Utility

SCMS Pune
 What you will learn
• What is Utility
• Cardinal & Ordinal Utility
• Total, Average & Marginal Utility
• Law of Diminishing Marginal Utility
• Indifference Curve Analysis
• Equilibrium of a Consumer
 What is Utility
• ‘Utility’ means the satisfaction obtained from
consuming a commodity
• ‘Want Satisfying’ power of a commodity
 Utility

Utility

Cardinal Ordinal
 Cardinal Utility
• Propagated by Alfred Marshall
• The cardinal utility theory says that utility is
measurable and by placing a number of
alternatives so that the utility can be added.
• The index used to measure utility is called
utils.
• LDMU is based on Cardinal Utility approach
 Ordinal Utility
• Propagated by Hicks & Allen
• The ordinal utility theory says that utility is not
measurable but it can be compared.
• Ordinal approach uses the ranking of
alternatives as first, second, third and so on.
• IC analysis is based on Ordinal Utility approach
 Total Utility
• Total Utility (TU) – The total satisfaction that a
person gets from the consumption of goods
and service.
• Average Utility (AU) – The average satisfaction
that a person gets from the consumption of a
unit goods and service.
AU = TU/n (n = number of units)
 Marginal Utility
• Marginal Utility (MU) – The addition to total
utility as a result of consuming one more unit of
the same good or service.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝑈𝑡𝑖𝑙𝑖𝑡𝑦 ∆𝑇𝑈
• MU = =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 ∆𝑄
MU = 𝑇𝑈𝑛 − 𝑇𝑈𝑛−1
• The idea/ concept of MU is extremely important
Law of Diminishing Marginal Utility (LDMU)
• The additional benefit that a consumer derives
from an increase in stock of a thing diminishes,
other things being equal, with every increase in
the stock that he already has.
• Law of Diminishing Marginal Utility states that as
consumption increases more and more, marginal
utility diminishes.
 LDMU Assumptions
• Cardinal Utility
• Rational Consumer
• Continuous Consumption
• Standard Units
• MU of Money remains constant
• No change in price & money income
• Quality is Constant
 LDMU Example
TU increases from consumption of 1st unit the 5th unit. After
the 5th unit, TU will decrease.

Units TU MU (TUn – TUn-1) MU will decrease and

1 20 0/ -/ 20 become zero at the 5th
2 35 35 – 20 = 15 unit and further
3 45 45 – 35 = 10 consumption of will not
4 50 50 – 45 = 5 satisfy the consumer as
5 50 50 – 50 = 0 the MU shows negative
6 45 45 – 50 = -5 signs.
LDMU Graph
1. When TU is
increasing, MU will be
positive.
2. When TU is at its
maximum, MU will be
zero.
3. When TU is
decreasing, MU will
be negative.
 LDMU Exceptions
• Money

• Addictive Commodities

• Rare Collection/ Articles

 Indifference Curve (IC)

Definition:
An indifference curve represents all the possible
combinations of two goods which will give the
same level of satisfaction
 Assumptions of IC
• Rationality
• Order/ Rank Preferences
• Non-Satiety
• Consistency and Transitivity of Choice
• Diminishing Marginal Rate of Substitution
 Indifference Curve
An indifference curve represents all those combinations of two goods; X and Y
which yield the same level of satisfaction to a consumer.

Combina Good Good

tions Y X
A 12 2
B 6 4
C 4 6
D 3 8
E 2 12
Indifference Map
An indifference map shows a set of
indifference curve.

The higher the

indifference curve
from the origin,
higher will be the
utility. IC3 has the
higher satisfaction.
 Characteristics of IC

• Downward Sloping
• Convex to Origin
• Higher IC gives higher level of satisfaction
• No two ICs can intersect each other
 Downward Sloping
• To ensure that the satisfaction level remains
the same throughout the curve.
• What Happens if the Indifference Curve is:
– Upward Sloping
– Horizontal (parallel to X-Axis)
– Vertical (parallel to Y-Axis)
• Note: In all the 3 cases satisfaction increases
 Convex to Origin
• Because of Diminishing MRS
• What happens if the Indifference Curve is:
– Concave to origin
– Straight line downward sloping
 Higher IC gives higher level of
satisfaction
• Because of Non-
Satiety
• More is referred
to less.
 No two ICs can intersect each other
• Because of Transitivity
• What happens if two Indifference Curves
intersect???
Which IC would you prefer???
 Budget Line
• A line representing the maximum of 2 goods that can
be bought with a given level of Income
𝑀 = 𝑝𝑥 𝑞𝑥 + 𝑝𝑦 𝑞𝑦
• Where:
– M = Money Income
– 𝑝𝑥 = price of good x
– 𝑞𝑥 = quantity of good x
– 𝑝𝑦 = price of good y
– 𝑞𝑦 = quantity of good y
 Budget Line - Diagram
Good Y
M/Py
Y Intercept =
Money Income/
price of good y

X Intercept =
Money Income/
Good X Price of Good x
O M/Px
Changes in Budget Line – Money
Good Y
If the money income
M/Py If money Income increases increases the budget
line shifts outward
parallely

If the money income

decreases the budget
line shifts inward
Good X parallely
O M/Px
If money Income decreases
 Changes in Budget Line – Px
Good Y
If the price of good x
M/Py If Px decreases increases the Budget
line will pivot inwards
(less of good x)

If the price of good x

decreases the Budget
line will pivot
Good X outwards (more of
O M/Px
If Px increases good x)
 Changes in Budget Line – Py
Good Y
If the price of good y
M/Py If Py decreases increases the Budget
line will pivot inwards
(less of good y)

If the price of good y

decreases the Budget
line will pivot
Good X outwards (more of
O M/Px
If Py increases good y)
 Budget Line – Changes
Good Y
1. Money income
M1/Py
M1/P1y increases by 50%
2. Price of Good x
M/Py
decreases by 25%
3. Price of Good y
increases by 25%

Good X
O M/Px M1/Px M1/P1x
Consumer Equilibrium - Conditions
• IC should be downward Sloping
• IC should be tangent to the budget line; i.e. slope
of IC (MRS) = Slope of Budget Line (Price Ratio)
• Consumer equilibrium is at a point where:
𝑃𝑥
𝑀𝑅𝑆𝑥𝑦 =
𝑃𝑦
• Which implies that the tradeoff of Good x & Good
y by the consumer (MRS) is same as the trade off
of Good x & Good y in the market (Price Ratio)
 Consumer Equilibrium
Good Y
Point B is not
M/Py c attainable
b
Points A, C, D & E are
e attainable
a IC3 Point e is on the
IC2 higher IC so point e is
d IC1
Good X equilibrium point
O M/Px