Economics Project - Kaustubh Singh Thakur - Copy.docx

Economics (Minor) Project | First Semester Significance of Marginal Utility in Measuring Consumer’s Behavior – an Analysis

Submitted by:

Submitted to:

Kaustubh Singh Thakur

Ms. Jasmine Kaur

Roll no. – 18042

RGNUL, Punjab Group: 03 (Section A)

Rajiv Gandhi National University of Law, Punjab 2018

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Acknowledgement I would like to express my sincere gratitude and ineffable indebtedness to my Economics (minor) professor Ms. Jasmine Kaur who gave me an opportunity and guided me throughout my research work on the project topic “Significance of Marginal Utility in Measuring Consumer’s Behavior – an Analysis.” It was my privilege to work under her guidance.

The RGNUL Library has also greatly contributed to the making of this project.

At last, I would also like to thank my friends for helping me and motivating me to complete this project on time.

Kaustubh Singh Thakur Rajiv Gandhi National University of Law Punjab First Year 18042

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Table of Contents 1) Research Methodology 2) Objectives 3) Introduction 4) Utility 5) Concepts of Utility 6) Law of Diminishing Marginal Utility 7) Conditions of Consumer Equilibrium in Case of a Single Commodity 8) Consumer Equilibrium in Case of Two Commodities 9) Conclusion 10) Bibliography

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Research Methodology The Research Methodology used in this project has been primarily library research and specifically doctrinal research where we derive the research material from the secondary sources such as books, research papers, journals and articles.

Objectives The objective of this study is to gain fundamental knowledge in the field of significance of marginal utility in measuring consumer’s behavior. This will enable me to learn and critically analyze the concept of marginal utility and consumer’s behavior. To do this, I have studied and examined various research papers and journals which are relevant to this field and I have also taken help of a few notable books based on ‘Microeconomics’.

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Introduction Meaning of Utility In Economics, the term utility refers to the quality of a commodity by virtue of which it satisfies a consumer’s wants. In other words, want satisfying power of good or commodity is called utility. It is quantitative measure of satisfaction. It refers to the amount of satisfaction, a consumer receives from consumption of a good or service. Meaning and Objectives of a Consumer The consumer occupies a pivotal place in the economic activity. He is an economic agent who consumes goods and services for the satisfaction of his or her wants or he buys goods and services for satisfaction of his wants. The satisfaction of wants is the beginning and end of all economic activities. The objective and behavior of a consumer is such that he spends his limited income on various goods and services in such a way that he obtains maximum satisfaction which implies that the objective of a consumer is to get maximum satisfaction from the expenditure incurred on various goods and services. There are two approaches to study consumer behavior and equilibrium: 1) Utility approach (Cardinal Utility Analysis). 2) Indifference curve approach/ analysis (Ordinal Utility Analysis) The cardinal utility approach is based on the concepts of total utility and marginal utility. It uses marginal utility curve to explain consumer equilibrium. On the other hand ordinal utility approach makes use of indifference curve to explain consumer equilibrium.

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Utility Utility is an economic term introduced by Daniel Bernoulli referring to the total satisfaction received from consuming a good or service. The economic utility of a good or service is important to understand because it will directly influence the demand, and therefore price, of that good or service. A consumer's utility is hard to measure, however, but it can be determined indirectly with consumer behavior theories, which assume that consumers will strive to maximize their utility. Characteristics of Utility 1) Utility depends upon urgency or intensity of want – utility is the function of intensity of want. More intensity of want implies a higher utility for a commodity. For example, woolen clothes give more utility in winters than in summers. 2) Utility is subjective – it cannot be quantified, it may vary from person to person, for example, a hungry person gets more satisfaction from chapattis in comparison to a person who is not hungry. It keeps changing with time or place. 3) Utility is measurable – there are two approaches for the measurement of utility – a) Cardinal Utility Analysis – this is given by Marshall which measures utility in quantitative order like 1, 2, 3, 4….etc. The units of utility are called utils. It is measured in absolute numbers. Marginal utility curve is used to explain consumer equilibrium. b) Ordinal Utility Analysis – also known as indifference curve analysis. This is given by Hicks and Allen. It measures utility in qualitative order like first preference, second preference, third preference etc. It is measured in ranks. Indifference curve is used to explain consumer equilibrium. 4) Utility is essentially not useful – higher utility does not always mean greater usefulness, e.g., drugs may give utility to a drug addict but are not useful otherwise.

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Concepts of Utility There are two types of utility – 1) Total Utility (TU). 2) Marginal Utility (MU). 1) Total Utility (TU) It is defined as the total psychological satisfaction, a consumer derives from consumption of a certain amount of commodity. It is the sum total of utility derived from the consumption of all the units of a commodity. To illustrate, if 2 units of a commodity are consumed and 1st units yields satisfaction of 10 utils, while the 2nd unit yields satisfaction of 9 utils, then total utility = 10 utils + 9 utils = 19 utils. Mathematically, TU is aggregation of marginal utility derived from consumption of different units of the commodity.

TUn = MU1 + MU2 + MUn TU = ∑ MU

2) Marginal Utility (MU) It refers to additional utility on account of the consumption of an additional unit of a commodity. It is an addition made to total utility by consuming an additional unit of the commodity or it is the additional utility derived from consumption of one or more unit of the given commodity. MUn = TUn – TUn-1 (when units consumed change in consecutive order, one by one). MUx = ∆TUx ∆Qx

(when units do not change in consecutive order)

Where, x is the commodity consumed and Qx is the quantity consumed of commodity x.

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Law of Diminishing Marginal Utility This law was first given by a German economist Gossen. That is why it is also popularly known as Gossen’s first law of consumption. This law states that as the stock of goods for consumption increases, the utility derived from it decreases. Marshall states the law as: “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.” According to law of DMU, as a consumer consumes more and more units of a commodity, marginal utility derived from additional units goes on falling i.e., the utility derived from each successive unit falls. Assumptions of Law of Diminishing Marginal Utility 1) Cardinal measurement of utility – it is assumed that utility can be measured in quantitative terms such as 1, 2, 3…..etc., otherwise it is a qualitative aspect. 2) Standard unit of measurement – unit of measurement should not be very large or very small. For example, water consumption should not be measured in drops, or in spoons, it should be measured as a glass full of water. 3) Continuous consumption – there should not be time gap between consumption of successive units of the commodity e.g., first chocolate in the morning and second chocolate in the evening. The law will not hold good in such a case 4) MU of a rupee remains constant – MU of a rupee is the purchasing power of a rupee. It is assumed that MU of a rupee remains same for all units of the commodity in the question. 5) Fixed income and price – it is assumed that there is no change in price of the good and income of an individual.

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Significance of the Law of Diminishing Marginal Utility

1. Basis of Economic Laws - The Law of Diminishing Marginal Utility is the basic law of consumption. The Law of Demand, the Law of Equi-marginal Utility, and the Concept of Consumer’s Surplus are based on it.

2. Diversification in Consumption and Production - The changes in design, pattern and packing of commodities very often brought about by producers are in keeping with this law. We know that the use of the same good makes us feel bored; its utility diminishes in our estimation. We want variety in soaps, toothpastes, pens, etc. Thus, this law helps in bringing variety in consumption and production.

3. Value Theory - The law helps to explain the phenomenon in value theory that the price of a commodity falls when its supply increases. It is because with the increase in the stock of a commodity, its marginal utility diminishes. 4. Diamond-Water Paradox- The famous “diamond-water paradox” of Smith can be explained with the help of this law. Because of their relative scarcity, diamonds possess high marginal utility and so a high price. Since water is relatively abundant, it possesses low marginal utility and hence low price even though its total utility is high. That is why water has low price as compared to a diamond though it is more useful than the latter.

5. Progressive Taxation - The principle of progression in taxation is also based on this law. As a person’s income increases, the rate of tax rises because the marginal utility of money to him falls with the rise in his income. Exceptions to the Law of Diminishing Marginal Utility 1)

Dissimilar units - This law is applicable for homogenous unit only, i.e. only if all units of a commodity consumed are similar in length, breadth, shape and size. If there is a change in such factors, the utility obtained from it can be increased. For example: If the 2nd orange is much larger than the 1st one, it will yield more satisfaction than the 1st.

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2) Unreasonable quantity - The quantity of the commodity a consumer consumes should be reasonable. If the units of consumption are too small, then every successive unit of consumption may give higher utility to the consumer. For example: If a person is given water by a spoon when he is very thirsty, each additional spoonful will give him more satisfaction.

3) Not a suitable time period - There should not be very long gap between the consumption of different units of the commodity. If there is time lag between the consumption of different units, then this law may not hold good. For example: If a man has lunch at 10 a.m. and dinner at 8 p.m. and eats nothing in between, the dinner will possibly yield even more satisfaction than the lunch, i.e. his marginal utility will not diminish.

4) Rare collection - This law does not apply for rare collections such as old coins, stamps and so on because the longer and larger the number he collects, the greater will be the utility.

5) Change in taste and fashion of the consumer - The law of diminishing marginal utility will be applicable only if the consumer is not supposed to change taste and fashion of the commodity whatever he/she was using previously.

6) Abnormal person - The law of diminishing marginal utility is applicable for normal person only. Abnormal persons such as drunkards and druggist are not associated with the law.

7) Change in income of the consumer - To hold the law good, there should not be any change in the income of the consumer. If the income of the consumer increases, he will consume more and more units of a commodity which he prefers. As a result, utility can be increased rather than decreased. 8) Habitual goods - The law will not be applicable for habitual goods such as consumption of cigarettes, consumption of drugs, alcohol, etc.

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Tabular and Graphical Representation of Law of Diminishing Marginal Utility Quantity (Units) 0 1 2 3 4 5 6

Total Utility 0 8 14 18 20 20 18

Marginal Utility 8 6 4 2 0 -2

Law of DMU 25 20 15 10

5 0 0

1

2

3

4

5

6

-5 Total Utility

Marginal Utility

Relation between Total Utility and Marginal Utility. As more and more units of a commodity are consumed, marginal utility derived from each successive unit tends to diminish. It may become zero or negative. So as long MU is positive, TU increases. TU is maximum when MU is zero. TU starts decreasing when MU is negative. Decreasing MU implies that TU increases at a decreasing rate.

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Conditions of Consumer Equilibrium in Case of a Single Commodity Consumer equilibrium refers to a situation in which a consumer spends his income on purchase of a commodity in such a way that gives him maximum satisfaction. Consumer equilibrium is determined when the following conditions are satisfied: 1) Marginal utility (MUx) = Price (Px) 2) Total gain decreases with additional purchase after equilibrium.

Condition 1. MUx = Px When MUx > Px , a consumer gains more satisfaction as compared to sacrifice he makes in terms of price paid by him. Hence, he gets prepared to buy more. Law of DMU operates. MU falls as he buys more and becomes equal to price of the commodity. When MUx< Px , a consumer suffers losses as he is paying more than what he actually gains. He reduces consumption of the commodity. Law of DMU operates. MU begins to rise and becomes equal to the price of the commodity.

Condition 2. Total gain fall after equilibrium It is because marginal utility is falling and after equilibrium it becomes smaller than the price paid for than the additional units of the commodity.

MU of a Rupee MU is measured in utils, but to make MU comparable to price, its need to be converted to MU in terms of money. MU in money terms/Rupees = MU(utils) (MU of a rupee) MU of a rupee is the utility obtained when an additional rupee is spent on other goods.

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Tabular and Graphical Representation of Consumer’s Equilibrium in Case of a Single Commodity Units

MU (Utils)

MU in terms Price

Consumed

Gain

of Money

1

10

5

3

2

2

8

4

3

1

3

6

3

3

0

4

4

2

3

-1

5

2

1

3

-2

6

0

0

3

-3

7

-2

-1

3

-4

8

-4

-2

3

-5

9

-6

-3

3

-6

Consumer Eqilibrium in case of one commodity 6 5 4 3 2 1

0 -1

1

2

3

4

5

6

7

8

9

-2 -3 -4 MU in terms of Money

Price

The above schedule is based upon the following assumptions – 1) MU falls as law of DMU operates. 2) MU of a rupee is 2 utils. 3) Price of the commodity is Rs. 3 per unit.

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Consumer Equilibrium in Case of Two Commodities A consumer usually consumes more than one commodity. In such a case, law of DMU is extended to many goods which the consumer purchases. Law of Equi-marginal utility helps in determining consumer equilibrium in case of two commodities. According to this law, a consumer gets maximum satisfaction when ratios of MU of two commodities of their respective prices are equal. In other words, a consumer will spend his income in such a way that utility gained from the last rupee spent on each commodity is equal. There are two ways in which consumer equilibrium can be determined in case of two commodities – 1) When price of each commodity is the same 2) When price of two commodities are different

When Price of each Commodity is the Same In case of 2 commodities, a consumer attains equilibrium when marginal utilities of both the goods are equal i.e., MU of good X = MU of Good Y. MUx = MUy = MUm (MU of last rupee spent) Px Py The conditions of equilibrium are 1) MUx = MUy 2) Law of diminishing marginal utility (DMU) operates. 3) Expenditure on commodity x + Expenditure on commodity y = Money income.

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Tabular and Graphical Representation of Consumer Equilibrium in case of Two Commodities When Price of each Commodity is the Same Units Consumed

MUx (Utils)/ MU of a MUY (utils)/ MU of a rupee

rupee

1

12

10

2

10

8

3

8

6

4

6

4

5

4

2

Assuming that price of each commodity is Rs. 1 and money income of a consumer is Rs. 5, a rational consumer will try to maximize his total satisfaction. He spends first on X, second on Y, third on X, fourth on Y and fifth on X. He gets maximum satisfaction equal to 48 utils. If he spends his money on any other combination, total utility would be less than 48 utils. Thus he buys 3 units of good X and 2 units of good Y.

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When Prices of Two Commodities are Different If the prices of two goods are different then the conditions of consumer equilibrium are – 1) MUx/Px = MUy/Py = MU of last rupee spent. 2) Law of Diminishing Marginal Utility operates. 3) Total expenditure = Money income i.e., P1x1 + P2x2 = M

Tabular of Consumer Equilibrium in case of Two Commodities When Price of two Commodities are different Units of X

MUx (Utils)

Px (Rs.)

MU

of

a

Rupee (Utils) 1

100

10

10

2

80

10

8

3

60

10

6

4

40

10

4

5

20

10

2

6

0

10

0

7

-20

10

-2

Units of Y

MUy (Utils)

Py (Rs.)

MU

of

a

Rupee (Utils) 1

24

2

12

2

22

2

11

3

20

2

10

4

18

2

9

5

16

2

8

6

14

2

7

7

12

2

6

Equilibrium is determined when the consumer buys 2 units of commodity x and 5 units of commodity y.

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Conclusion Cardinal utility analysis or utility approach or marginal utility approach lets us quantitatively determine utility, but it also has certain shortcomings and limitations, such as – 1) The utility analysis assumes that utility is cardinally measurable, i.e., it can be assigned definite numbers. But it is wrong to say that utility can be measured cardinally. Utility is subjective and as such it cannot lie measured. We can only say whether satisfaction is more or less. We cannot say exactly how much. That is, ordinal measurement is possible and not cardinal measurement.

2) The utility analysis further assumes that utilities are independent. That is why it is said that utility of a commodity varies with its quantity and of that commodity alone. But the fact is that commodities are interlinked and the utility of one is influenced by that of another. 3) Besides, the utility analysis does not fully bring out the income effect and substitution effect of a change in price. It is unable to explain how much of the increased demand for a commodity is due to the income effect and how much to the substitution effect when price of the commodity has changed. As Hicks says, "The distinction between direct and indirect effects of a price change is accordingly left by the cardinal theory as an empty box, which is crying out to be filled."

4) Also, the utility analysis assumes that the marginal utility of money remains constant as a consumer goes on spending the money on the purchase of a commodity. This is not correct, because as the amount of money goes on decreasing, its marginal utility must rise.

5) Finally, the utility analysis fails to explain the demand for certain commodities which are big and indivisible, e.g., a house, a car. In view of these shortcomings of the utility analysis, modern economists have adopted a new technique, called the indifference curve technique, to explain consumer demand.

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Bibliography Books 1) Introductory Microeconomics, Radha Bahuguna 2) Microeconomics, M.L Jhingan 3) Microeconomics, T.R Jain, V.K Ohri Websites 1) https://economics.knoji.com 2) https://www.pdfcoke.com 3) http://www.economicsdiscussion.net

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