Utility Analysis

Namrata K
The market of an economy comprises of two different groups of
participants: Consumers and Producers. Demand analysis focuses on
the behavior of consumers, while supply analysis examines the
behavior of producers. The consumer indirectly tells the producer what
she is willing to buy and how much she is willing to pay based on her
actual spending patterns. The producer supplies the product if she can
make a profit by doing so. The forces of demand and supply coordinate
to arrive at an equilibrium price and quantity of output which best
satisfies the consumers and reaps maximum profits to producers. The
concept of demand and supply is based on concept of Utility ….
Let’s understand Utility….
Human wants are unlimited and they are of different intensity. The means at the disposal
of a man are not only scarce but they have alternative uses. As a result of scarcity of
resources, the consumer cannot satisfy all his wants. He has to choose as to which want is
to be satisfied first and which afterward if the resources permit. The consumer is
confronted with making a choice.
For eg: if a man is hungry and goes to market, he purchases Chole Kulche instead of a
samosa or burger.Examining the economic forces which make him purchase a particular
commodity is: the consumer buys a commodity because it gives him more satisfaction.
Utility of a good is its expected capacity to satisfy a human want. To a consumer, the
utility of a good is the satisfaction which he expects from its consumption.
It is a subjective thing. It depends upon the mental assessment of the consumer and is
determined by several factors which influence the consumer’s judgment. These factors
include, for example, the intensity of the want(s) to be satisfied.
Thus it can be inferred:–
● Utility of a good differs from consumer to consumer. This is because a given
want can be felt in different intensities by different consumers.
●
● The utility of a good keeps changing even for the same consumer on account of
changes in the intensity of the want(s) to be satisfied by its use. This change may
be the result of a shift in the circumstances faced by the consumer, or it may take
place in the process of the satisfaction of the want itself.
●
● The utility of a good is not to be equated with its usefulness. Satisfaction of a
want need not add to the welfare of the consumer. For example, smoking, drug
taking or consumption of similar other things is believed to be harmful for the
health of the consumer. But the consumer believes that they have utility for him
because he can use these to satisfy his wants.
 What is Utility?

● Product angle: Want satisfying property of any product (absolute).

● Consumer angle: The psychological feeling of satisfaction or happiness

or well being or benefit derived by the consumer by the consumption of
certain units of a good or service at a certain point of time (subjective).
In the words of Hibbdon , “Utility is the Quality of a good to satisfy a want.” Thus
we can say that wants satisfying power of a commodity is called utility.
 Features of Utility

UTILITY IS SUBJECTIVE: It is subjective because it deals with the mental

satisfaction of a man.Eg. Medical books re not useful for commerce students.
UTILITY IS RELATIVE: Utility of a commodity never remains the same.it varies
across the time and place. E.g. Cooler has utility in the summer but not during winter.
UTILITY IS NOT ESSENTIALLY USEFUL: A commodity having utility need not
be useful. Liquor and cigarette are not useful, but to satisfy the want of an addict then
they gave utility for him.
UTILITY IS INDEPENDENT OF MORALITY: Utility has nothing to do with
morality.eg. Use of opium, liquor
UTILITY CAN BE MEASURED: Marshall assumes cardinal measurement of
utility.’Utils’
 Features of Utility

UTILITY DEPENDS ON THE INTENSITY OF WANT: A want which is

unsatisfied and greatly intense will imply a high utility for commodity concerned to
a person.

UTILITY IS CONCERNED WITH CONSUMER GOODS NOT WITH

PRODUCTIVE GOODS: eg.atta in restaurants (productive goods) does not give
direct satisfaction to customers, at home (consumer good)

UTILITY HAS NO PHYSICAL SHAPE: It is psychological concept and differs

from person to person , place to place ad time to time.

UTILITY DOES NOT DEPEND ON ACTUAL CONSUMPTION: the utility

starts the moment when he consumer thinks of buying a commodity and the
satisfaction is derived after the consumption of the commodity.
 Measurement of Utility

The need for measuring utility arises so that it can be used in the analysis of demand
behaviour of individual consumers, and therefore, of the market as a whole. The
basis of the reasoning is that a consumer compares utility of a good with the price
he has to pay for it. He keeps buying its additional units so long as the utility from
them is at least equal to the price to be paid for them. In economic theory, utility
can be measured in two ways:
– Cardinal Approach
– Ordinal Approach
 Measurement of Utility- Cardinal Utility

Cardinal utility approach assumes that utility can be measured in cardinal numbers
such as 1, 3, 10, 15, etc. The utility expressed in imaginary cardinal numbers tells us
a great deal about the preference of the consumer for a good.
In cardinal measurement, utility is expressed in absolute standard units, such as there
being 20 units of utility from the first loaf of bread and 15 units from the second.
Pareto, an Italian Economist, severely criticized the concept of cardinal utility. He
stated that utility is neither quantifiable nor addible. It can, however be compared.
He suggested that the concept of utility should be replaced by the scale of
preference.
 Measurement of Utility-Ordinal Utility
Ordinal utility approach is purely subjective and is immeasurable. Ordinal
measurement of utility is the one in which utility can not be expressed in absolute
units. Utility from two or more sources is only ‘ranked’ or ‘ordered’ according to
their preference in relation to each other.
Utility from one source may be ‘equal to’, ‘more than’ or ‘less than’ utility from
another source. But it is not possible to state the difference in absolute or
numerical units. The fact is that utility is a subjective thing and varies from person
to person and from one situation to another. For this reason, it is neither possible to
measure it in absolute terms, nor compare utility of a good for two individuals. This
implies that cardinal measurement of utility is only a theoretical phenomenon, and
has less validity in practice. Utility is best measured in ordinal terms.
 Measurement of Utility-Ordinal Utility
In a number of cases, analysis of demand decisions requires the use of a cardinal
measurement of utility. For this reason, economists adopted a standard unit of
measuring utility and called it ‘util’ (also frequently used in plural as ‘utils’). But
‘utils’ itself happens to a subjective, discretionary and imprecise measure and,
therefore, does not determine the demand behaviour of consumers.
To overcome this limitation, Marshall advocated that utility of a good to the
consumer should be measured in units of money which the consumer is willing to
pay for buying the commodity. For example, if a consumer is willing to pay, at the
most, 5 Rs. for the first bottle of a cold drink and only 4 Rs. for the second one, then
according to this approach, the utility of the first bottle to the consumer equals Rs. 5
and that of the second equals Rs. 4. This approach was widely accepted and seemed
to be useful in analyzing demand decisions of the consumers because, in practice,
the consumers pay for their purchases in monetary terms.
 Assumptions of Utility
Rational consumer

Cardinal utility-Measured in cardinal numbers 1,2,3,4,5 etc.

Independent Utility: it is assumed that the utility that a consumer gets from a commodity
depends upon the quantity of that commodity itself.it is not affected by the utility derived
from other goods.

Marginal Utility of money is constant

Divisibility

Diminishing marginal utility

Total Utility Depends on quantities of Individual Commodities: if there are ‘n’

commodities in the bundle with n1,n2,…nn quantities the total utility is U=f(n1,n2,…nn )
 Concepts of Total, Average and Marginal Utility
It is clear that utility of good X to the consumer is directly related to the intensity of the
want to be satisfied through its consumption which is explained as follows:
– For a given consumer, the three measures of utility depend upon the intensity of the want,
which he expects to satisfy.
– When a consumer consumes a good to satisfy his want, its intensity also undergoes a
change. Therefore, the three measures of utility are also affected by the stock of X with the
consumer.
– The intensity of a want being satisfied tends to change over time. The capacity of different
goods to satisfy wants also differs. These factors also cause a shift in the three measures of
utility.
– Generally speaking, wants are not felt with equal intensity by all consumers. Therefore,
the measures of utility tend to vary from consumer to consumer.
 Concepts of Total, Average and Marginal Utility
When a consumer consumes a good, the utility derived from it varies with its quantity, and
generates three concepts; namely

– Total Utility(TU) { TUn = Ui, i = 1, 2, 3, ............. n }

– Average Utility(AU) { AUn=TUn /n – MUn = TUn – TUn-1}

– Marginal Utility(MU){ MUof nth unit of consumption, MUn = dTU/dX}
If a consumer buys n units of a good X then, for him, Total utility (TU) from it is the
summation of utilities derived from all the n units. By dividing this total utility (TU) by
the number of units of X, i.e. n, the resultant is Average utility (AU). The additional
satisfaction a consumer gains from consuming one more unit of ‘X’ is Marginal utility
(MU) of that unit of X. Symbolically, if Ui stands for the utility of ith unit of good X,
Concepts of Total, Average and Marginal Utility
 Concepts of Total, Average and Marginal Utility
Table 2.3 illustrates interrelationship between three concepts of utility by considering a hypothetical
example of a consumer who consumes slices of bread to satisfy his hunger. It should be specifically
noted that the consumer is to consume bread without allowing any unreasonable time gap between the
intakes of successive slices. This assumption is essential to ensures that the intensity of hunger of the
consumer decreases as he consumes additional slices. By implication, the marginal utility of slices also
falls, and depending upon the number of slices consumed, it can even become zero or negative. MU
are shown in column 4. It becomes negative when the consumer consumes 9th slice. Figures of TU are
shown in column 2. At each stage, TU is the cumulative total of the MU in column 4. Thus, for
example, for four slices, TU equals 144, that is, (40 + 38 + 35 + 31). Average utility is shown in
column 3. Its entries are obtained by dividing the figures in column 2 with their corresponding figures
in column 1. It should be noted that, for the first slice, all the three measures of utility are equal to each
other. Moreover, since MU falls with successive slices of bread, therefore, TU increases at a
decreasing rate. It reaches its maximum when MU falls to zero and actually declines when MU
becomes negative. In our example, TU reaches its maximum with 8th slice and decreases with the
consumption of 9th slice because its MU becomes negative (-4). It should also be noted that when
MU is falling, AU also falls but at a slower rate.
Concepts of Total, Average and Marginal Utility
Concepts of Total, Average and Marginal Utility
 PEAK

no TU AU MU
TU

1 50 50 50

2 90 45 40

3 110 110/3= 20

4 115 115/4 5

AU 5 105 105/5=2 -10

MU=0
MU
 Concepts of Total, Average and Marginal Utility
In other words, the total utility rises at a falling rate. This is shown by corresponding
downward or negative slope of the marginal utility curve. When the total utility reaches its
maximum value, marginal utility becomes zero. Before this point, though marginal utility
falls, it always remains positive. The total utility stops rising at this stage. When consumption
is expanded beyond this, the total utility starts to fall because marginal utility becomes
negative.
It is conventionally assumed that MU diminishes with successive units of good X. This show:
– Marginal Utility Curve slope downwards.
– Average Utility Curve falls slower than Marginal Utility Curve. Therefore, AU curve
has a flatter slope and lies above MU curve.
– Total Utility Curve rises at a diminishing rate. It reaches its maximum distance from
X-axis when MU is zero. Thereafter, it also slopes downwards, when MU is negative.
 RELATIONSHIP of TU, AU and MU

➢ Total utility is increasing at increasing rate so long as marginal utility

is positive.

➢ Total utility becomes maximum when marginal utility is zero.

➢ Total utility starts declining when marginal utility is negative.

 SIGNIFICANCE of TU, AU and MU

Significance of the difference between Total Utility and marginal Utility

Paradox of Value or The Diamond – Water Paradox-Total utility of Water is
more and marginal Utility of Diamond is more.

Value/Price is according to marginal utility. Consumer’s surplus- Customer

willing to pay according to total utility but actually pays according to
marginal utility. Difference between two is Consumer Surplus.
 Concepts of Total, Average and Marginal Utility

Geometrically, TU curve itself provides complete information regarding total, average

and marginal utility as follows. Given the quantity of good X (say, OX’), we consider
the corresponding point (P’) on TU curve. Then, the perpendicular distance P’X’
measures total utility of the quantity OX’. The slope of the ray from the origin to P’
(OP’) measures its average utility. The slope of the tangent to total utility curve at point
P’ measures marginal utility. Recall that marginal utility is also the first derivative of
total utility with respect to quantity of the good that is dTU / dX.
 LAW OF DIMINISHING MARGINAL UTILITY (DMU)

The law of diminishing marginal utility states that as the stock of a

commodity increases with the consumer, its marginal utility to the consumer
decreases. It eventually falls to zero and become even negative. The law
describes a familiar psychological tendency of the human beings. Marshall
says that “the additional benefit which a person derives from a given increase
in his stock of a thing diminishes with every increase in the stock that he
already has.” The specific behaviour of marginal utility as described by the
law of DMU follows from the conventional (and realistic) assumption that
the intensity of a given want keeps decreasing if the process of its satisfaction
is continued without interruption, that is, a single want can be fully satisfied
provided the consumer consumes a large enough quantity of the relevant
good/service.
 LAW OF DIMINISHING MARGINAL UTILITY (DMU)

In other words, during the process of its satisfaction, nothing should happen to
increase its intensity. For example, the consumer should not allow an unduly
long interval between the consumption of any two units of the good; he should
not get news of an unexpected change in his income or the price of the good,
etc. It should also be noted that the good to be consumed should be
homogeneous. Its successive units should have the same technical
specifications. Any change in them can cause a change in the intensity of the
want being satisfied and thereby violate the law of DMU.
 LAW OF DIMINISHING MARGINAL UTILITY (DMU)

It states that as the consumer goes on consuming more and more amount of commodity the
marginal utility of the commodity goes on declining becomes zero and finally becomes negative.
E.g. If you are set to buy ,say, fountain pens at and given time, then as the number of pens with
you goes on increasing, the marginal utility from each successive pen will go on decreasing.

“As the quantity consumed of a commodity goes on increasing, the utility derived from
each successive unit goes on diminishing, consumption of all other commodities
remaining the same” When the changes in consumption are infinitely small, marginal
utility is the derivative of total utility. MU = dTU/dX
 ASSUMPTIONS OF LAW OF DIMINISHING MARGINAL UTILITY
(DMU)
● Utility can be measures in the cardinal number system.
● Marginal utility of money remains constant.
● Marginal utility of every commodity is independent.
● Every unit of the commodity being used is of same quality and size.
● There is a continuous consumption of the commodity.
● Suitable quantity of the commodity is consumed.
● There is no change in the income of consumer, price of the
commodity and its substitutes.
● There is no change in the tastes, character, fashion and habits of
consumer.
LAW OF DIMINISHING MARGINAL UTILITY (DMU)
LAW OF DIMINISHING MARGINAL UTILITY (DMU)
LAW OF DIMINISHING MARGINAL UTILITY (DMU)
 EXCEPTIONS TO LAW OF DIMINISHING MARGINAL UTILITY
(DMU)
Curious and Rare Things: Law does not these things. Those persons who collect old and
rare coins ,postage stamps etc derive increasing marginal utility as the stock of these rare
articles goes on increasing.
Misers: It seems as if the 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: Reading a good book or listening to a melodious song or beautiful
poem again and again, one gets more utility than before so these also exceptions to this law.
Drunkards: When drunkards takes more and more pegs of liquor his desire to have more
of it goes on increasing.
Initial units: when the initial units of a commodity are used in less than the appropriate
quantity, then MU from the additional units goes on increasing.
 CAUSES OF APPLICATIONS TO LAW OF DMU

Commodities are Imperfect Substitutes: tea in place of coffee and coffee in

place of tea cannot be used to unlimited extent.
Satiability of Particular Wants: a particular want can be submitted.
Alternative Uses: Each and every commodities have more than one uses. E.g.
electricity
 LIMITATIONS OF LAW OF DMU

● Suitable units:- It is assumed that the commodity is taken in suitable units.

● Suitable time:-It is further assumed that the commodity is taken within a certain time,
otherwise law will not apply.
● No change in consumers tastes:-Another assumption is that the character of the consumers
does not change.
● Normal persons:- The law of diminishing marginal utility applies to normal persons and not
to eccentric or abnormal persons like misers.
● Constant income:-it is also essential that the income remains the same. Any change in
income will falsify the law.
● Rare collections:- In case of rare collections ,the law does not hold good.
● Fashion:- Further, fashion utility depends on fashion too.
 IMPORTANCE OF LAW OF DMU

Basis of the Laws of Consumption: Law of diminishing marginal utility is the basis of all laws
of consumption.(1) Law of equi -marginal utility.(2)Law of demand and (3) Concept of
Consumer’s Surplus.
Variety in Production and Consumption: It is because of the operation of law of diminishing
marginal utility. Continuous consumption of one commodity will yield less and less M.U. to
the consumer. So the producers will have to produce different varieties of goods.
Basis of progressive taxation : In this direct taxes come.
Advantage to the consumer: Due to law of diminishing M.U a consumer always buys till that
point where Price=M.U.
Difference between Value-in Use and Value-in- Exchange.
Price Determination
Basis of re– distribution.
 IMPORTANCE OF LAW OF DMU

Derivation of Demand Curve with the help of Law of Diminishing Marginal Utility The price
that a consumer pays for a commodity is equal to its marginal utility. As a consumer goes on
purchasing more and more units of a commodity, its marginal utility goes on diminishing.
 CRITICISM OF LAW OF DMU

Cardinal measurement of utility is not possible: It cannot be measured in cardinal

numbers because it is subjective concept.
Every commodity is not independent commodity: Example – Car and Petrol.
Marginal Utility cannot be estimated in all conditions.
Unrealistic Assumptions.
Marginal utility of money is not constant.
 LAW OF EQUI MARGINAL UTILITY
● The Law of equi-marginal Utility is another fundamental principle of Economics. This law
is also known as the Law of substitution or the Law of Maximum Satisfaction. As we
know that human wants are unlimited whereas the means to satisfy these wants are strictly
limited.In order to maximise satisfaction with a limited amount of money a consumer has to
compare the satisfaction obtained from each rupee that he spends on different commodities.
● Every prudent consumer will try to make the best use of the money at his disposal and
derive the maximum satisfaction
● If he finds that a rupee spent on one commodity gives him more utility than the same rupee
spent on another commodity, he shall continue to spend money on the former till the
utilities derived from the last rupee spent on the two commodities are equal.
● In other words, he substitutes some units of a commodity giving more utility for some units
giving less utility. As a result of this substitution that the marginal utility of the former will
fall and that of the latter will rise. This will continue until the two marginal utilities are
equalised. This is equal to the Law of Substitution or the Law of Equi-marginal Utility.
 LAW OF EQUI MARGINAL UTILITY

● Second law of Gossen - This law is based on the principle of obtaining maximum
satisfaction from a limited income. It explains the behavior of a consumer when he
consumes more than one commodity.
● This law points out how a consumer can get maximum satisfaction out of his
expenditure on different goods.
● Marshall called it law of equi marginal utility.
● The 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.
● According to the law of equi marginal Utility , other things being equal , a consumer
maximize his utility will spend his income among different goods in such a manner
that the utility derived from the last unit of money spent on each good is equal.
 LAW OF EQUI MARGINAL UTILITY
According to samuelson , “ A consumer gets maximum satisfaction when the ratio of marginal
utilities of all commodities and their price is equal.”
MU1/ P1 = MU2/ P2 = MU3 / P3
Here, MU1, Mu2 and MU3 refers to the marginal utility of first, second and third commodity
and P1,P2 and P3 refers to price of first, second and third commodity.
This is also called the Law of Proportionality. This law can be extended to cover any number of
commodities. In case the price of one commodity rises, less of this commodity and more of
others will be purchased so as to maintain the proportion. However, the above law will hold only
if the consumer’s tastes and other factors remain unchanged and the commodities are perfectly
divisible.
 ASSUMPTIONS OF LAW OF EQUI MARGINAL UTILITY

● Cardinal measurement of utility is possible.

● Consumer is rational, that is, he wants maximum satisfaction from his income. A consumer
has perfect knowledge of utility.
● Income of the consumer is fixed and constant.
● Marginal Utility of money remains constant.
● Prices of the commodities remain constant.
● Commodity is divisible into small units. Its means that the consumer can spend his income
in small units of money , say , one rupee.
● Consumption takes places at a given time period.
● There are substitutes for goods and a consumer has many wants.
● There is perfect competition in the market.
● The Law of Diminishing Marginal Utility operates.
LAW OF EQUI MARGINAL UTILITY
 EXPLANATION OF LAW OF EQUI MARGINAL UTILITY

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. As the marginal utility of
oranges is higher, we should buy more of oranges and less of apples.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.
 LAW OF EQUI MARGINAL UTILITY
Suppose chocolates and ice-creams are two purchasable goods. A consumer has Rs. 70 to spend. Let us
spend Rs. 30 on ice-creams and Rs. 40 on chocolates. What is the result? The utility of the 3rd unit of
ice-creams is 6 and that of the 4th unit of chocolates is 2. As the marginal utility of
ice-cream is higher the consumer would buy more of ice-creams and less of
chocolates.Suppose he substitutes one ice-cream for one chocolate so that he buys 4
ice-creams and 3 chocolates. Now the marginal utility of both ice-creams and chocolates is the same,
i.e., 4. This combination of ice-cream and chocolate yields maximum total utility of satisfaction.
The total utility of 4 ice-creams would be 10 + 8 + 6 + 4 = 28 and of 3 chocolates 8 + 6 +
4=18 giving us a total utility of 46. If he further consumes additional unit of Ice cream i.e. 5 units
his utility is 10+8+6+4+2=30 and 2 units of chocolates, MU=8+6=14, therefore total utility is 30 +14=44.
So the conclusion is that we obtain maximum satisfaction when we equalise marginal utilities by
substituting the more useful for the less useful commodity.
Total Utility

2 unit(IC)+1 unit(C)= 10+8 +8=26

3 +2 =10+8+6+8+6=38
4 +3 =10+8+6+4+8+6+4=46
5 +2 =10+8+6+4+2+8+6=44
 Diagrammatic Representation- LAW OF EQUI MARGINAL UTILITY
The horizontal axis we measure money and on vertical axis marginal utilities. Suppose a person has
Rs. 70 to spend on ice-creams and chocolates whose diminishing marginal utilities are shown by the
two curves I and C respectively. The consumer will gain maximum satisfaction if he spends OM’
amount of money (Rs. 30) on chocolates and OM amount of money (Rs. 40) on ice-creams because
when he buys (this combination) the marginal utilities of the two are equal (PM=PM’). Any other
combination of the two goods will give less total satisfaction.
 Diagrammatic Representation- LAW OF EQUI MARGINAL UTILITY
Let one representative consumer spend MN money (Rs. 10) more on ice-creams and the same
amount of money, N’M’ (= MN) less on chocolates. Utility lost is shown by the shaded area LN’M’
P’ and utility gain by the PMNE area. As MN = N’M’ and PM=P’M’, the LN’ MP’ (loss of utility from
reduced consumption of Chocolates) is bigger than PMNE (gain of utility from increased consumption
of Ice Cream). Hence the total utility of this new combination is less. So the conclusion is that no
other combination of ice-cream and chocolate gives as utility satisfaction to the consumer as
when PM = PM’, i.e., where the marginal utilities of ice-cream and chocolate purchased are
equal.
 IMPORTANCE OF LAW OF EQUI MARGINAL UTILITY

● Consumption- rational consumers allocate capital proportionately for max. satisfaction.

● Production-using limited resources effectively to maximize profit,economical
combination for maximum profit.
● Exchange - goods, wealth,trade, import/ exports are exchanged for one another.
● Distribution- share of each factor of production is determined, The use of each factor is
pushed up to a point where its marginal product is equal to the marginal product of
every other factor. This necessitates substituting one factor for another.
● Public Finance- concentrate its resources / expenses on productive resources
● Distribution of Income between Saving and Consumption
● Allocation of time for production of various assets.
● Distribution of Assets and ratio of savings v/s expenditure.
● Influences Prices: The law of substitution influences prices. When a commodity
becomes scarce and its price soars high, we substitute for it things which are less
scarce. Its price, therefore, comes down.
 LIMITATIONS OF LAW OF EQUI MARGINAL UTILITY

(i) Ignorance: If the consumer is ignorant or blindly follows custom or fashion, he

may not know where the utility is greater and where less not acting rationally. 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.
 LIMITATIONS OF LAW OF EQUI MARGINAL UTILITY

(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 especially 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.
 CRITICISM OF LAW OF EQUI MARGINAL UTILITY

● Consumer are not fully rational

● Consumer is not Calculating
● Shortage of Goods
● Influence of Fashion, Customs and Habits
● Ignorance of the Consumer
● Indivisibility of Goods
● Constant Income and Price
● Cardinal Measurement of Utility of Money
● Complementary Goods
 CRITICISM OF LAW OF EQUI MARGINAL UTILITY
Economists like Hicks, Allen, Samuelsons, Edgeworth etc have criticised the utility
analysis on the following grounds:
•Utility is subjective.
•Indivisible Goods.
•Goods are not independent.
•Marginal Utility of Money is not Constant.
•Cardinal Measurement is not Possible.
•Consumer is not so calculative.
•Income Effect of Price change Ignored.
 INDIFFERENCE CURVE ANALYSIS
Indifference Curve analysis is a modern method to analyse consumer’s behaviour. It is
based on ordinal utility. There are two concepts of utility cardinal and ordinal.
Cardinal is used to count or indicate how many while ordinal are words that represent
rank and order in a set, scale of preference and the marginal rate of substitution.
Ordinal utility refers to the level of satisfaction. The ordinal utility function means the
utilities obtained from goods can be compared as being greater or less or equal
through the level of satisfaction. The scale of preference is the quantitative
expression of consumer’s desire for goods. It shows the way in which an individual
consumer decides to spend his money income on various commodities.
 INDIFFERENCE CURVE ANALYSIS
An IC is the locus of points – particular combinations which yield the same utility or
level of satisfaction to the consumer, so that he is indifferent as to particular
combination he consumes. In other words, IC analysis refers to the locus of points
representing the various combinations of two goods which yield the same level of
satisfaction to the consumer.
According to Hicks: “It is the locus of the points representing parts of quantities
between which the individual is indifferent and so it is termed as an indifferent curve.”
According to Leftwhich : “A single indifference curve shows the indifferent
combination of X and Y that yield equal satisfaction to the consumer.”
An indifference curve is a curve that represents all the combinations of goods that
give the same satisfaction to the consumer. Since all the combinations give the same
amount of satisfaction, the consumer prefers them equally.
 ASSUMPTIONS OF INDIFFERENCE CURVE ANALYSIS
• Rationality of Consumer.
• Ordinal Utility (Order or Preference of choice).
• Diminishing marginal rate of substitution.
• Based on comparison.
• Consistency of Choice.
• Consumer is not oversupplied with goods.
 INDIFFERENCE CURVE ANALYSIS
An Indifference curve schedule refers to a schedule that indicates different
combinations of 2 goods that yield same level of satisfaction. Indifference curve is
diagrammatic representation of schedule as a line/ curve.
 INDIFFERENCE CURVE ANALYSIS
Here we are explaining MRS with the help of IC approach. The marginal rate of
substitution of Y for X (MRSxy) is defined as the amount of Y the consumer is just
willing to give up to get one additional units of X and maintain the same level of
satisfaction. From the above table it is seen when the consumer moves from
combination A to B, the consumer forgoes 4 units of Y good for one unit gain of good
X. Thus, marginal rate of substitution comes 4. In this way, when the consumer moves
from B to C, the consumer forgoes 3 units of Y good for another unit of X good. Thus
the consumer has more and more unit of X good, the consumer is willing to a forgoes
less units of Y good as of 2 and 1. In E combination, satisfaction of the consumer is
1:1. Thus utility gained = utility lost. It can also be expressed as MRSxy = y/x. In
short, as the stock of X increases (MU decreases), so the amount of Y in exchange
will decrease. In this way, the marginal rate of substitution diminishes and the slope
of indifference curve indicates the same.
 INDIFFERENCE CURVE ANALYSIS
In fig. given below at point A, consumer
has 1 unit of X commodity and 15 units of
Y commodity. At point B, he has 2 units of
X commodity and 4 units of Y commodity.
According to the law of diminishing
marginal utility, MU of additional units of
X commodity is diminishing and marginal
utility of Y starts increasing. Therefore,
consumer will be willing to give up less
and less of Y commodity for every
additional units of X commodity. In other
words, marginal rate of substitution of X
commodity for Y commodity diminishes.
 MARGINAL RATE OF SUBSTITUTION
Marginal rate of substitution refers to the rate at which consumer is
willing to give up amount of other good to obtain one extra unit of the
good in question without affecting total satisfaction. So, the rate of
substitution of one commodity for another is called marginal rate of
substitution. It is expressed as MRSxy of good X for good Y.
Symbolically, MRSxy = Loss of good Y/ Gain of good X = 'Y/ 'X.
MRS(XY) = 'Y/'X = AC/CB
AC/CB is the slope of indifference curve, i.e. slope of indifference
curve = MRS (XY). As the consumer gets more and more units of
good X, marginal utility of good X goes on falling with every increase
in units of good X. Simultaneously, the consumer is left with lesser
units of good Y. So, marginal utility of Y rises. Therefore, he is willing
to give up lesser quantity of good Y for obtaining additional units of
good X. Hence MRS diminishes along an indifference curve when we
move from upwards to downward.
 INDIFFERENCE MAP
An Indifference Map is a set or group of Indifference Curves each of which expresses a given level of
satisfaction. It depicts the complete picture of a consumer’s preferences.
We know that a consumer is indifferent among the combinations lying on the same indifference curve.
However, it is important to note that he prefers the combinations on the higher indifference curves to
those on the lower ones.This is because a higher indifference curve implies a higher level of
satisfaction. Therefore, all combinations on IC1 offer the same satisfaction, but all combinations on
IC2 give greater satisfaction than those on IC1.

If the Indifference curve shifts to right, level of satisfaction increases.

IC1<IC2<IC3 from point of view of satisfaction.

 PROPERTIES OF INDIFFERENCE CURVE
An IC slopes downwards to the right
This slope signifies that when the quantity of one commodity in combination is increased, the
amount of the other commodity reduces. This is essential for the level of satisfaction to remain the
same on an indifference curve.

An IC is always convex to the origin

From our discussion above, we understand that as P substitutes Goods Y for X, he is willing to part
with less and less Goods Y. This is the diminishing marginal rate of substitution. The rate gives a
convex shape to the indifference curve. However, there are two extreme scenarios:

● Two commodities are perfect substitutes for each other – In this case, the indifference curve is a
straight line, where MRS is constant.
● Two goods are perfect complementary goods – An example of such goods would be gasoline and
water in a car. In such cases, the IC will be L-shaped and convex to the origin.
 PROPERTIES OF INDIFFERENCE CURVE
Indifference curves never intersect each other nor tangent
Two ICs will never intersect each other. Also, they need not be parallel to each other either. Look at the
following diagram:It shows two ICs intersecting each other at point A. Since points A and B lie on IC1,
they give the same satisfaction level to an individual. Similarly, points A and C give the same satisfaction
level, as they lie on IC2. Therefore, we can imply that B and C offer the same level of satisfaction, which
is logically absurd. Hence, no two ICs can touch or intersect each other.
 PROPERTIES OF INDIFFERENCE CURVE
IC curve are parallel, and a higher IC indicates a higher level of satisfaction as compared to a
lower IC

A higher IC means that a consumer prefers more goods than not as in higher IC curve more of
one or either both goods combination are their instead lower IC has less goods.

An IC does not touch the axis

This is not possible because of our assumption that a consumer considers different
combinations of two commodities and wants both of them. If the curve touches either of the
axes, then it means that he is satisfied with only one commodity and does not want the other,
which is contrary to our assumption.
 Budget Line

Since a higher indifference curve represents a higher level of satisfaction, a consumer will try to
reach the highest possible IC to maximize his satisfaction. In order to do so, he has to buy more
goods and has to work under the following two constraints:

1. He has to pay the price for the goods and

2. He has limited income, restricting the availability of money for purchasing these goods.
As we can see, a budget line shows all possible combinations of two goods that a consumer can buy
within the funds available to him at the given prices of the goods. All combinations that are within
his reach lie on the budget line.

A point outside the line (point H) represents a combination beyond the financial reach of the
consumer. On the other hand, a point inside the line (point K) represents under-spending by the
consumer.
 Budget Line

A budget line graphically represents all possible combinations of

two goods which a consumer can buy with his entire income at the
prevailing market prices. Anywhere on the budget line consumer is
spending his entire income either on single or both the goods.
Suppose, the consumer wants to buy good X and good Y; price of
each unit of X is P and that of Y is P2; Then Accordingly the
expenditure on X will be equal to P1X and the same on Y will be
equal to P2Y. Total expenditure on good X and Y will be P1X + P2Y.
Let the money required to buy these goods is denoted as M. So we
can write that P1X + P2Y = M. This is called the equation for budget
line. AB is the budget line. Point A is located by dividing the entire
income over quantity of good Y only. Similarly point B is located by
dividing the entire income over quantity of good X only. At any point
on the line AB other than, A and B, the consumer can buy certain
combination of X and Y by using her income.
A budget line changes when either the prices of the goods or income of
the consumer or both changes. A budget line is negatively sloped because
to buy more units of a good, consumer must buy less units of other good
as consumer’s income is fixed. Slope of budget line = Quantity of other
good sacrificed/ Quantity of good obtained = 'Y/'X Suppose, price of
good X is `.2 and that of good Y is Re.1. So, he has to sacrifice 2 units of
good Y to obtain one unit of good X. In this example, Slope of budget line
= 'Y/'X = 2/1.

2/1 is nothing but the price ratio between good X and good Y. So the price
ratio indicates the slope of budget line. Thus, Slope of budget line =
Px/Py. This is also called market rate of exchange (MRE) because the two
goods can be exchanged at this rate, given their prices in the
market.Budget set is the set of all possible combinations of two goods
which a consumer can afford, given his income and market prices of the
two goods. So, a budget set includes all the bundles of two goods which
consumer can afford even if her entire income is not spent.
 CONSUMER EQUILIBRIUM

Consumer’s equilibrium refers to a situation when he gets maximum satisfaction and he feels no
need to change his position, subject to his income and market prices of two goods. A situation
when he gets maximum satisfaction and he feels no need to change his position, subject to his
income and market prices of two goods.

Condition of Consumer’s Equilibrium

According to indifference curve approach, a consumer will be at equilibrium when:

(i) Budget line is tangent to the indifference curve. i.e. slope of budget line = slope of
indifference curve Or, MRS(xy) = Px/Py Suppose, two goods consumed are X and Y. Further
suppose the consumer wants to increase consumption of good X in place of good Y. MRS is the
rate/at which consumer is willing to sacrifice amount of Y to get one more unit of X. Market rate
of exchange (MRE) is the rate at which consumer has to sacrifice amount of Y to get one more
unit of X.
 CONSUMER EQUILIBRIUM

Market rate of exchange (MRE) is the rate at which

consumer has to sacrifice amount of Y to get one more unit of
X.
When MRS>MRE, it implies that in order to obtain one unit of
X, the consumer is willing to sacrifice more units of Y than the
market allows. This will lead to increase in consumption of X
but decrease in consumption of Y. MRS starts falling.He
continues to consume more of X till MRS becomes equal to
MRE.
When MRS<MRE, it implies that in order to get one more unit
of X, the consumer is willing to sacrifice less units of Y than the
market requires. He will reduce the consumption of X and
increase consumption of Y. MRS Starts rising. He continues
reducing consumption of X till MRS becomes equal to MRE.
 CONSUMER EQUILIBRIUM

Given the indifference map and the budget line, the consumer
is at equilibrium at point E. The consumer obtains maximum
satisfaction when, he consumes bundle E containing OXl
quantity of good X and OY1 quantity of good Y. At E point
budget line is tangent to the indifference curve IC2, i.e. MRS
= MRE= Px/PY

Note that the consumer can buy bundles C and D because

they also lie on his budget line but these bundles lie on lower
indifference curve which represents lower level of
satisfaction. He will like to consume bundle G lying on
indifference curve IC3 which represents highest level of AB is price line Points C,E,D lie
satisfaction but it is beyond his budget. So the consumer's on budget line but E-highest
equilibrium bundle is X1, Y1 at point E where the budget line satisfaction as it lies of IC2 while
is tangent to indifference curve. C & D lies on IC1..
 CONSUMER EQUILIBRIUM

Let us understand the consumer’s equilibrium in the case of two commodities with an example.
Suppose a consumer has to spend ₹. 24 on two commodities i.e. X and Y. Further, assume that
the price of each unit of X is 2 and that of Y is 3 and his marginal utility schedule is given
below.
 CONSUMER EQUILIBRIUM

mu(x)/p(x)=mu(y)/p(y); 3 Units(x) +1 unit (y)=3(2rs)+1(3rs)=6+3=9Rs

4(2)+2(3)=8+6=14, ; 5(2)+3(3)=19, ; 6 Unit of x (p.2)+4 units of y (p.3)=24Rs (Max. purchase)

 CONSUMER EQUILIBRIUM

To attain the maximum satisfaction from spending his income of ₹. 24, the consumer will buy 6
units of X by spending Rs. 12 ( 2 × 6 = Rs.12) and 4 units of Y by spending Rs. 12 ( 2 × 6 = Rs.
12). This combination of goods gives him maximum satisfaction (or state of equilibrium)
because a rupee worth of MU in the case of good X is 5 i.e. In the case of good Y also. It is 5
i.e. Consumer’s maximum satisfaction is determined by the budget constraints i.e. the amount
of money spent by consumers (₹24 in this example).
 ASSUMPTIONS CONSUMER EQUILIBRIUM

In the case of two or more commodities, let’s assume:

● The consumer purchases only two goods i.e. A and B.

● The price of both the goods is already given in the
market. The consumer cannot change or influence the
price of both the goods. He can only decide how much
to buy of these goods at a given price.
● The consumer's income to be spent on these goods is
already given and is constant.
● The consumer is a rational human being and his goal is
to maximize the (cardinal) amount of utility from his
AB is price line Points C,E,D lie
purchase and consumption of the goods subject to his on budget line but E-Equilibrium.
constraints.
 CONSUMER EQUILIBRIUM - one good

In the case of a single commodity, the consumer equilibrium can be explained on the basis of
the law of diminishing marginal utility. Therefore, how consumers decide how much to
purchase depends on the following two factors.

● The price for each unit which he/she pays is given

● The utility he/she gets
While purchasing a unit of a commodity, a consumer compares the price of the given
commodity with its utility. The consumer will be at an equilibrium stage when marginal utility
(in terms of money) gets equal to the price paid for the commodity say ‘X’ i.e. MUx = Px
 CONSUMER EQUILIBRIUM - one good

In case MUx > Px,

In the case when MUx is greater than price, the consumer goes on buying the commodity
because she is paying less for each additional amount of satisfaction he is getting. As she buys
more, MU will fall and situations will arise when the price paid will exceed marginal utility (
the concept of the law of diminishing marginal utility is applied here). In order to avoid this
situation i.e. dissatisfaction, he will minimize his consumption and MU will go on increasing
till MUx = Px. This is the state of equilibrium.

In case MUx < Px,

In the case when MUx is less than price,, the consumer will have to minimize his consumption
of the commodity to raise his total satisfaction till MU becomes equal to price. This is because
she is paying more than the additional amount of satisfaction she is getting.
Importance of Consumer Equilibrium

● It enables consumers to maximize his/her utility from the consumption of one or more
commodities.
● It helps the consumers to arrange the combination of two or more products based on
consumer taste and preference for maximum utility.
● Equilibrium Condition :
● MUx = Px (in case of one good)
● MUx/Px = MUY/PY = MU of the last rupee spent on each commodity or simply can be said
MU of Money. (in case of two goods)
●

Similarly, if there are three commodities i.e. X, Y, Z then the condition of equilibrium, in this case, will
be simply MY Money.
Thus, to attain an equilibrium position
1. Marginal utility of the last rupee spent on each good is the same.
2. Marginal utility of a commodity falls as more of it is consumed.
 CONSUMER SURPLUS

Alfred Marshall, British Economist defines consumer’s surplus as follows: “Excess of the price
that a consumer would be willing to pay rather than go without a commodity over that which he
actually pays.”

Hence, Consumer’s Surplus = The price a consumer is ready to pay – The price he actually pays

Further, the consumer is in equilibrium when the marginal utility is equal to the price. That is, he
purchases those many numbers of units of a good at which the marginal utility is equal to the
price. Now, the price is fixed for all units. Hence, he gets a surplus for all units except the one at
the margin. This extra utility is consumer surplus.From the table above, we see that as the
consumption increase from 1 to 2 units, the marginal utility falls from 30 to 28. This diminishes
further as he increases consumption. Now,

● Marginal utility is the price the consumer is willing to pay for that unit.
● The actual price of the unit is fixed.
Therefore, the consumer enjoys a surplus on all purchases until the sixth unit. When he buys the sixth
unit, he is in equilibrium, since the price he is willing to pay is equal to the actual price of the unit.
 CONSUMER SURPLUS

In the figure, you can see that the X-axis measures the amount of commodity,
while the Y-axis measures the price and marginal utility. Further, MU
represents the marginal utility curve, sloping downwards. This indicates that as
the marginal utility falls, the consumer purchases more units of the commodity
and vice-versa.Next, if OP is the price of a unit of the commodity, the
consumer is in equilibrium only when he purchases OQ units. In other words,
when marginal utility is equal to the price OP.

Further, the Qth unit does not yield any surplus since the price and marginal
utility is equal. However, for the purchase of all units before the Qth unit, the
marginal utility is greater than the price, offering a surplus to the consumer.

In Fig. 2 above, the total utility is equal to the area under the marginal utility
curve up to point Q (ODRQ). However, for price = OP, the consumer pays
OPRQ. Hence, he derives extra utility equal to DPR which is consumer
surplus.
 LIMITATIONS OF CONSUMER SURPLUS

1. It is difficult to measure the marginal utilities of different units of a

commodity consumed by a person. Hence, the precise measurement
of consumer’s surplus is not possible.
2. For necessary goods, the marginal utilities of the first few units are
infinitely large. Hence the consumer’s surplus is infinite for such
goods.
3. The availability of substitutes also affects the consumer’s surplus.
4. Deriving the utility scale for prestigious goods like diamonds is very
difficult.
5. We cannot measure the consumer’s surplus in terms of money. This is
because the marginal utility of money changes as a consumer makes
purchases and his stock of money diminishes.
6. This concept is acceptable only on the assumption that we can
measure utility in terms of money or otherwise. Many modern
economists are against the concept.