103 EADB

Chapter-2

Dr. Rakesh Bhati

Utility & Demand Analysis: Utility –
Meaning, Utility analysis, Measurement
of utility, Law of diminishing marginal
utility, Indifference curve, Consumer’s
equilibrium - Budget line and Consumer
surplus.
Demand for a commodity depends on the
utility of that commodity to a consumer.
Problem Of Choice
As we know resources are
limited and wants are unlimited
so there is a problem of choice
for the consumer.
It is also known as Problem of
scarcity.
That’s why the consumer has to
decide what to purchase from
his existing income to gain
maximum satisfaction.
Classification of wants……
Classification of Wants….
• Goods which are required for our
Necessities survival. (Ex. Food, Medicines
- etc.)
• Goods which make our life
Comforts easy. (Ex. Fan, Tables, Chairs
etc.)
• Goods which make our life
Luxuries lavish. (Ex. Car, AC etc.)
 UTILITY
 Every individual has certain wants and he consumes
commodities which lead to the satisfaction of such
wants. It means that the commodities have a capacity
to satisfy human wants. Therefore, in general terms,
we say that a commodity is useful if it satisfies our
want.
 In Economics, the want satisfying power of a
commodity is called “utility”. Utility is the capacity
of a commodity to satisfy particular human want.
Utility is the want satisfying power of a commodity.
OR
Utility is satisfaction and it is subjective in nature.

Utility Usefulnes
s
 UTILITY
Also, utility and satisfaction are two different terms but they are
inter-related. Utility is pre-consumption and satisfaction is post-
consumption. Utility is assumed satisfaction but satisfaction is
something that is actually realized.

UTILITY SATISFACTION
 UTILITY
Consumption of goods and services depends on utility. Every
product possesses power to satisfy human wants. This inner
quality of a commodity which satisfies human wants is called as
utility.
 UTILITY
UTILITY SATISFACTION
•Pre-consumption • Post-consumption
• Assumed satisfaction • Something that is actually
realized
 FEATURES
F - Forms the basis for demand
E - Ethical significance not considered
A - Also different from usefulness
T.- The measurement not possible
U.- Utility - subjective concept
R - Relative Concept
E - Even different from pleasure
S - Satisfaction and utility are Different
U - Utility depends on intensity of the want
 FEATURES
F - FORMS THE BASIS FOR
DEMAND
E – Ethically neutral
A - Also different from usefulness T - The
measurement not possible U - Utilitydemand
subjective concept
R - Relative Concept
E - Even different from pleasure
S - Satisfaction and utility are different
U - Utility depends on intensity of the
want
A person will demand a
commodity only if it has utility
for him.
An uneducated person will not
- a book as it has no
utility for him. A student will
demand a book as it has utility
for him.
A student pursuing Arts will not
demand a calculator as it has no
utility for him. A student pursuing
Commerce will demand it.
 FEATURES
F - Forms the basis for demand The concept of utility does not
consider whether the
E – ETHICALLY NEUTRAL
commodity satisfies a good
A - Also not the same as usefulness T - want or a bad want. A
The measurement not possible U - Utility commodity can have utility
- subjective concept even if it
unethical want. Utility does
R - Relative Concept satisfies
not considera anybad moralor or
E - Even different from pleasure ethical factors. In short, it is
S - Satisfaction and utility are different ethically neutral.

U - Utility depends on intensity of the

 FEATURES
F - Forms the basis for demand A gun has utility for a soldier as well
as a terrorist.
E - ETHICAL SIGNIFICANCE
NOT CONSIDERED
A - Also different from usefulness T - The
measurement not possible U - Utility -
subjective concept
R - Relative Concept
E - Even different from pleasure
S - Satisfaction and utility are different
U - Utility depends on intensity of the
 FEATURES
F - Forms the basis for demand
E – Ethically neutral
A - ALSO NOT THE SAME AS
USEFULNESS
T - The measurement not possible
U - Utility - subjective concept R -
Relative Concept
E - Even different from pleasure
S - Satisfaction and utility are different
U - Utility depends on intensity of the
Usefulness is the benefit that
is derived by consuming a
commodity whereas utility is
the want satisfying power of a
commodity. A commodity
having utility need not be
useful.
 FEATURES
F - Forms the basis for demand Alcohol has utility to drunkard but it
E – Ethically neutral is not useful as it harms his health.

A - ALSO NOT THE SAME AS

USEFULNESS
T - The measurement not possible
U - Utility - subjective concept R - Hookahs have utility for customers
Relative Concept of a hookah bar but it is not useful
as it harms their health.
E - Even different from pleasure
S - Satisfaction and utility are different
U - Utility depends on intensity of the
 FEATURES
F - Forms the basis for demand Utility is a psychological
E – Ethically neutral concept. It is intangible and
A - Also not the same as usefulness invisible. It is an inherent
T - THE MEASUREMENT NOT feeling. Therefore, it cannot
POSSIBLE be measured cardinally i.e. in
U - Utility - subjective concept R - numbers.
Relative Concept
E - Even different from pleasure
S - Satisfaction and utility are different
U - Utility depends on intensity of the
want
 FEATURES
It cannot be said that “Good Day”
F - Forms the basis for demand
biscuit has 5 utility and “Dark
E – Ethically neutral Fantasy” biscuit has 10 utility.
A - Also not the same as usefulness However, utility can be
T - THE MEASUREMENT NOT measured in relative terms.
POSSIBLE
U - Utility - subjective concept R -
Relative Concept
The utility of food is ‘higher’ for a
E - Even different from pleasure person who is hungry and ‘lower’ for
S - Satisfaction and utility are different a person who is not hungry.
U - Utility depends on intensity of the
want
 FEATURES
F - Forms the basis for demand “Subjectivity” means
E – Ethically neutral changing from one person to
A - Also not the same as usefulness T - another. A product may give
The measurement not possible U - utility to one person but the
UTILITY - SUBJECTIVE same product may not give as
Therefore, utility is a
CONCEPT much utility to another.
as
R - Relative Concept utility of a commodity differs
subjective
from personconcept
to person theon
E - Even different from pleasure
account of differences in
S - Satisfaction and utility are different
tastes, preference, habits,
surroundings, age, occupation
etc.
 FEATURES
F - Forms the basis for demand A measuring tape will have
E – Ethically neutral more utility to a tailor as
A - Also not the same as usefulness T - compared to a cobbler.
The measurement not possible U -
UTILITY - SUBJECTIVE
CONCEPT A fish curry will have more
R - Relative Concept utility to a non-vegetarian
E - Even different from pleasure
while it may have less utility or
S - Satisfaction and utility are different
no utility at all to a vegetarian.
 FEATURES
F - Forms the basis for demand Utility of a commodity
E – Ethically neutral changes from time to
and place to place.
A - Also not the same as usefulness T time
- The measurement not possible U -
Utility - subjective concept
R - RELATIVE CONCEPT
E - Even different from pleasure
U
S -- Satisfaction
Utility depends
and on intensity
utility are of the
want
different
 FEATURES
F - Forms the basis for demand
E – Ethically neutral
A - Also not the same as usefulness T -
The measurement not possible U - Utility
- subjective concept
R - RELATIVE CONCEPT
E - Even different from pleasure
S - Satisfaction and utility are different
U - Utility depends on intensity of the
Aquaguard (water purifier) has
more utility in the rainy
season compared to other
seasons because the risk of
water- borne diseases is high.
A room freshner has more
utility in the bathroom as
compared to the drawing
room.
 FEATURES
Utility and pleasure are different.
F - Forms the basis for demand
A commodity may have uility but it
E – Ethically neutral is not necessary that its
A - Also not the same as usefulness consumption will give pleasure to
T - The measurement not possible the consumer.
U - Utility - subjective concept
A textbook has utility for a student
R - Relative concept but he may not derive pleasure from
E - EVEN DIFFERENT FROM reading it.
PLEASURE
S - Satisfaction and utility are different
U - Utility depends on intensity of the
want
 FEATURES
. Utility and satisfaction are
F - Forms the basis for demand
interrelated but there is a difference.
E – Ethically neutral The following are difference:
A - Also not the same as usefulness T - 1.Utility is the want satisfying power
The measurement not possible U - Utility of a commodity i.e. utility is
- subjective concept considered pre-consumption.
Satisfaction Is the happiness derived
R - Relative concept
by the consumer after consuming a
E - Even different from pleasure commodity i.e. it is post-consumption.
S - SATISFACTION AND UTILITY
ARE DIFFERENT
U - Utility depends on intensity of the
want
 FEATURES
F - Forms the basis for demand 2.Utility is assumed satisfaction
E – Ethically neutral but satisfaction is something
A - Also not the same as usefulness T - that is actually realized.
The measurement not possible U - Utility
- subjective concept 3.Utility is related to the
R - Relative concept commodity whereas satisfaction
E - Even different from pleasure is experienced by a person.
S - SATISFACTION AND UTILITY
ARE DIFFERENT
U - Utility depends on intensity of the
want
 FEATURES
• F - Forms the basis for demand The utility of a commodity
• E – Ethically neutral depends on the intensity of
• A - Also not the same as usefulness the want. If the want is
T - The measurement not possible intense and the commodity
U - Utility - subjective concept satisfies the want, then the
• R - Relative concept utility of the commodity is
• E - Even different from pleasure higher.
• S - Satisfaction and utility are
different
• U - UTILITY DEPENDS ON
INTENSITY OF THE WANT
 FEATURES
F - Forms the basis for demand
E – Ethically neutral
A - Also not the same as usefulness T
- The measurement not possible U
- Utility - subjective concept
R - Relative concept
E - Even different from pleasure
S - Satisfaction and utility are different
U - UTILITY DEPENDS ON
INTENSITY OF THE WANT
The utility of notes is higher
when exams are closer as the
want for notes is intense.
The utility of the fan is high
when the weather is warm
outside as the want for the
fan’s breeze is high.
 By
BAy,lfre
Alfred
By
d Marl asrsh
M Hicks
Allen
&
Marginal Indifference
haalll Utility Curve
Analysis Analysis
OR OR
Cardinal Utility Ordinal Utility
Analysis Analysis
 The Cardinal Approach to Consumer Equilibrium
Alfred Marshall (1842-1924), an important member of the
neo- classical school of economics, gave us the cardinal
utility theory of consumer behaviour in his book
Principles of Economics (1890).
Marginal Utility Analysis
This theory will explain us how a consumer spends
his income on different goods & services to attain
maximum satisfaction.
Utility can be of two types:

• Total
TU Utility
• Marginal
MU Utility
Total Utility Marginal Utility
 The word Marginal means
It is the sum of utility
“Border” or “Edge”.
derived from different  It is the additional utility derived
units of a commodity from the consumption of an
additional unit of a commodity.
consumed by a MU = TUn – Tun-1
consumer.
OR
TU = sum of all MUs
MU = Change in TU /
OR Change in units
TU = ∑ MU
 Unit 1 Unit 2 Unit 3 Unit 4 Unit 5 Unit 6

8 Utils 6 Utils 4 Utils 2 Utils 0 Utils -2 Utils

Relationship between TU & MU
Ex. Suppose consumer wants to consume ice-cream.
25

20

15
5 6
-5

Till MU remains +ve, TU increases.

When MU is zero, TU is maximum.
When MU is –ve, TU decreases.
 Assumption of Law of Diminishing Marginal Utility
The cardinal measurement of utility is possible (as
unit of measurement of utility is ‘util’)
MU of money remains constant
The hypothesis of independent utility
Consumer is rational
The Law Of Diminishing Marginal Utility

The law is based on some important facts:

Total wants of the person are unlimited but each single
want is satiable.

Since each want is satiable, as consumer consumes more

& more units of a good, the intensity of his want for the
good goes on increasing.
The law describes fundamental tendency of human
nature.
Law of DMU
According to the Law of Diminishing
Marginal Utility, as a consumer
takes more and more units of a
good, the extra(additional)
satisfaction that he derives from an
extra(additional) unit of a good goes
on falling.
 This is called Point of
Satiety.
(maximum satisfaction)
Law of DMU
Quantity of ice- Marginal

(cont.)
cream
consumed
1
Utility

30
2 20
3 10
4 0
5 -10
Limitations of Law of DMU
Homogeneous Units
Standard Units of consumption
Continuous consumption
The law fails in the case of prestigious
goods
Case of related goods
 How to maximize total satisfaction?

The consumer will maximize total utility

when he allocates his income among
various commodities in such a way that the
MU of last rupee spent on each commodity
is equal.
H.H.Gossen’s Law
H.H. Gossen’s first law :- Law
of Diminishing Marginal Utility

Gossen’s second law :- Law Equi-

of marginal Utility
 Consumer Surplus
Marshall defined the concept as “excess price which a consumer would
be willing to pay rather than go without a thing over that which he
actually does pay.”
Measurement of Consumer’s Surplus

No. of M U Price Consumer’s

units of surplus
ice-
cream
1 40 20 40-20 = 20

2 30 20 30- 20 = 10

3 20 20 20-20 = 0

4 10 20 10-20 = -10
 Measurement
At equilibrium(Maximum satisfaction level) when
consumer buys 3rd unit.
- Marginal Utility = Market price (MUX = Px)
- He is willing to pay a sum equal to the actual
market price.
 What a consumer What he
Consumer’
is ready to pay actually pays
s Surplus
It can not be measured precisely.

In case of necessities the MU of earlier units

are infinitely large.
Affected by availability of substitutes.

It can not be measured in terms of

money.
The Model of Consumer Behavior (Assumptions)

• Consumers are free to spend their incomes as they please

• Consumers have perfect knowledge of all factors that may affect
their decision
• The sales units of commodities are divisible
• The consumer’s tastes and preferences are well established
• The marginal utility of each commodity diminishes for the
consumer as the quantity consumed increases
• More is better than less
• Consumers always attempt to maximize utility
Consumer Equilibrium at Maximum Utility
• ?: How does a consumer decide what to buy?
– Consumers always try to get the most for their money

• Maximum utility is a position of equilibrium

• The cost of consumption (the utility of money) is

balanced against the utility to be gained from the
purchase (see next slide)
Consumer’s Equilibrium
• Each commodity purchased provides marginal utility that
diminishes as consumption increases
– and each can be purchased at a particular price

MU X MU Y
  ...  MU M
PX PY
• At this point the consumer can no longer increase total
utility by buying more or less
– The marginal utility per last dollar spent is equal for all
commodities
 Effects of Advertising and Promotion
• Ex: suppose X sales are rising at the expense of Y sales
MU X MU Y

PX PY
• How can the producers of Y halt the decline in their sales?
– Reduce the price of Y to equalize the ratios
– Change the marginal utility of Y
• The utility of commodity exists only in the consumer’s mind
– Marginal utility may be changed by persuasive advertising and
promotion
Marginal Utility and Demand Curves
• A consumer’s demand curve can be derived from
marginal utility data MU
PX  X
MU M
• E.g.:
• MUM=2; MUX= 200 – 4QX
• Calculating of price from information on marginal utility of commodity X and marginal
utility of money
Overview
I. Consumer Behavior
– Indifference Curve Analysis.
– Consumer Preference Ordering.
II.Constraints
– The Budget Constraint.
– Changes in Income.
– Changes in Prices.
III.Consumer Equilibrium
IV.Indifference Curve Analysis & Demand
Curves
– Individual Demand.
– Market Demand.
 Consumer Behavior
 Consumer Opportunities
– The possible goods and services consumer can afford to
consume.
 Consumer Preferences
– The goods and services consumers actually consume.
 Given the choice between 2 bundles of goods a
consumer either:
– Prefers bundle A to bundle B: A f B.
– Prefers bundle B to bundle A: A p B.
– Is indifferent between the two: A  B.
 Indifference Curve Analysis

Indifference Curve
Good Y
–A curve that defines the combinations of 2 or
III.
more goods that give a consumer the same level of
II.
satisfaction.
I.
Marginal Rate of Substitution
–The rate at which a consumer is willing to
substitute one good for another and maintain
the same satisfaction level.

Good X
Consumer Preference Ordering Properties
 Completeness
 More is Better
 Diminishing Marginal Rate of
Substitution
 Transitivity
 Complete Preferences
 Completeness Property Good Y
– Consumer is capable of expressing III.
preferences (or indifference) between all
II.
possible bundles. (“I don’t know” is
I.
NOT an option!)
A B
• If the only bundles available to a
consumer are A, B, and C, then the
consumer
C
 is indifferent between A and C (they
are on the same indifference curve).
 will prefer B to A.
 will prefer B to C.
Good X
4-
60
 More Is Better!

 More Is Better Property

– Bundles that have at least as much of Good Y
every good and more of some good are III.
preferred to other bundles.
• Bundle B is preferred to A since B II.
contains at least as much of good Y I.
and strictly more of good X.
• Bundle B is also preferred to C 100
A B
since B contains at least as much
of good X and strictly more of good
Y. C
33.33
• More generally, all bundles on ICIII
are preferred to bundles on ICII or
ICI. And all bundles on ICII are 1 3
Good X
preferred to ICI.
4-
61
 Diminishing MRS
 MRS
– The amount of good Y the consumer is
willing to give up to maintain the same
satisfaction level decreases as more of Good Y
good X is acquired. III.
– The rate at which a consumer is willing
to substitute one good for another and II.
maintain the same satisfaction level. I.
100 A
 To go from consumption bundle A to B the consumer
must give up 50 units of Y to get one additional unit
of X. B
50
 To go from consumption bundle B to C the consumer C
must give up 33.33 D
• 16.67 units of Y to get one 25
• additional unit of X.
 To go from consumption bundle C to D the consumer 1 2 3 4 Good X
must give up only 8.33 units of Y to get one
additional unit of X.
 Consistent Bundle Orderings

 Transitivity Property
– For the three bundles A, B, and C, Good Y
the transitivity property implies that if III.
C f B and B f A, then C f A.
II.
– Transitive preferences along with the I.
more-is-better property imply that 100 A

• indifference curves will not 75

C
B
intersect. 50
• the consumer will not get caught
in a perpetual cycle of indecision.
1 2 5 7 Good X
 The Budget Constraint
 Opportunity Set
– The set of consumption bundles that are The Opportunity Set
Y
affordable.
• PxX + PyY  M. Budget Line
 Budget Line M/PY
Y = M/PY – (PX/PY)X
– The bundles of goods that exhaust a consumers
income.
• PxX + PyY = M.

 Market Rate of Substitution

M/P X
– The slope of the budget line X
• -Px / Py.
 Changes in the Budget Line
 Changes in Income Y
M1/PY
– Increases lead to a parallel, outward shift
inthe budget line (M1 > M0).
M0/PY
– Decreases lead to a parallel, downward shift
(M2 < M0). M2/PY

 Changes in Price X
M2/PX M0/PX M1/PX
– A decreases in the price of good X Y
rotates the budget line counter- New Budget Line for
M 0/P Y
clockwise (PX0 a price decrease.

> PX ).1
– An increases rotates the budget line
clockwise (not shown). M /P M /P X
0 X0 0 X1
 Consumer Equilibrium

 The equilibrium consumption

bundle is the affordable
bundle that yields the highest Y
level of satisfaction. M/P Y
Consumer
Equilibrium
– Consumer equilibrium occurs at
a point where
MRS = PX / PY.
– Equivalently, the slope of the III.
indifference curve equals the
budget line. II.
I.
M/P X
X
 Price Changes and Consumer Equilibrium

 Substitute Goods
– An increase (decrease) in the price of good X leads to an
increase (decrease) in the consumption of good Y.
• Examples:
 Coke and Pepsi.
 Verizon Wireless or AT&T.
 Complementary Goods
– An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.
• Examples:
 DVD and DVD players.
4-
 Computer CPUs and monitors. 67
 Complementary Goods

When the price of (Y)

good X falls and the
M/P
consumption of Y Y1

rises, then X and Y

B
are complementary Y2
II
A
goods. (PX1 > PX2) Y1

I
0 X1 M/PX1 X2 M/PX2 Beer (X)
Income Changes and Consumer Equilibrium

 Normal Goods
– Good X is a normal good if an increase
(decrease) in income leads to an increase
(decrease) in its consumption.
 Inferior Goods
– Good X is an inferior good if an increase
(decrease) in income leads to a decrease
(increase) in its consumption.
 Normal Goods

Y
An increase in income
increases the M1/Y

consumption of normal
goods.
B
(M0 < M1). Y1
M0/Y
II
A
Y0
I
0 X0 M0/X X1 M1/X X
 Decomposing the Income and Substitution Effects

Initially, bundle A is consumed. A decrease Y

in the price of good X expands the
consumer’s opportunity set.
The substitution effect (SE) causes the C
consumer to move from bundle A to B.
A higher “real income” allows the A II
consumer to achieve a higher indifference B
curve.
The movement from bundle B to C I
represents the income effect (IE). The new
equilibrium is achieved at point C. 0 IE X
SE
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71
 A Classic Marketing Application

Other
goods
(Y)

A
A buy-one,
C E
get-one free D II
pizza deal. I

0 0.5 1 2 B F Pizza
(X)

4-
72
 Individual Demand Curve

An individual’s
demand curve is
derived from each II
I
new equilibrium point
$ X
found on the
indifference curve as P0
the price of good X is P1 D
varied. X0 X1 X

4-
73
 Market Demand
 The market demand curve is the horizontal summation of
individual demand curves.
 It indicates the total quantity all consumers would purchase
at each price point.
Rs. Individual Demand Rs. Market Demand Curve Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
 Conclusion
 Indifference curve properties reveal information
about consumers’ preferences between bundles of
goods.
– Completeness.
– More is better.
– Diminishing marginal rate of substitution.
– Transitivity.
 Indifference curves along with price changes
determine individuals’ demand curves.
 Market demand is the horizontal summation of
individuals’ demands.
Thank you for your Attention!!!
Any Questions?