Economics Notes

1. Describe Graphicaly Law of Diminishing Marginal utility.

Ans: LAW OF DIMINISHING MARGINAL UTILITY:

The law of diminishing marginal utility explains an ordinary experience of a consumer. “If a consumer
takes more and more units of a same commodity, the additional utility he derives from an extra unit of
the commodity goes on falling”.

ASSUMPTIONS OF THE LAW:

(a) The law holds good only when the process of consumption continues without anytime gap.
(b) The consumer’s taste, habit or preference must remain the same during the process of
consumption.
(c) The income of the consumer remains constant.
(d) The prices of the commodity consumed and its substitutes are constant.
(e) The consumer is assumed to be a rational economic man. As a rational consumer, he wants to
maximise the total utility.
(f) Utility is measurable.
(g) All the units of the commodity must be identical in all aspects like taste, quality, colour and size.
(h) The units of consumption must be in standard units e.g., a cup of tea, a bottle of cool drink etc.

TABLE – TOTAL AND MARGINAL UTILITY SCHEDULE

Units of apple Total utility Marginal utility
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
7 35 - 10

DIAGRAM OF LAW OF MARGINAL UTILITY

Exceptions to the Law of Diminishing Marginal Utility

Some of the important exceptions to the law are following:

(i) A miser is not a good subject for this law. His desire for more wealth may in fact increase with every
successive increase in the accumulation of wealth.

(ii) A collector of rare articles like stamps, coins, paintings etc. may escape this law.

(iii) The law may not apply when it comes to a melody recital or a beautiful scenic view.
2. How does a consumer attain equibriliam in a two Goods model?
The law of diminishing marginal utility applies in case of one commodity only. But in real life a consumer
normally consumes more than one commodity. In such a situation, law of equi-marginal utility helps in
optimum allocation of his income. Law of equi-marginal utility is based on law of diminishing marginal
utility.
According to the law of equi-marginal utility a consumer will be in equilibrium when the ratio of marginal
utility of a commodity to its price equals the ratio of marginal utility of other commodity to its price.

Let a consumer buys two goods X and Y. Then at equilibrium,

MUx/Px = MUy/Py = MU of last rupee spent on each good, or simply MU of Money.

MUx/Px = MUy/Py = MUMoney

Similarly if there are three goods X, Y, Z then the condition of equilibrium will be simply MU Money.

Thus, to be in equilibrium
1. Marginal utility of the last rupee of expenditure on each good is the same.
2. Marginal utility of a good falls as more of it is consumed.

For example,

Let us assume that the total money income of a consumer is ₹7, which he wants to spend on commodities x
and y. The price of each of these commodities is ₹1 per unit. Hence, the consumer can purchase maximum 7
units of commodity x, or 7 units of commodity y. The marginal utility derived by the consumer from different
units of x and y are:

MU of MU of
Commodity x commodity y
Units (in utils) (in utils)

1 26 22

2 20 18

3 16 15

4 15 13

5 12 11

6 10 4
3. Describe the consumer attend equibriliam in a One Goods model?
A consumer, when consuming a single commodity (say x) will be at equilibrium when: Marginal Utility
(MUx) is equal to Price (Px) paid for the commodity.

MUx = Px

If MUx > Px, then the consumer will not be at equilibrium and he continues to purchase the commodity
as the benefit gained from the consumption is more than the cost of the commodity. As the consumer
buys more, Marginal Utility falls because of the Law of DMU, and when it becomes equal to the price,
the consumer gets maximum satisfaction and is said to be in equilibrium.

Similarly, if MUx < Px, then also the consumer will not be at equilibrium and he will have to reduce the
consumption of the commodity in order to increase the satisfaction level, till MU becomes equal to the
price.

For example:
Let’s assume, a consumer wants to buy a good (say x), of price ₹10 per unit and the marginal utility
derived from each successive unit (in utils and in ₹) is as follows (let’s assume that 1 util/MUM = ₹1):

Marginal
Price Marginal Utility
Units (Px) Utility in ₹ (MUx) MUx –
Remarks
of x (₹) (Utils) 1 util = ₹1 Px

1 10 30 30/1 = 30 20 Here, MUx > Px,

so the consumer
will increase the
2 10 20 20/1 = 20 10 consumption

Consumer’s
3 10 10 10/1 = 10 0 Equilibrium
MUx = Px

-10
Here, MUx < Px,
so the consumer
4 10 0 0/1 = 0
will decrease the
consumption
4. Describe the Demand curve from the law of diminishing marginal utility?
The demand curve, as derived from the law of diminishing marginal utility, illustrates the relationship
between the price of a good or service and the quantity demanded by consumers. The law of diminishing
marginal utility posits that as a consumer consumes additional units of a good or service, the additional
satisfaction or utility derived from each successive unit decreases.

This concept directly influences the shape of the demand curve. The demand curve slopes downwards
from left to right, indicating an inverse relationship between price and quantity demanded. Here's how
the law of diminishing marginal utility influences the demand curve:

(i) High Marginal Utility at Lower Quantities: Initially, when a consumer has only a few units of a
good, each additional unit provides significant marginal utility. This leads to a higher willingness
to pay, and consumers are willing to buy more at higher prices.

(ii) Diminishing Marginal Utility: As the quantity consumed increases, the marginal utility of each
additional unit diminishes. Consumers become less willing to pay higher prices for additional
units because the satisfaction gained from each extra unit is lower.

(iii) Price and Quantity Relationship: The demand curve reflects the negative relationship between
price and quantity demanded. As the price decreases, consumers are willing to buy more because
the marginal utility of the additional units is relatively higher. Conversely, as the price increases,
consumers demand fewer units due to the diminishing marginal utility.

(iv) Equilibrium Point: The point where the demand curve intersects with the supply curve
represents the equilibrium price and quantity in the market. At this point, the quantity
demanded equals the quantity supplied, and the market is in balance.

5. Discuss the property of Indifference curve with proof?

Properties or Characteristics of Indifference Curve
The properties or characteristics of the indifference curve are as follows:

1. Indifference curve has a negative slope:

An indifference curve slopes downward from left to right, ie, it has a negative slope. A negative slope
implies that the two goods are substitutes for one another. Therefore, if the quantity of one commodity
decreases, the quantity of the other commodity must increase if the consumer has to stay at the same
level of satisfaction.

In the above figure, when the consumer moves from point A to B, the quantity of Y decreases from Y1 to
Y2. At the same time, the quantity of X increases from X1 to X2 keeping the level of satisfaction the same.
The same thing happens as the consumer moves from point B to C. But the decrease in Y i.e. Y2Y3 is less
than Y1Y2 and the increase in X, ie. X2X3 is equal to X1X2.
 2. Indifference Curve is Convex to the origin:

Indifference curves for normal goods are convex to the origin. This implies that the two goods are
imperfect substitutes for one another and the marginal rate of substitution between the two goods
decreases as a consumer moves along an indifference curve. Diminishing marginal rate of substitution
means that as the quantity of X is increased by an equal amount then that of Y diminishes by a smaller
amount.

In the above figure, the indifference curve is convex to the origin. Convexity of indifference curve implies
diminishing slope because consumer gives up less and fewer units of Y to have an equal additional unit of X.
The slope of the IC curve measures the marginal rate of substitution (MRS). Therefore, MRS also diminishes.

3. Indifference curves neither Intersect nor become tangent to one another:

If two indifference curves intersect or are tangent to each other, it means that an indifference curve indicates
two different levels of satisfaction. If two indifference curves intersect, it violates consistency or transitivity
assumption.

Let us suppose that the two indifference curves IC1 and IC2 intersect to each other at point C. Point C lies on
both indifference curves where points A and B lie on IC1 and IC2 curves respectively. Points A, B, and C
represent three different combinations of commodities X and Y. Combination C is common to both the
indifference curves.
4. Higher indifference curve represents a higher level of satisfaction than the lower ones:

A higher indifference curve represents a higher level of satisfaction than the lower one. The reason is that an
upper indifference curve contains a larger quantity of one or both goods than the lower one.

Let us consider three indifference curves IC1 and IC2 and IC3. IC2 is a higher indifference curve than IC1 and
IC3 is a higher indifference curve than IC2. Every point that lies on IC2 gives higher satisfaction than that of
IC1. Every point that lies on IC3 gives higher satisfaction than that of IC2 because they contain more quantity
of both goods (X and Y) than the combinations on lower ICs. Hence, by the assumption of non-satiety, the
consumer prefers IC3 to IC2. Similarly, we will prefer any other combination that lies on IC2 than on IC1.

6. Proof that, Prize Effect = subtitution Effect + Income Effect.

The price effect is the combination of both the income and substitution effects. The substitution effect is
always positive, however, the income effect can be positive or negative. Therefore, the price effect can be
positive or negative depending on the direction and magnitude of both substitution and income effects.

The price, income and substitution effects are analyzed using indifference curves and ordinal utility analysis.
To learn the basics, go to the post on Ordinal Utility analysis.

Price effect: price effect can be defined as the change in quantity demanded of a commodity as a result of a
decrease in its price. This change in quantity demanded takes place through the substitution effect and
income effect simultaneously.

Substitution effect: as the price of a commodity falls, it becomes cheaper in comparison to other
commodities. Therefore, consumers will buy more of the commodity as it is relatively cheaper compared to
other goods that are expensive. This increase in quantity demanded due to a change in relative price is called
the substitution effect. The substitution effect is always positive, but, its magnitude depends on the nature
and type of commodity.

Income effect: with a fall in the price of a commodity, purchasing power of the consumer increases. He or
she can buy the same quantity of commodity with less income spent. In the case of normal goods, the income
effect is positive as the quantity demanded of commodity increases with an increase in income. However,
the income effect is negative for inferior goods because consumers prefer to buy other goods as their real
income rises.

Price effect = substitution effect + income effect

There are three possible combinations of income and substitution effects that lead to different price effects:

Normal goods

The overall price effect is positive for normal goods because both the income and substitution effects are
positive.

Price effect = substitution effect + income effect

where the price effect is positive as income and substitution effects are positive

In fig, The X-axis shows the quantity of apple juice and the Y-axis shows the quantity of mango juice. AB is
the original budget line and the consumer is in equilibrium at point D with indifference curve IC.

Inferior goods

The substitution effect is positive, but the income effect is negative for inferior goods. However, the overall
price effect is still positive for inferior goods. This is because the magnitude of the positive substitution effect
is greater than the magnitude of the negative income effect.

Price effect = substitution effect + income effect

where the price effect is positive because (substitution effect) > (income effect)

In fig, The X-axis shows the quantity of inferior Commodity-1 and the Y-axis shows the quantity of
Commodity-2. AB is the original budget line and the consumer is in equilibrium at point D with indifference
curve IC.
Giffen goods

Similar to inferior goods, the substitution effect is positive but the income effect is negative for Giffen goods.
However, the overall price effect becomes negative for Giffen goods. This happens because the magnitude
of the positive substitution effect is less than the magnitude of the negative income effect.

Price effect = substitution effect + income effect

where the price effect is negative because (income effect) > (substitution effect)

In fig, The X-axis shows the quantity of Giffen Commodity-1 and the Y-axis shows the quantity of Commodity-
2. AB is the original budget line and the consumer is in equilibrium at point D with indifference curve IC.

7. Write a Short note on Consumer surplus?

Definition: “the excess of price which a person would be willing to pay a thing rather than go without the
thing, over that which he actually does pay is the economic measure of this surplus satisfaction. Tins may be
called consumer’s surplus”.

ASSUMPTION

1. The utility can be measured.

2. The marginal utilities of money of the consumer remain constant.
3. There are no substitutes for the commodity,
4. The taste, income and character of the consumer do not change.
5. Utility of one commodity does not depend upon the other commodities
6. Demand for a commodity depends on its price alone; it excludes other determinants of demand
EXPLANATION OF DIAGRAM

In the above figure, MU is the marginal utility curve. OP is the price and OM is the quantity purchased. For
OM units, the consumer is willing to pay OAEM. The actual amount he pays is OPEM. Thus consumer's surplus
is OAEM - OPEM = PAE (the shaded area). A rise in the market price reduces consumer's surplus. A fall in the
market price increases the consumer’s surplus.

8. Income consumption curve

Income Consumption Curve:

It is the curve that shows equilibrium quantities of two commodities that would be purchased by the buyer
at different levels of income, keeping prices the same.

The income consumption curve is explained with the following graphical representation:

In fig, X-axis shows the quantity of rasgulla and Y-axis shows the quantity of Gulab Jamun. The income is
shown by budget line AB and E is the equilibrium point where the budget line is tangent to an indifference
curve. When the income of consumer increases., the equilibrium point and budget line shifts to the right i.e.
E1 on the budget line CD. Similarly, with a fail in the income, the consumer's equilibrium and price or budget
line shift to on EF. Thus, the line joining points E, E1 and E2 is called Income Consumption Curve, Thus, ICC
shows the quantities of rasgutla and Gulab Jamun, the consumer buys at different levels of income.

The slope of the Income Consumption Curve :

The slope of the ICC curve varies with the type of goods involved. It can be ctassified as :

1. Positive Sloped ICC curve

2. Negative Sloped ICC curve

These can be explained as:

Positive Sloped Income Consumption Curve :

The slope of ICC is positive in case of normal goods. As the consumption of both normal goods increases with
the increase in income, the positive relation is defined. Hence, it is positively sloped if both goods are normal.
In the above fig., it is shown that ICC of normal goods slopes upwards from left to right indicating that there
will be an indication of both goods with an increase in income. In fig, ICC curve implies that the same
proportionate increase in the consumption of both commodities with a rise in income. ICC1 curve indicates
the more proportionate increase in commodity-1 and ICC2 curve indicates the more proportionate increase
in commodity-2.

Negative Sloped Income Consumption Curve :

The slope of the ICC is negative in the case of inferior goods. It implies, that the consumption of inferior goods
declines with the increase in income and the inverse relation is defined. Hence, it is negatively sloped if any
or both of the goods are inferior goods.

Graphical Representation:

1. When one commodity is inferior and another commodity is normal:

Suppose, commodity-1 is inferior and commodity-2 is normal The following graph shows the relation of ICC
when any of the commodity is inferior.

In fig, X-axis shows the quantity of inferior commodity-1 and Y-axls shows the quantity of normal commodity-
2. Here, AB is the price line, drawn based on the income of consumer and given prices of two commodities,
touches the indifference curve IC at the point Equilibrium Point). As the income of consumer increases, the
price line shifts to the right to CD and then EF touching IC1 and IC2 at the equilibrium points E1 and E2
respectively. Consequently, the quantity of commodity-1 decreases from 3 units to 2 units and 1 unit
respectively. Hence, the increase in income of the consumer is followed by a decrease in the demand for
inferior commodity -1. The decreased income reflects the negative income effect.

2.When both commodities are inferior goods.

Suppose, both the commodities which are purchased by the consumer are inferior goods. The following graph
shows the relation of ICC when both commodities are inferior.

In fig, ICC1 curve shows that commodity-2 is an inferior commodity. This curve turns downwards after point
A. it means that less of the commodity-2 will be purchased when the income of consumer increases. Similarly,
ICC2 curve shows the inferior commodity-1. This curve turns backwards after point B which means that less
of commodity-1 will be purchased when the income of consumer increases.

9. Price Consumption Curve

When, the price of good charges, the consumer would be either better off or worse off than before,
depending upon whether the price falls or rises. In other words, as a result of change in price of a good, his
equilibrium position would lie at a higher indifference curve in case of the fall in price and at a lower
indifference curve in case of the rise in price. The graph represents the price consumption curve;

The price-usage curve is the PCC that connects the central core of these equilibria. Given his revenue, tastes,
choices, and the price of good Y, the PPC shows the price effect of a change in its X price on the user's buying
of the two goods X and Y.
10. Marginal Rate of Substitution (MRS)

The marginal rate of substitution (MRS) is the quantity of one good that a consumer can forego for additional
units of another good at the same utility level. MRS is one of the central tenets in the modern theory of
consumer behavior as it measures the relative marginal utility.

Marginal rates of substitutions are similar at equilibrium consumption levels and are calculated between
commodity bundles at indifference curves. Combinations of two different goods that give consumers equal
utility and satisfaction can be plotted on a graph using an indifference curve. The MRS is based on the idea
that changes in two substitute goods do not alter utility whatsoever.

MRS Formula

The marginal rate of substitution is calculated using this formula:

Where:

 X and Y represent two different goods

 d’y / d’x = derivative of y with respect to x
 MU = marginal utility of two goods, i.e., good Y and good X

11. Cardinal Utility Theory

The Cardinal utility approach was originally given by Marshall. According to him, utility can be measured in
utils, where utils is a scale like 1,2,3,… where one can measure his level of satisfaction or utility.

The theory of consumer behaviour attempts to seek the consumption of goods which maximize the
consumer’s utility. It also helps a consumer in his decision-making about how to allocate his consumption
expenditure on different goods so that his total utility could be maximized. But before moving ahead in the
theory of consumer behaviour based on the cardinal approach, it is important to know the assumption of
this approach.

Assumptions of Cardinal Utility Theory

● Rationality: A consumer is always rational, i.e. he always prefers more goods and services to derive
maximum utility. Thus he always buys the commodity which gives him maximum utility first, and then he
buys the least utility-giving commodity at the end.

● Finite Money Income: The consumers have limited money income, which they spend on the purchase of
all the goods and services for their living. Thus they allocate this income as their consumption expenditure
on all goods and services.

● Cardinal Utility: The utility derived from the consumption of each good is measurable in terms of utils
which is, in turn, equal to the money a consumer is willing to pay for it, i.e. 1 util= utility of 1 unit of money.

● Constant Marginal Utility of Money: The utility of each unit of money spent on buying the good remains
the same, i.e. one.

● Diminishing Marginal Utility: According to this, the utility derived from the consumption of each successive
unit of the good diminishes. As we consume more of a good, the utility derived from each successive unit of
it decreases (although the total utility from the consumption of the total quantity of good increases). This is
also known as ‘Gossen’s first law’. Note that here each successive unit of the good is homogeneous in nature.

● Additive Utility: According to this, the utility derived from the consumption of all goods and services is
additive in nature.
This can be explained with the help of the following table:

Quantity (in units) Total Utility (in utils) Marginal Utility (utils)

0 0 –

1 40 40

2 70 30

3 90 20

4 100 10

5 100 0

6 90 -10

Thus we can conclude that there exists the following relationship between total utility and marginal utility:

 Total utility increases initially at an increasing rate first, and marginal utility also increases.
 Thereafter total utility increases at a diminishing rate, and marginal utility diminishes.
 When total utility reaches its maximum, marginal utility becomes zero.
 When more of the units of the good is consumed even after achieving the highest level of total utility,
then the total utility decreases and correspondingly, marginal utility becomes negative.
12. Distinguish between cardinal utility and ordinal utility

Ordinal Utility Cardinal Utility

Consumer derived satisfaction after Consumer derived satisfaction after

consumption of products evaluation done consumption of products evaluated in
without using number. numerical numbers

Ordinal utility used qualitative approach Cardinal utility used quantitative approach
during analysis of degree of satisfaction. during analysis of degree of satisfaction.

Consumer in ordinal utility rank of Consumer in cardinal utility makes

preference according to their derived measurements of degree of satisfaction
satisfaction after consumption of products. derived after consuming products in utils.

Indifference curve analysis used for Marginal utility analysis used for explanation
explanation ordinal utility. of cardinal utility.

Ordinal utility measurements promoted by Cardinal utility measurement promoted by

modern economist traditional economist.

Ordinal utility measurements results Cardinal utility measurement results

considered as more realistic. considered not realistic in comparison with
ordinal utility.