UTILITY ANALYSIS

Introduction:
A consumer demands a good or a service. He demands a good
b e c a u s e i t g i v e s h i m utility. Wants – satisfying capacity of a good is called utility.

Meaning of Utility:
The term utility in economics is used to denote that quality in a commodity or service by
virtue of which our wants are satisfied. In other words, want – satisfying power of a good is called
utility.

Definitions:
•
According to Jevons, “Utility refers to abstract quality whereby an object serves our purpose.
•
In the words of Hibdon, “Utility is the quality of good to satisfy a want.”
•
According to Mrs. Robinson, “Utility is the quality in commodities that makes
individuals wants to buy them”.

Features:

1. Utility is Subjective:
as it deals with the mental satisfaction of a man. A thing may have different utility to
different persons. E.g. Liquor has utility for drunkard but for  person who is teetotaler, it has no
utility.
2. Utility is Relative:
As a utility of a commodity never remains the same. It varies with time and place. E.g. Cooler
has utility in summer not during winter season.3.
3. Utility is not essentially useful:
A commodity having utility need not be useful. E.g. Liquor and cigarette are not useful, but if
these things satisfy the want of addict then they have utility for him. 4.
4. Utility is independent of Morality:
It has nothing to do with morality. Use of opiumliquor may not be proper from moral point
of view, but as these intoxicants satisfy wants of the opium – eaters, drunkards, they
have utility.

Concepts of Utility:
1) Initial Utility:
The utility derived from the first unit of commodity is called initialutility. It is
obtained from the consumption of the first unit of a commodity. It is always positive.2)

2) Total Utility: The aggregate of utility obtained from the consumption of

differentunits of a commodity, is called Total utility.1
Tux=f(Qx)
Tux = total utility of x is a function (f) of quantity of commodity x.

 
3. Marginal Utility:
The change that takes place in the total utility by the consumptionof an additional unit of
commodity is called marginal utility.

Marginal utility can be:

a) Positive Marginal Utility:
If by consuming additional units of commodity, totalutility goes on increasing, then marginal
utility of these units will be positive. b)

Zero Marginal Utility:
I f t h e c o n s u m p t i o n o f a d d i t i o n a l u n i t o f c o m m o d i t y causes no change in the total
utility, it means the marginal utility of additional unitis zero.c)

Negative Marginal Utility:
I f   t h e   c o n s u m p t i o n   o f   a n   a d d i t i o n a l   u n i t   o f   a commodity causes fall in total
utility, it means the marginal utility is negative.

Relation between Total Utility and Marginal Utility:

Total utility is the summation of the marginal utilities of different units of a commodity.

Table shows that:

a) As more and more units of commodity is consumed, the marginal

utility derivedfrom each successive unit goes on diminishing. But the total utility increases up
toa limit.

2 MUnth = Tn – Tn-1 or MU = change TU/ change Q

MUnth = Marginal utility of nth unit.Tn = total utility of n units.Tn-1 = total utility of n-1
unitsChange TU = change in total utilityChange Q = change in the quantity of commodity
TU = Sum of MU
Total utility is summation of Marginal utility

 
  b) Marginal utility of the first four units being positive, the total utility goes on
increasing. Thus as long as the marginal utility of the commodity remains positive, total utility
goes on increasing.

c) Marginal utility of the fifth unit is zero. In this situation total utility (20) will bemaximum.
This situation also represents point of saturation.
d) Marginal utility of the sixth unit is negative. As a result of it, total utility of six units of the
commodity falls from 20 to 18 units.

Assumptions:
1. Utility can be measured in the Cardinal number system.
2. Marginal Utility of money remains constant.
3. Marginal Utility of every commodity is independent.
4. Every unit of the commodity being used is of same quality and size.
5. There is a continuous consumption of commodity
6. Suitable quantity of a commodity is consumed.
7. There is no change in the income of consumer.
8. There is no change in the price of commodity and its substitutes.
9. There is no change in the tastes, character, fashion, and habits of consumer.

Exceptions:
Law does not apply under the following situations:

Curious and rare things

L a w d o e s n o t a p p l y t o r a r e o r c u r i o u s t h i n g s l i k e  persons who collect old and
rare coins, postage stamps as increasing marginal utility as the stock of these rare articles
goes on increasing. They are always keen to obtain more and more units of such things.

Misers
It seems law does not apply to misers who are out to acquire more and more of
wealth. Their desire for money seems to be insatiable.

Good book or poem

I t i s s a i d t h a t b y r e a d i n g a g o o d b o o k o r l i s t e n i n g t o a melodious song and a
beautiful poem again and again one gets more utility than  before.

Drunkards
It can be said that when a drunkard takes a liquor and intoxicant than as he takes more and
more pegs of liquor his desire to have more of it goes on increasing.

Initial units
W h e n   t h e   i n i t i a l   u n i t s   o f   a   c o m m o d i t y   i n   u s e d   i n   l e s s   t h e n ap
propriate quantity, then the marginal utility from the additional units goes
onincreasing.In short, Prof Taussig has rightly said that the tendency of law
of diminishing marginalutility is so widely relevant that it would not be wrong to call it as
universal law.
Causes of its application:
Commodities are imperfect substitutes.
According to this law it applies
becausec o m m o d i t i e s   a r e   i m p e r f e c t   s u b s t i t u t e s .   I n   o t h e r   w o r d   o n e   c o m m o d i t y 
c a n n o t always be used for other commodity. Example tea in place of coffee or vice versa.2.

Satiability of particular wants

Another cause of its application is that there ishardly any particular want which
cannot be fully satisfied. As before arriving at saturation point total utility increases at a
diminishing rate and at saturation pointis no increase in it.3.

Alternative uses
Each commodity has many alternative uses. Some uses are moreimportant while others are less.
Example every consumer gives first priority to themost important use. If we have to give
little quantity of milk, it will be used for  feeding the infant only, but if we have large
quantity of milk then after feeding theinfant rest can be used for making tea for elders or for
making curd etc.

Importance of the law

Basis of the law of consumption
Law of diminishing marginal utility is the basisof all law of consumption. There are three laws of
consumption:

a) Law of equi marginal utility

According to this law a consumer does nots p e n d a l l h i s i n c o m e o n o n e c o m m o d i t y .
I n o r d e r t o g e t t h e m a x i m u m satisfaction the consumers spends his income in
such a way that the lastunit of money spent on different commodities yield equal marginal
utility.
 b) L a w o f d e m a n d
A c c o r d i n g t o t h i s l a w a c o n s u m e r w i l l d e m a n d m o r e units of a commodity at low
price.

c) Concept of consumer surplus

According to this concept unit prior to themarginal unity yield more utility. This surplus
utility is called consumer surplus

Variety in production and consumption

It is because of the operation of the lawof diminishing marginal utility that variety in
production and consumption
isf o u n d .   C o n t i n u o u s   c o n s u m p t i o n   o f   o n e   c o m m o d i t y   w i l l   y i e l d   l e s s   a n d   l e s
sm a r g i n a l   u t i l i t y   t o   t h e   c o n s u m e r s .   S o   e v e r y   p r u d e n t   c o n s u m e r   s t o
p s   t h e consumption of that good after a particular limit and shift to other commodity
Difference between value in use and value in exchange
According to AdamSmith goods having more value in use command low price and those
having morev a l u e i n e x c h a n g e c o m m a n d h i g h p r i c e . I t c a n b e e x p l a i n e d o n
t h e b a s i s o f   diminishing marginal utility as there is abundant supply of water air
etc and thes a m e c a n b e u s e d i n l a r g e q u a n t i t y , c o n s e q u e n t l y t h e r e m a r g i n a l
utility fallsr a p i d l y a n d s o i s t h e p r i c e . T h u s g o o d s h a v i n g m o r e
v a l u e i n u s e h a v e l e s s marginal utility.

Price determination
Price of every commodity is determined by its demand andsupply. Demand for a commodity
depends upon its marginal utility. The consumer  buys more units only when the price per unit
falls.

Basis of progressive taxation

Progressive taxation system refers to that system of taxation under which rate of taxation
increases as the income of person increases.I t i s s o b e c a u s e w i t h i n c r e a s e i n i n c o m e
m a r g i n a l u t i l i t y o f m o n e y g o e s o n diminishing.

Advantage to the consumer

According to this law, in order to get maximumsatisfaction from the consumption of
a good a consumer should buy only that many units of it whose marginal utility is equal to
its price.

Basis of redistribution
A c c o r d i n g   t o   t h i s   l a w   t h e   f u n d a m e n t a l   r e a s o n   o f   redistribution of income
is that marginal utility of money to the rich is less then to poor. So it wealth is redistributed in
favor of poor, total welfare of society would increase money spent on present consumption
should yield the same utility as the last unit of money kept in the form of saving. Such a
distribution is called optimum allocation.
Optimum distribution of commodities
Optimum distribution of commodities refersto that distribution, a slight change whereof may
diminish the total utility enjoyed bysociety as a whole. Optimum distribution becomes
possible when a commodity isdistributed among different persons in such a way that
marginal utility derives fromeach person becomes equal.

Distribution of assets:
This law helps people distribute their assets in differentforms like bank deposits,
bonds, stock, share etc. According to this law, investment s h o u l d b e m a d e i n
d i f f e r e n t f o r m o f a s s e t s i n s u c h a w a y t h a t l a s t u n i t o f m o n e y invested in
each form should yield equal marginal utility.
Criticism of the Law:
1. Consumers are not fully rational
T h e a s s u m p t i o n t h a t c o n s u m e r s a r e n o t f u l l y rational is not correct. Some
consumers are idle by nature, and so to satisfy their  habits and customs, they
sometimes buy goods yielding less utility. Consequently they do not get maximum
satisfaction.

2. Consumer is not calculating.

T h e l a w i s b a s e d o n w r o n g a s s u m p t i o n t h a t w h i l e spending his income a consumer
constantly calculates the utility derived by him
outo f   e a c h   r u p e e   s p e n t .   I n   a c t u a l   l i f e   o n e   h a r d l y   c o m e s   a c r o s s   s u c h  
a   c a l c u l a t i n g consumer. So the application of this law is practically difficult.

3. Shortage of goods
If goods giving more utility are not available in the market, the consumption will
have to consume goods yielding less utility.

4. Influence of Fashion, Customs and Habits

Actual expenditure of every consumer is
influenced by fashion, customs, and habits. Under their influence, many
a   t i m e consumer buys more of such goods which give less utility.

5. Ignorance of the Consumer

Consumer is ignorant about many things concerning consumption. He is ignorant
about right price of goods, less expensive substitute, different uses of goods. The
consumer fails to spend his income in a manner that may yield him maximum satisfaction.

6. Indivisibility of Goods
T h e l a w d o e s n o t a p p l y t o t h o s e g o o d s w h i c h c a n n o t b e divided into small parts
e.g. Car, LCD etc.

7. Constant Incomes and price

I n c o m e o f c o n s u m e r i s l i m i t e d a s s u c h h e c a n n o t increase his satisfaction beyond
a particular limit. Likewise, prices being constant, he will get only as much of satisfaction as the
amount of goods that he can buy with his limited income.12
 
8. Indefinite Budget period
The budget period of consumer is not definite. Budget  periods refer to that period in
which a consumer has to spend his income of different uses. It may be a month or an year. Goods
like TV Set, Refrigerator are bought in one budget period, but they continue to yield utility over
many budget periods.
9. Cardinal measurement of utility is not possible
U t i l i t y c a n n o t b e m e a s u r e d i n cardinal number system. How can a consumer say he
would get 12 utils of utility from f i r s t   m a n g o   a n d   1 0 u t i l s
f r o m   s e c o n d ?   U n l e s s   t h e   m a r g i n a l   u t i l i t y   i s   e s t i m a t e d application of the law
remains dubious.

10.Change in the marginal utility of money

In actual life marginal utility of money may increase or decrease. When a consumer
buys more goods, he is left with less amount of money. Smaller the amount of
money higher is its marginal utility. As a result of it application of the law will
become pretty difficult.

11. Complementary goods

The law does not apply to complimentary goods because they are used in fixed
proportion. By using less of one commodity, use of other can not be increased. In
short, Chapman has rightly said about this law, “We are not, of course, compel to
distribute our income according to the law of substitution or Equi-marginal expenditure, a s a
stone thrown in the air is compelled, in a sense to fall back to the earth
b u t a s a matter of fact, we do so in a certain rough fashion because we are reasonable”.

Criticism of utility analysis:

Economists like Edge worth, Pareto, Hicks, Allen, and Samuelson etc. have
criticized utility analysis on the following grounds:

1.
Utility is subjective
A s i t r e l a t e s t o m a n ’ s p s y c h o l o g y . I t i s n o t p o s s i b l e t o objective about it. But the
analysis of consumer’s demand based on it is objective.

2.
Cardinal measurement of Utility is not possible
Utility cannot be measured incardinal number system like 1,2,3 because, utility derived
from different goodscan neither be added or subtracted.

3.
Every commodity is not an independent commodity
It means that utility of acommodity is very much dependent upon the utility of other
commodities. Nocommodity is independent commodity.

4.
Marginal utility cannot be estimated in all conditions
It can only be measuredwith commodities that can be measured which are divisible.

5.
Marginal utility of money does not remain constant.
As the quantity of moneywith a person increases, its marginal utility diminishes and as
the quantity of money decreases, its marginal utility increases.
 
6.
Too many assumptions.
Practicability of any theory depends on its
practicala s s u m p t i o n s .   M a n y   a s s u m p t i o n s   l i k e   C a r d i n a l   n u m b e r   s y s t e m ,   i n d e
p e n d e n t commodities etc. are unrealistic and impracticable.

7.
No division of price effect between income effect and substitution effect
As it does not indicate that when as a result of change in price, demand changes,
how much of this changed demand is due to change in real income(Income effect), and how
much due to substitution of good for the expensive one (Substitution effect).

8.
Consumer is regarded as computer
According to this analysis while spending his money, consumer always compares the
amount of gain he will have by way of utility of the commodity purchased with the loss that he
will have to suffer by the way of sacrifice of the money spent. But in real life none of us is
calculating.

9.
Utility analysis breaks down in an under – developed planned economy
Utility analysis is based on the assumption that the taste of consumer
remainu n c h a n g e d .   i t   m a y   a l s o   b e   s o   f o r   a   s h o r t   p e r i o d   o n l y   b u t   i n   l
o n g   p e r i o d , consumer’s taste undergo a change. In a planned economy long – term
plans are formulated keeping in view a fact that in the long run demand of consumer
will change with change in taste.

10.
It does not explain Geffen’s paradox
.
 
As it has no answer to explain as to why demand curve of many inferior goods slopes
upward (positive slope) from left to right. In other words, why demand extend with rise in price
and why does demand contacts with fall in
price.I n   s h o r t ,   a l t h o u g h   u t i l i t y   a n a l y s i s   i s   b a s e d   o n   m a n y   u n r e a l i s t i c   a n d   i m
p r a c t i c a l assumptions, yet being the first theory seeking to determine consumer’s equilibrium,
it will continue to occupy an important place. It is worth mentioning that indifference analysis
and revealed preference analysis have their genesis in the scathing criticism of cardinal utility
analysis