Demand and Utility

Meaning of Demand

 Demand means “ Desire for a commodity backed by the willingness to pay for it”.
 The desire without adequate purchasing power and willingness to pay do not
affect the market, nor do they generate production capacity.
 A want with three attributes – desire to buy, ability to pay and willingness to pay.
 Consumers demand for a commodity because they derive or expect to derive
utility from the consumption of that commodity.
 Utility
 “Utility is the want satisfying property of a commodity.” ( Product angle)
 Utility is the psychological feeling for satisfaction, pleasure, happiness or well being, which a
consumer derives from the consumption, possession or the use of a commodity. ( Consumers angle)
 The central theme of the consumption theory is the utility maximizing behavior of the consumer
 Utility is a subjective concept:
 A commodity need not be useful for all
 Utility of a commodity varies from person to person from time to time.
 Utility need not have the same utility for the same consumer at different points of time.
 Quantitative concepts related to utility – Total Utility
Marginal Utility
Total Utility (TU)
It can be derived as the sum of the utility derived by a consumer from the various units of a good or
service consumer consumes at a point or over a period of time.
TUn = MU1 + MU2 +MU3 + ….……….. + MUn

Marginal Utility
Utility derived from the additional unit consumed. It is the addition to the total utility as consumption is
increased by one more unit of the commodity.
MUn = TUn – TUn-1
or
MUx = Change in TUx / Change in units of X
Law of Diminishing MU
The law states that as the quantity of a commodity goes on increasing, the utility
derived from each successive unit consumed goes on decreasing, consumption of all
the other commodities constant.
The utility gained from a unit of a commodity depends on the intensity of the desire
for it.
The law of Diminishing MU holds only under certain conditions
 The unit of the consumer good must be a standard one.
 The taste’s and preferences of the consumers must remain the same during the period of
consumption.
 There must be continuity in consumption.
 Mental condition of the consumer must be normal during the period of consumption.
Cardinal Utility Concept
 Utility is cardinally or quantitatively measurable
 Attributed to Alfred Marshal and his followers. Also known as Neo – Classical Approach
Assumptions:
 Rationality
 Cardinal Utility
 Constant MU of money
 Diminishing MU.
 Utility is additive
Cardinal Utility Theory
Case 1: One Commodity
 Suppose that a consumer with a given money income consumes only one commodity X.
The consumer can either spent the money income on commodity X, or can retain it.
 If the MUx > MUm (MU of money), a utility maximizer will exchange his money income
for the commodity.
 Consumer is in equilibrium : MUx = Px (Marginal Utility of the good = Price of the
good)
 Consumer will spent his money income as long as MUx > Px
Case II : Multiple Commodity Model.
 A rational and a utility maximizing consumer consumes commodities in the order of their utilities. MU
schedule of various commodities may not the same.
 The consumer spends on different goods he consumes so that the MU from each good is equal. This is
called the law of Equi – Marginal utility
 The Law of Equi – Marginal states that consumer consumes various goods in such quantities that the
MU derived per unit of expenditure from each good is the same.
 Suppose that the consumer consume only two commodities X and Y, their prices given as Px, Py
 The consumer will spent his income on the commodities in such a way that
MUx = Px
MUy = Py
 Consumers Equlibruim Condition => MUx / Px = MUy/Py
Ordinal Utility Approach

 Utility can be measured only comparatively.

 Ordinal utility approach was introduced by J. R. Hicks and R. G. D Allen .
 In order to analyse consumer behavior, Hicks used a tool of analysis called
Indifference curve.
Assumptions
 Rationality
 Ordinal Utility
 Transitivity and consistency of Choice
 Dimnishing Marginal Rate of Substitution (MRS)
Indifference Curve (IC)
 Indifference curve can be defined as the locus of points each representing a
different combination of two substitute goods, which yield the same utility or level
of satisfaction to the consumer.
 He is indifferent between any two combinations of two goods when it comes to
making a choice between them.
 When such are plotted in a graph, its called the Indifference Curve.
 An IC is also called iso – utility curve or equal utility curve.
Law of Marginal Rate of Substitution.
 Indifference curve is formed by substituting one good for another.
 The rate at which one good is substituted for another, the level of satisfaction
remains the same is called Marginal Rate of Substitution.
 The MRS is expressed as change in X to change in Y, moving down the IC
 MRS goes on Diminishing, because the quantity of a commodity that a
consumer is willing to sacrifice for an additional unit of another goes on
decreasing when he goes on substituting one commodity for the other.
 The diminishing MRS causes the IC to be convex to the origin.
 MRS diminishes along the IC curve because, in most cases no two goods are perfect substitutes for one
another.
 In case any two goods are perfect substitutes, the IC will be a straight line negatively sloped showing
constant MRS.
 If the goods are not substitutes, the subjective value attached to the additional quantity of a commodity
decreases fast in relation to the other commodity whose total quantity is decreasing.
 Therefore, the consumer becomes increasingly unwilling to sacrifice more units of Y for one unit of X.
Properties of Indifference Curve

 Indifference Curve slopes downward to right

 Indifference Curve is convex to the origin
 Indifference curve do no intersect each other nor are they tangent to each
other.
 Upper Indifference Curve indicates higher level of satisfaction.
1. Indifference Curve slopes downward to right
1. The two goods can be substituted for each other
2. If the quantity of one commodity decreases, quantity of the other commodity must so increase
that the consumer stays at the same level of satisfaction.
2. Indifference Curves are convex to the origin
1. The two commodities are imperfect substitutes for one another
2. The MRS between the two goods decreases as the consumer moves along an Indifference
curve
3. Indifference curve do no intersect each other nor are they tangent to each
other.

 Point A falls on both the IC, Point B on IC’ and Point C on IC

 Point A and B fall on the same IC’, it means
A= B
 Point A and C falls on the same IC, it means
A= C
 According to the transitivity assumption
B=C
(ON of X+BN of Y= ON of X+CN of Y)
 But the intersection of IC violates the transitivity
and consistency rule.
4. Upper Indifference Curve indicates higher level of satisfaction
A larger basket of commodities yield a greater satisfaction than the smaller one.
Budgetary Constraint
 A utility maximizing consumer has 2 constraints:
1. Limited Income
2. He has to pay price for the goods
 They act as a constraint on high a consumer can ride on his Indifference Map. This is known as
budgetary Constraint.
 Budget Equation : Px * Qx + Py * Qy = M
 The equation states that the total expenditure of the consumer on its good X and Y, cannot exceed his
income, M.
 When the values of Qx and Qy are plotted on the graph, we get a negative slope straight line called the
Budget Line.
 Budget Line shows the alternative options of commodity combinations available to the consumer given
his income and the prices of X and Y
Budget Line(BL) shows the alternative options of commodity combinations available to the
consumer given his income and the prices of X and Y
 Budget line divides the commodity space into two parts,
1. Feasible Area 2. Non Feasible Area
 The area under BL is Feasible area, and above
Is Non Feasible area.
 Any combination of goods X and Y represented by a
point within this area, point A or a point on the budget line
is a feasible combination, given M, Px and Py
 The area beyond the budget line is non feasible area
because any point falling in this area , like point B is
unattainable.
Consumers Equilibrium
 A consumer attain equilibrium when he maximizes his total utility, given his income
and market prices of goods and services that he consumes.
 Two Conditions for consumers equilibrium
1. Necessary Condition – First Order Condition
2. Supplementary Condition – Second Order Condition.
 First order condition – MUx/MUy = Px/Py
MUx/MUy = MRSx,y
MRSx,y = MUx/MUy = Px/Py

 Second Order Condition – First order condition to be fulfilled at a Higher possible

Indifference Curve.
 Indifference curve IC1, IC2, IC3. Budget Line AB.
 BL And IC2 are tangent at point E. Slope of IC gives MRS, Slope of BL gives Price ratio of X and Y
 At point E, MRSx,y = Px/Py
 IC2 indicated the highest IC, that the consumer can reach.
 Both necessary and supplementary conditions are satisfied at
point E
 Consider other points J and K ( Point of intersection between BL
and IC1)
 These points do not satisfy the second order condition.
 IC1 is the highest possible IC.
 Level of satisfaction at E is greater than any other point.
 Due to budget constraint, he will not able to move the IC above IC2.
 IC3 falls in the infeasibility area.
Derivation of Consumers Demand Curve
 Suppose Mux anf Price of the commodity X is a given as
P3.
 Consumer is in equilibrium at point E1.