic activities, e.g., the manufacturing and sale
of alcohol goods or opium, etc. Here Robbins says, Why talk pf welfare at all? Why not throw away the mask
altogether?

(iii) Welfare is a vague concept: The third objection levied by him was on the concept of welfare. In his
opinion welfare is a vague concept. It is purely subjective. It varies from man to man, from place to place and
from age to age. Moreover, he says what is the use of a concept which cannot be quantitatively measured and on
which two persons cannot agree as to what is conducive to welfare and what is not. For example, the
manufacturing and sale of guns, tanks and other war heads, production of opium, liquor etc., are not conducive to
welfare but these are all economic activities. Hence, these cannot be excluded from the study of economics.

(iv) Impractical: The definition of welfare is of theoretical nature. It is not possible in practice to divide mans
activities into material and non-material.

(v) It involves value judgment: Finally, the word Welfare' in the definition involves value judgment and the
economists according to Robbins, are forbidden to pass any verdict.

Elasticity and Price elasticity of Demand

What is 'Elasticity'
Elasticity is a measure of a variable's sensitivity to a change in another variable.

In business and economics, elasticity refers the degree to which individuals, consumers
or producers change their demand or the amount supplied in response to price or
income changes. It is predominantly used to assess the change in consumer demand as a
result of a change in a good or service's price.

For example, if the quantity demanded for a good increases 15% in response to a 10% decrease in
price, the price elasticity of demand would be 15% / 10% = 1.5.
When the value of elasticity is greater than 1, it suggests that the demand for the good or
service is affected by the price, A value that is less than 1 suggests that the demand is
insensitive to price.
Elasticity is an economic concept that's used to measure the change in the aggregate quantity
demanded for a good or service in relation to price movements of that good or service. A product is
considered to be elastic if the quantity demand of the product changes drastically when its price
increases or decreases. Conversely, a product is considered to be inelastic if the quantity demand of
the product changes very little when its price fluctuates.
For example, insulin is a product that is highly inelastic. For diabetics who need insulin, the
demand is so great that price increases have very little effect on the quantity demanded. Price
decreases also do not affect the quantity demanded; most of those who need insulin aren't holding
out for a lower price and are already making purchases.
On the other side of the equation are highly elastic products. Bouncy balls, for example, are highly
elastic in that they aren't a necessary good, and consumers will only decide to make a purchase if
the price is low. Therefore, if the price of bouncy balls increases, the quantity demanded will
greatly decrease, and if the price decreases, the quantity demanded will increase.

The Importance of Price Elasticity in Business

Understanding whether or not a business's product or service is elastic is integral to the
success of the company. Companies with high elasticity ultimately compete with other businesses
on price and are required to have a high volume of sales transactions to remain solvent. Firms that
are inelastic, on the other hand, have products and services that are must-haves and enjoy the
luxury of setting higher prices.
The degree to which the quantity demanded for a good changes in response to a change in price can
be influenced by a number of factors. Factors include the number of close substitutes (demand is
more elastic if there are close substitutes) and whether the good is a necessity or luxury
(necessities tend to have inelastic demand while luxuries are more elastic).
Businesses evaluate price elasticity of demand for various products to help predict the impact of a
pricing on product sales. Typically, businesses charge higher prices if demand for the product is
price inelastic.

What Is Consumer Surplus?

At first glance, the term 'consumer surplus' might seem like it just means more than enough or an over
abundance for consumers. However, based on current economic research, consumer surplus is defined as
the difference of consumers willingness to pay for a product, service or good and the actual price of it. In
other words, the difference between what we will pay compared to the actual price of something determines
the amount of surplus. Actual price is initial price of the product.

What Determines Surplus?

Surplus is based on the consumer's individual perception. Since the surplus is the difference of what the
consumer is willing to pay versus what the consumer actually pays, we have to understand what determines
this difference. In economics, we say that this difference is determined by the value placed on the product,
good or service. The value could be associated with the enjoyment, happiness, longevity, endurance,
security and/or satisfaction produced by purchasing the item. For example, my willingness to pay over the
actual price for a leather jacket is based on the value of longevity, endurance and enjoyment.

Who Creates Consumer Surplus?

We, the people are the consumers. We create surplus. People as consumers drives the cost of goods or
services based on desires and demand. Before an item hits the market, producers and manufacturers
have already researched the probability of consumers' purchases and a range of how much they may
pay for it. This is done with various tools like surveys, coupons or market testing. For example, before that
new toy robot hits the market, the manufacturer has determined which demographics to market to, what type
of advertisement to use and what should be an initial price. However, the value the consumers place on the
purchase is what ultimately determines the surplus based on what they are willing to pay over the actual
price.

A Consumer Surplus Formula

Consumer Surplus = willingness to pay - actual price

Lets take the toy robot scenario and plug in these numbers into the formula:

Actual price of product = $10.

Amy is willing to pay $15 for the product.

Amy's surplus is $5.

$15 - $10 = $5
You go into a store and find a sweater that you like. The price tag on it is $50. You don't notice another sign saying that
there's a sale on these items and that the discount is 40%. You decide you value the sweater more than $50 and so you
go to the sales clerk to buy it. When she goes to ring you up, she tells you that there's a 40% discount. So you pay $30.
You get at least $20 in consumer surplus.

When graphed, the market surplus is equal to the

area under the demand curve which is above the
market price.

Prof. Hicks theory of consumer behavior

Theory of consumer behaviour:
Introduction:
Consumer has a pivotal role in the economic activity. He consumes goods and services for the
satisfaction of his wants. Satisfaction of wants is the beginning and end of all economic activity.
Thus micro economics analysis always begins with the understanding of the consumers
behaviour by investigating into fundamental basis of demand. Stanley Jevouns a noted
classical economist originated the concept of utility as the fundamental basis of consumers
demand for a commodity. The term utility refers to the want satisfying power of a commodity or
service assumed by a consumer to constitute his demand for that commodity or service.
Utility thus is an introspective or subjective term. It relates to the consumers mental attitude
and experience regarding a given commodity or service. Thus, utility of a commodity may differ
from person to person. Utility is a relative term it depends on time and place. Thus, the
consumer may experience a higher or lesser utility for the same commodity at different times
and different places. Moreover, utility has no ethical or moral consideration. A commodity that
satisfies any type of want whether morally good or bad has utility. Further utility is not
necessarily equaled with usefulness. A commodity may have utility, a power to satisfy some
want but, it may not be useful to the consumer. For example: a Cigarette has utility to a smoker
but it is injurious to his health. Utility is the function of intensity of want. A want which is
unsatisfied or greatly intense will imply a high utility for the commodity concerned to a person.
But a want is satisfied in the process of consumption it tends to become less intense than
before. As such the consumer tends to experience a lesser utility of that commodity than
before. Such an experience is very common and it is described as the tendency of diminishing
utility experienced with the increase in consumption of a commodity. In other words more of a
commodity we have, the less we want it.
Utility and satisfaction:
The term utility is, however, distinct from satisfaction. Utility implies potentiality of satisfaction in
a commodity. It serves as a basis to induce the consumer to buy the commodity. But, the real
satisfaction is the end result of the consumption of a given commodity.
Though utility and satisfaction are psychological, there is a distinctive gap between the two
experiences. Utility is anticipation of satisfaction visualized. Satisfaction is the actual
realization. Sometimes, satisfaction derived from the consumption of a commodity may be less
or more than what is expected in the visualization of utility. For example when a consumer
buys a motor car and if it starts giving him trouble his satisfaction so realized from the use of
the motor car will be less than what he had estimated about his utility. Nonetheless in economic
theory for the sake simplicity and convenience in analysis, economist usually assumes utility
and satisfaction as synonymous terms.
Measurement of utility:
Utility being an introspective phenomenon cannot be directly measured in a precise manner.
Economist however adopted an indirect measurement of utility in terms of price a consumer is
willing to pay for a given commodity. When a consumer is willing to pay a high price for a
commodity, it means there is high utility estimated by him for that commodity and vice versa.
But, this is just a rough indication it suggests no precise and proportionate measurement of
utility.
From the stand point of theory, however, there are 2 basic approaches to the measurement of
utility namely:
1. Cardinal approach
2. Ordinal approach
The cardinal measurement of utility was propounded by prof. Alfred Marshall and his followers.
According to them utility of a commodity is quantifiable hence measurable numerically. They
assume that for a consumer an apple may yield 10 utils (utils is the term used by Marshall for
expressing the measurement of imaginary units of utility or satisfaction) while mango may yield
30 utils. Thus, utility of a mango is 3 times more in proportion to a utility of an apple. Such a
numerical measure is imaginary. When a utility statement is tabulated as a schedule of utility, it
is referred to as the cardinal measurement of utility.
The terms cardinal and ordinal have been taken from mathematics. The numbers 1,2,3,4,5,6,
etc are cardinal in the sense that number 6 is twice the size of number 3 and number 4 is twice
the size of 2. In the cardinal analysis, the utility contained in commodities are made
quantifiable. For example: an orange may yield to a consumer utility of 10 units whereas a
mango yields 20 units. From this it is clear that the consumer derives twice as much utility from

a mango compared to an orange. The units of measurements are purely imaginary and the
cardinal analysis termed the imaginary units of utility of utils.
On the other hand Prof Hicks Allen and their followers among the modern economists have
suggested an ordinal measurement of utility. In their view utility cannot be quantified so its
numerical expression is unrealistic.
The ordinal measurements are 1st, 2nd, 3rd, 4th, 5th, 6th etc. It is not possible from this
ranking to know the actual size of related number. The 2nd need not be twice as that of 1st, the
size may be of any pattern. For example: 1st, 2nd, 3rd, could be 10, 15, 25, or 10, 20, 45 or
55, 65, 95 etc. According to ordinalists, utility being subjective and a mental concept cannot be
measured and to quantify utility is absurd.
Ordinal approach contains that the theory of consumer behaviour can be explained or analyzed
even without measuring utility as the cardinal approach does. In the all ready stated example
the ordinalists say that the consumer prefers a banana to an orange and rank the
commodities in the scale of preferences without taking the trouble of measuring the
imaginary quantum of utility. This method of ordinal approach is also called indifference
curve approach.
Dr. Alfred Marshall and his followers advocated the cardinal approach to utility, while, the
modern economists like Hicks, Allen, supported the ordinal approach. Hence the cardinal
approach has come to be known as, Marshallian utility analysis and the ordinal approach is
called Hicksians indifference approach.
1. Define the concept of consumer's equilibrium through in indifference curve analysis. Explain its
properties as well.
Introduction
The goal of a consumer is to get maximum satisfaction from the commodities he purchases. At the
same time, the consumer possesses limited resources. Hence, he is trying to maximize his satisfaction
by allocating the available resources (money income) among various goods and services rationally.
This is the main theme of the theory of consumer behavior. Further, you could ascertain that a
consumer is in equilibrium when he obtains maximum satisfaction from his expenditure on the
commodities given the limited resources. You can analyze consumers equilibrium through the
technique of indifference curve and budget line.
Assumptions
1. The consumer under consideration is a rational human being. This means that the consumer
always tries to maximize his satisfaction with limited resources.
2. There prevails perfect competition in the market.
3. Goods are homogeneous and divisible.
4. The consumer has perfect knowledge about the products available in the market. For instance,
prices of commodities.
5. Prices of commodities and consumers money income are given.
6. Consumers indifference map remains unchanged throughout the analysis.
7. Consumers tastes, preferences and spending habits remain unchanged throughout the
analysis.

Price Line or Budget Line

Price line or budget line is an important concept in analyzing consumers equilibrium. According to Prof.
Maurice, The budget line is the locus of combinations or bundles of goods that can be purchased if the
entire money income is spent.
Table 1
Total Amount Spent on X +
X (units)
Y (units)
Y (in $)
4
0
8+0=8
3
2
6+2=8
2
4
4+4=8
1
6
2+6=8
0
8
0+8=8
Suppose there are two commodities, namely X and Y. Given the market prices and the consumers
income, the price line shows all the possible combinations of X and Y that a consumer could purchase
at a particular time. Let us consider a hypothetical consumer who has a fixed income of $8. Now, he
wants to spend the entire money on two commodities (X and Y). Suppose the price of commodity X is

$2, and the price of commodity Y $1. The consumer could spend all money on X and get 4 units of
commodity X and no commodity Y. Alternatively, he could spend entire money on commodity Y and get
8 units of commodity Y and no commodity X. The table given below exhibits the numerous
combinations of X and Y that the consumer can purchase with $8.

In figure 1, horizontal axis measures commodity X and vertical axis measure commodity Y. The budget
line or price line (LM) indicates various combinations of commodity X and commodity Y that the
consumer can buy with $8. The slope of the budget line is OL/OM. At point Q, the consumer is is able to
buy 6 units of commodity Y and 1 unit of commodity X. Similarly, at point P, he is able to buy 4 units of
commodity Y and 2 units of commodity X.
The slope of the price line (LM) is the ratio of price of commodity X to price of commodity Y, i.e., P x/Py.
In our example, price of commodity X is $2 and price of commodity Y is $1; hence, the slope of the
price line is Px. Note that the slope of the budget line depends upon two factors: (a) money income of
the consumer and (b) prices of the commodities under consideration.
Reasons for Many Budget Lines
(a) Consumers Income Change
An outward parallel shift in the budget line occurs because of an increase in consumers money income
provided that the prices of commodities X and Y remain unchanged (it means constant slope - P x/Py).
Likewise, a reduction in consumers money income creates a parallel inward shift in the budget line.

In figure 2, LM denotes the initial price line. Assume that the prices of the two goods and consumers
money income are constant. Now, the consumer is able to purchase OM quantity of commodity X or OL
quantity of commodity Y. If his income increases, the price line shifts outward and becomes L 1M1. He
can now buy OM1quantity of commodity X and OL1 quantity of commodity Y. A further increase in
income causes a further outward shift in the price line to L 2M2. Price line L2M2indicates that the
consumer can buy OM2 quantity of commodity X and OL2quantity of commodity Y. Similarly, if there is a
decrease in consumers income, the price line will shift inward (for example, L 3M3).
Indifference Map

A set of indifference curves that shows a consumers preferences is known as an indifference map. The
indifference map of a consumer, since is composed of indifference curves, exhibits all properties of a
normal indifference curve. Some of the most important properties of an indifference curve are:
indifference curves are convex to the origin; they always slope downwards from left to right; higher
indifference curves indicate higher levels of satisfaction; they do not touch any of the axes (example:
figure 4).
Necessary conditions for consumers equilibrium
The following are the two important conditions to attain consumers equilibrium:
Firstly, marginal rate of substitution must be equal to the ratio of commodity prices. Symbolically,
MRSxy = MUx/MUY = Px/Py.
Secondly, indifference curve must be convex to the origin.
Consumer's Equilibrium
Now we have both budget lines and indifference map of the consumer. A budget line represents
consumers limited resources (what is feasible) and indifference map represent consumers preferences
(what is desirable). The question now is that how the consumer is going to optimize his limited
resources. An answer for this question would be consumers equilibrium. In other words, the
consumers equilibrium means the combination of commodities that maximizes utility, given the budget
constraint. To obtain consumers equilibrium graphically, you just need to superimpose the budget line
on the consumers indifference map. This is shown in figure 5.

At point E, consumers equilibrium is attained. Because the indifference curve IC 2is the best possible
indifference curve that the consumer can reach with the given resources (budget line). The tangency of
indifference curve IC2 and the price line represent the above statement. At the point of tangency, the
slope of the budget line (Px/Py) and the marginal rate of substitution (MRS xy = MUx/MUy) are equal:
MUx/MUy = Px/Py (first condition for consumers equilibrium). From figure 5, we can understand that the
second condition for consumers equilibrium (indifference curve must be convex to the origin) is also
fulfilled.
A small algebraic manipulation in the above equation gives us MU x/Px = MUy/Py, which is the marginal
utility per dollar rule for consumers equilibrium. Thus, all the conditions for consumers equilibrium are
fulfilled. The combination (X0Y0) is an optimal choice (point E) for the consumer.

law of equi-marginal utility

The Law of equimarginal Utility is another fundamental
principle of Economics.
This law is also known as the Law of substitution or
the Law of Maximum Satisfaction.
We know that human wants are unlimited whereas the means
to satisfy these wants are strictly limited. It, therefore becomes
necessary to pick up the most urgent wants that can be satisfied
with the money that a consumer has. Of the things that he
decides to buy he must buy just the right quantity. Every
prudent consumer will try to make the best use of the money at
his disposal and derive the maximum satisfaction.

Assumptions of the Law of Equi Marginal Utility:

There is no change in the prices of the goods.

The income of consumer is fixed.
The marginal utility of money is constant.
Consumer has perfect knowledge of utility
obtained from goods.
Consumer is normal person so he tries to seek
maximum satisfaction.
The utility is measurable in cardinal terms.
Consumer has many wants.
The goods have substitutes.

Explanation of the Law:

In order to get maximum satisfaction out of the funds we have,
we carefully weigh the satisfaction obtained from each rupee
had we spend If we find that a rupee spent in one direction has
greater utility than in another, we shall go on spending money
on the former commodity, till the satisfaction derived from the
last rupee spent in the two cases is equal.
It other words, we substitute some units of the commodity of
greater utility tor some units of the commodity of less utility.
The result of this substitution will be that the marginal utility of
the former will fall and that of the latter will rise, till the two
marginal utilities are equalized. That is why the law is also
called the Law of Substitution or the Law of equimarginal
Utility.
Suppose apples and oranges are the two commodities to be
purchased. Suppose further that we have got seven rupees to
spend. Let us spend three rupees on oranges and four rupees on
apples. What is the result? The utility of the 3rd unit of oranges
is 6 and that of the 4th unit of apples is 2. As the marginal
utility of oranges is higher, we should buy more of oranges and
less of apples. Let us substitute one orange for one apple so that
we buy four oranges and three apples.
Now the marginal utility of both oranges and apples is the
same, i.e., 4. This arrangement yields maximum satisfaction.
The total utility of 4 oranges would be 10 + 8 + 6 + 4 = 28 and
of three apples 8 + 6 + 4= 18 which gives us a total utility of 46.
The satisfaction given by 4 oranges and 3 apples at one rupee

each is greater than could be obtained by any other

combination of apples and oranges. In no other case does this
utility amount to 46. We may take some other combinations
and see.

We thus come to the conclusion that we obtain maximum

satisfaction when we equalize marginal utilities by substituting
some units of the more useful for the less useful commodity. We
can illustrate this principle with the help of a diagram.

Limitations of the Law of Equimarginal Utility:

Like other economic laws, the law of equimarginal utility too has
certain limitations or exceptions. The following are the main
exception.

(i) Ignorance:

If the consumer is ignorant or blindly follows custom or fashion,

he will make a wrong use of money. On account of his ignorance
he may not know where the utility is greater and where less. Thus,
ignorance may prevent him from making a rational use of money.
Hence, his satisfaction may not be the maximum, because the
marginal utilities from his expenditure cannot be equalised due to
ignorance.

(ii) Inefficient Organisation:

In the same manner, an incompetent organiser of business will fail

to achieve the best results from the units of land, labour and
capital that he employs. This is so because he may not be able to
divert expenditure to more profitable channels from the less
profitable ones.

(iii) Unlimited Resources:

The law has obviously no place where this resources are unlimited,
as for example, is the case with the free gifts of nature. In such
cases, there is no need of diverting expenditure from one direction
to another.

(iv) Hold of Custom and Fashion:

A consumer may be in the strong clutches of custom, or is inclined

to be a slave of fashion. In that case, he will not be able to derive
maximum satisfaction out of his expenditure, because he cannot
give up the consumption of such commodities. This is specially
true of the conventional necessaries like dress or when a man is
addicted to some intoxicant.

(v) Frequent Changes in Prices:

Frequent changes in prices of different goods render the

observance of the law very difficult. The consumer may not be able
to make the necessary adjustments in his expenditure in a
constantly changing price situation.
Importance:

The law of equi marginal utility is helpful in the field of production. The producer has limited
resources. He uses limited resources to purchase production factors. He tries to equalize
marginal utility of all factors. He wishes to get maximum output and profit.
National income is distributed among factors of production according to this law. An
entrepreneur can pay factors of production equal to marginal product measured in money

terms. He will substitute one factor for another until marginal productivity of all factors is equal
to prices of their services.
The law is used in the field of exchange. The people like to exchange a commodity having low
utility with a commodity having high utility. There is maximum benefit from exchange of
commodities. The law is helpful in exchange of wealth, trade, import and export.
The law is applicable in consumption. A rational consumer tries to get maximum satisfaction
when he spends his limited resources on various things. He tries to equalize weighted marginal
utility of all the things.
The law is applicable in public finance. The government can spend its revenue to get maximum
social advantage. The marginal utility of each dollar spent in one sector must be equal to
marginal utility derived from all other sectors.
The law is useful for workers in allocating the time between work and rest. They can compare
the marginal utility of work and the marginal utility of rest. They can decide working hours and
rest hours.
The law holds well in case of saving and spending. The consumer can make choice between
present wants and future wants. He can feel that a dollar saved has greater utility than a dollar
spent, he can save more and spend less. He will substitute saving and spending till marginal
utility of a dollar spent and a dollar saved are equal.
The law is helpful in prices. Due to scarcity of commodity its prices go up. The law tells us to
use substitute commodity, which is less scarce. The result is that the price of commodity comes
down.

2. Define utility? Explain the cardinal law of utility?

3. Define and explain objectives of a firm in detail using graphs and tables if necessary.
4. Demonstrate income and substitution effects on different types of goods.

Final Term Syllabus

5. Define optimum firm. What is the optimum level of production for the firm?
6. The law of diminishing returns is only one phase of the universal law of
variables proportions. Explain.
7. State and explain
diagrammatically.

the

law

of

variables

proportions.

Illustrate

8. Define monopoly. How price and output is determined under monopoly in

short run and long run?
9. Explain different short run cost functions with the help of schedule and
diagram
10.
Explain the classification of markets according to nature of
commodity, extent, time and degree of competition.
11.
Define perfect competition. How price and output is determined
under perfect competition in short run and long run.
12.
Define monopoly. How price and output is determined under
monopoly in short run and long run?
13.
Explain different short run cost functions with the help of schedule
and diagram.
14.
Why should a market be regulated and discuss role of government in
its regulation.