UNIT - I

1.1 Utility Analysis

UTILITY
 Economic term referring to the added value or
“usefulness” of a product.

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UTILITY CONT.
 There are two views of utility:
 Cardinal Utility

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 Cardinal utility is the belief that utility can be
measured and compared on a unit by unit basis.
 EX - A utility measure of 200 is twice as big as a utility
measure of 100.
 Ordinal Utility
 Ordinal utility is where you rank bundles of goods,
but cannot say how much greater one bundle is to
another.
 Ranking is the only thing that matters when dealing
with ordinal utility.

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UTILITY THEORY… DEFINITIONS
 Utility:
A measure of the satisfaction,
happiness, or benefit that results from the
consumption of a good.

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 Util: An artificial construct used to measure utility.
 Total Utility: The total satisfaction received
from consuming a particular quantity of a
good.
 Marginal Utility: The additional utility a
person receives from consuming an additional
unit of a good.
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CHARACTERISTICS OF UTILITY -

1. Utility is a subjective term – Differs from

person to person
2. It is a relative term – Value changes according
to time, place, person

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3. It has no ethical or moral significance – Ex -
Knife
4. It is different from usefulness – Ex -
Cigarettes
5. It is different from pleasure – Ex - Injection
6. It depends on the intensity of want – Ex -
Thirst
7. It cannot be objectively measured – Cannot
assign numbers for satisfaction derived
8. It is different from satisfaction – Satisfaction 5
is the end result
MARGINAL UTILITY
 Marginal utility refers to the net addition
made to the total utility by consuming one
more unit

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 In mathematical terms,

MU= Δ Total Utility/ Δ in units of

consumption of a commodity
or MU = TU n – TU n-1
 Note that Δ means change

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TOTAL UTILITY -
 Total utility means the total satisfaction obtained
by the consumer from the consumption of all
units at a time.

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 TU = Sum total of MU

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TOTAL AND MARGINAL
UTILITY
Utils

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150
Marginal
utility
100
Total
Utility
50

0
First Slice Second Slice Pizza 8
TOTAL AND MARGINAL
UTILITY
Utility

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Total Utility is
Satiation point maximized when
Utility marginal utility is
zero.

Satiation point
LAW OF DIMINISHING MARGINAL
UTILITY
 Concept developed by Alfred Marshall
 Other things being equal, as the quantity

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consume increases the MU of that commodity
tends to diminish.
 It means more we have of a thing, the less we
want to have of it because the utility of every
additional unit appears to go on diminishing

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LAW OF DIMINISHING MARGINAL UTILITY

 The marginal utility gained by consuming equal

successive units of a good will decline as the
amount consumed increases.

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 EXAMPLE

Amount

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Consumed (x) Total Utility (U) Marginal Utility
0 0
4 = ((4-0)/(1-0))
1 4
2 = ((6-4)/(2-1))
2 6
0 = ((6-6)/(3-2))
3 6
-2 = ((4-6)/(4-3))
4 4
-4 = ((0-4)/(5-4))
5 0
-6 = ((-6-0)/(6-5))
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6 -6
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LESSONS LEARNED FROM
EXAMPLE
 As long as marginal utility is positive, total
utility will increase.

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 Total and marginal utility can be negative.

 Total Utility follows marginal utility.

 When marginal utility is zero, total utility is

maximized.
 This graph demonstrated the Law of
Diminishing Marginal Utility.

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UTILITY ASSUMPTIONS
1. Homogeneous – Various units are alike in all
aspects
Continuity – Continuous consumption

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2.
3. Standard unit – Standard size of all units
4. No change in taste or habit of the consumer
5. Rationality – Behaviour of consumer is normal
and rational
6. Cardinal measurement – Utility is measurable
in numerical units

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EXCEPTIONS OF THE LAW -
1. Rare collections – Ex - Stamps, Coins
2. Drunkards – Ex – Liquor

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3. Misers – Ex- Money
4. Music & Poetry –
5. Reading –
6. Money – MU of money does not diminish

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IMPORTANCE OF LAW OF DMU –
THEORETICAL IMPORTANCE
1. Law explains the consumers equilibrium –
MU=P

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2. Diminishing utility is a universal truth
3. The law explains the Water- Diamond paradox

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PRACTICAL IMPORTANCE -
1. In Business – Sales can be promoted by
reducing price

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2. In Public Finance – Taxation policy –
Progressive tax for rich people as MU of money
is less for rich
3. In Welfare Policy – Redistribution of wealth to
promote welfare from rich to poor

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UTILITY MAXIMIZATION /
EQUILIBRIUM OF THE CONSUMER
 In equilibrium, the consumer balance the utility
of the good against its cost.

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 MUx=Px

 The consumer is in equilibrium if he consumes

up to the point where the MU of the goods equals
the market price of the good

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LAW OF EQUI-MARGINAL UTILITY
 In real life, consumer purchases many goods with
the help of their incomes

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 He has to decide how he should spend his limited
income on different goods so as to get maximum
possible satisfaction
 A consumer maximizes his TU by allocating his
income among goods available to him in such a
way that the MU per rupee’s worth of one good
equals the MU per rupee’s worth of any other
good
 Mux/Px = MUy/Py=……..MUn/Pn
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MU SCHEDULE OF CONSUMER
Good X (Px=1) Good Y (Py=1)
Units of X MUx Units of Y MUy

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1 80 1 60
2 72 2 58
3 64 3 56
4 56 4 54
5 48 5 52
6 40 6 50
7 24 7 48
8 8 8 40
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CRITICISMS / LIMITATIONS OF
UTILITY ANALYSIS -
1. Cardinal measurement – Utility cannot
measured numerically

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2. Unrealistic assumptions – Difficult to satisfy
the conditions of homogeneity, continuity,
rationality conditions simultaneously
3. Inapplicability in case of indivisible goods
(goods cannot be broken into pieces for
consumption) – Ex – T.V., Scooter, House
4. Constant MU of money – MU of money never
remains constant
5. Law is based on observation – Scientific 22
validity has not been tested
REVIEW QUESTION
 Carrot halwa sells for Rs 40/kg. A family
consumes 3.5kg of carrot halwa (over a month)
and its marginal utility is 100 utils. Assume that

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carrot halwa can be measured continuously. If for
this family the marginal utility of rupee is 2 utils,
should it consume more, less or is its
consumption level of carrot halwa optimal?

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