Utility Analysis
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1. UTILITY ANALYSIS Two questions arise with regard to the behaviour of the consumer: (i) why does a consumer demand a good or a service? How does a consumer spend his income on various goods and services so that he gets maximum satisfaction or that he may be in equilibrium? The answer to the first question is that a consumer demands a good or service because it gives him satisfaction/utility. The answer to the second question is that Economists have put forward three main theories in this regards: (i) cardinal utility analysis, (ii) ordinal utility analysis, and (iii) revealed preference analysis. The present chapter deals with the cardinal utility analysis. 2. CARDINAL UTILITY ANALYSIS 2.1 Utility Utility is the capacity of a good that satisfies human want. 2.2 Features of utility The following main features of utility merit attention: (i)
Utility is subjective: Utility is subjective because it deals with the metal satisfaction of a man. A thing may have different utrility for different persons. Liquor has utility for drunkardbut for a person who is teetotaller, liquor has no utility. (ii) Utility is relative: Utility of a commodity never remains the same. It varies across place and time. Desert cooler has utility during summer but not during the winter season. (iii) Utility is not essentially useful: A commodity having utility need not be useful. Wine and cigarrette are not useful, but it satisfies the want of a driner and smoker and have utility for them. (iv) Utility is independent of morality: Utility has nothing to do with morality. Use of wine may be immoral but these satisfy the want of a drunkard and thus has utility. 2.3 Basic assumptions of utility analysis Utility analysis is based on the following assumptions: (i) (ii)
(iii)
Rational consumer: Consumer is assumed to be rational. A rational consumer is one who is keen to get maximum satisfaction out of his limited income. Cardinal utility: Utility of evey commodity can be measured in terms of cardinal numbers, such as, 1, 2, 3, 4 etc. It is measured in terms of money. The utility is measured by money that the consumer is prepared to pay for a unit of the commidity. Independent utility: It is assumed that the utility that a consumer gets from a commodity depends upon the quantity of that every commodity. It is not affected by the utility derived from other goods.
(iv) (v) (vi) (vii)
Marginal utility of money is constant: It is assumed that money measures the marginal utility of a commodity; as such, its own marginal utility should remain constant so as to serve as an ideal measure. Divisibility: Goods are divisible. The quantity consumed of the commodity can be exactly adjusted. Diminishing marginal utility: As a consumer consumes increasing units of a commidity, the marginal utility of the successive units of that commodity diminishes. Total utility depends on quantities of individual commodities: The total utility of a basket of goods depends on the quantities of individual commodities. If there are ‘n’ commodities in the bundle with n1, n2, …, nn quantities of total utility is, U = f(n1, n2, …, nn)
Cardinal Measurement of utility It is assumed that utility can be measured and can be given definite quantity like 1, 2 or 3. This means that a person can express the satisfaction derived from consumption of commodity in quantitative term. Marginal utility analysis assumes in the first place that utility can be measured by assigning definite numbers such as 1,2,3,4, e.t.c. That is it is assumed that utility is the quantifiable entity. This means that a person can express the satisfaction derived from his consumption of commodity is quantitative terms. He can say, for instance, that for him the first unit of the commodity has utility equal to 10, the second unit 8, and so on, In this way, it is possible for a consumer to compare the utilities of different goods. Utility is usually measured in imaginary units. Utilities are independent Marginal utility assumes that utility of different commodities are independent to each other. Marginal utility analysis assumes that the utilities are different commodities are independent of one another. That is the utility of one commodity does not in any way affect that of another. Thus according to this assumption, the utilities of various goods are additive or separate utilities of various goods can be added to obtain the total sum of the utilities of all goods consumed. Constant marginal utility of money Another important assumption is that the marginal utility of money remains constant. Another important assumption of marginal utility analysis is that marginal utility of money remain constant can even though the quantity of money with the consumer is diminished by the successive purchase made by him. It is assumed that while marginal utility of a commodity varies with quantity of the commodity purchases their marginal utility of money remains throughout the same as the quantity of the goods purchase varies. Introspection
The marginal utility analysis al so assumes that from one’s experience, it is possible to draw inference about other person. The marginal utility analysis also assumes that from ones own experience (judging what happens in ones own mind), it is possible to draw inference about another person. This is self-observation applied to another person.
2.4 Concepts of utility There are two main concepts of utility: (i) total utility, and (ii) marginal utility. (i)
Total utility:
(ii)
Marginal utility:
Marginal utility can be (i) positive, (ii) zero, or (iii) negative. (i)
(ii)
(iii)
Positive marginal utility: If by consumingadditional units of a commodity, total utility goes on increasing then the marginal utility of these units will be positive. Suppose you take bread to satisfy your hunger. The first piece of bread gives you 8 utils and the second 6 utils of utility. Thus from two pieces of bread you get total utility equal to 14 utils. Thus by taking additional units of bread, total utility goes on increasing. Marginal utility derived from the subsequent units remains positive. Zero marginal utility: If the consumption of an additional unit of a commodity causes no change in total utility, marginal utility of the additional unit is zero. At this level of consumption, total utility will be maximum. This is called the saturation point of the consumer. Suppose 4 pieces of bread yield total utility of 20 utils. Consumption of 5th piece of bread does not make any change in the total utility. It remains 20 utils. It is obvious that marginal utility of the 5th piece of bread is zero. Negative marginal utility: If the consumption of an additional unit of a commodity causes a fall in total utility, it means that marginal utility of that unit is negative. After eaching the saturation point if the consumer is compelled to take 6th piece of bread then it may upset his digestive system. Consequently, the total utility of six pieces of bread may come down to 18 utils. It means the marginal utility of the 6th piece of bread is -2 units.
2.5 Difference between total utility and marginal utility
The difference between total utility and marginal utility may be explained with the Table 1 and Figure 1: Table 1: Difference between total utility and marginal utility Quantity
Total utility
Marginal utility
Conclusion
0 1 2 3 4 5
6 7
Following observations can be made about the difference between total utility and marginal utility: (i) (ii)
Total utility is the sum of utility derived from all theu units of a commodity consumed. Marginal utility, on the other hand, is additional utility due to the consumption of an additional unit of the commodity. Total utility is the sum total of marginal utilities of the various units of the commodity consumed, TU = MU TU = total utility; =summation; MU = marginal utility TU6 = MU (1st) + MU (2nd) + MU (3rd) + MU (4th) + MU (5th) + MU (6th) 18 = 8 + 5 + 4 + 2 + 0 + (-2) Marginal utility, on the other hand, refers to change in total utility due to a unit change in the consumption of a commodity. It is the difference between two successive total utility figures. Symbolically,
(iii) 2.6 Relation between total utility and marginal utility
2.7 Significance of the difference between total utility and marginal utility (i) The diamond-water paradox (ii) Consumer’s surplus 2.8 Basic laws of utility analysis Utility analysis has two main laws: (i) (ii) 2.9
The law of diminishing marginal utility The law of equi-marginal utility
Utility is subjective: Utility is subjective because it deals with the metal satisfaction of a man. A thing may have different utrility for different persons. Liquor has utility for drunkardbut for a person who is teetotaller, liquor has no utility. (ii) Utility is relative: Utility of a commodity never remains the same. It varies across place and time. Desert cooler has utility during summer but not during the winter season. (iii) Utility is not essentially useful: A commodity having utility need not be useful. Wine and cigarrette are not useful, but it satisfies the want of a driner and smoker and have utility for them. (iv) Utility is independent of morality: Utility has nothing to do with morality. Use of wine may be immoral but these satisfy the want of a drunkard and thus has utility. 2.3 Basic assumptions of utility analysis Utility analysis is based on the following assumptions: (i) (ii)
(iii)
Rational consumer: Consumer is assumed to be rational. A rational consumer is one who is keen to get maximum satisfaction out of his limited income. Cardinal utility: Utility of evey commodity can be measured in terms of cardinal numbers, such as, 1, 2, 3, 4 etc. It is measured in terms of money. The utility is measured by money that the consumer is prepared to pay for a unit of the commidity. Independent utility: It is assumed that the utility that a consumer gets from a commodity depends upon the quantity of that every commodity. It is not affected by the utility derived from other goods.
(iv) (v) (vi) (vii)
Marginal utility of money is constant: It is assumed that money measures the marginal utility of a commodity; as such, its own marginal utility should remain constant so as to serve as an ideal measure. Divisibility: Goods are divisible. The quantity consumed of the commodity can be exactly adjusted. Diminishing marginal utility: As a consumer consumes increasing units of a commidity, the marginal utility of the successive units of that commodity diminishes. Total utility depends on quantities of individual commodities: The total utility of a basket of goods depends on the quantities of individual commodities. If there are ‘n’ commodities in the bundle with n1, n2, …, nn quantities of total utility is, U = f(n1, n2, …, nn)
Cardinal Measurement of utility It is assumed that utility can be measured and can be given definite quantity like 1, 2 or 3. This means that a person can express the satisfaction derived from consumption of commodity in quantitative term. Marginal utility analysis assumes in the first place that utility can be measured by assigning definite numbers such as 1,2,3,4, e.t.c. That is it is assumed that utility is the quantifiable entity. This means that a person can express the satisfaction derived from his consumption of commodity is quantitative terms. He can say, for instance, that for him the first unit of the commodity has utility equal to 10, the second unit 8, and so on, In this way, it is possible for a consumer to compare the utilities of different goods. Utility is usually measured in imaginary units. Utilities are independent Marginal utility assumes that utility of different commodities are independent to each other. Marginal utility analysis assumes that the utilities are different commodities are independent of one another. That is the utility of one commodity does not in any way affect that of another. Thus according to this assumption, the utilities of various goods are additive or separate utilities of various goods can be added to obtain the total sum of the utilities of all goods consumed. Constant marginal utility of money Another important assumption is that the marginal utility of money remains constant. Another important assumption of marginal utility analysis is that marginal utility of money remain constant can even though the quantity of money with the consumer is diminished by the successive purchase made by him. It is assumed that while marginal utility of a commodity varies with quantity of the commodity purchases their marginal utility of money remains throughout the same as the quantity of the goods purchase varies. Introspection
The marginal utility analysis al so assumes that from one’s experience, it is possible to draw inference about other person. The marginal utility analysis also assumes that from ones own experience (judging what happens in ones own mind), it is possible to draw inference about another person. This is self-observation applied to another person.
2.4 Concepts of utility There are two main concepts of utility: (i) total utility, and (ii) marginal utility. (i)
Total utility:
(ii)
Marginal utility:
Marginal utility can be (i) positive, (ii) zero, or (iii) negative. (i)
(ii)
(iii)
Positive marginal utility: If by consumingadditional units of a commodity, total utility goes on increasing then the marginal utility of these units will be positive. Suppose you take bread to satisfy your hunger. The first piece of bread gives you 8 utils and the second 6 utils of utility. Thus from two pieces of bread you get total utility equal to 14 utils. Thus by taking additional units of bread, total utility goes on increasing. Marginal utility derived from the subsequent units remains positive. Zero marginal utility: If the consumption of an additional unit of a commodity causes no change in total utility, marginal utility of the additional unit is zero. At this level of consumption, total utility will be maximum. This is called the saturation point of the consumer. Suppose 4 pieces of bread yield total utility of 20 utils. Consumption of 5th piece of bread does not make any change in the total utility. It remains 20 utils. It is obvious that marginal utility of the 5th piece of bread is zero. Negative marginal utility: If the consumption of an additional unit of a commodity causes a fall in total utility, it means that marginal utility of that unit is negative. After eaching the saturation point if the consumer is compelled to take 6th piece of bread then it may upset his digestive system. Consequently, the total utility of six pieces of bread may come down to 18 utils. It means the marginal utility of the 6th piece of bread is -2 units.
2.5 Difference between total utility and marginal utility
The difference between total utility and marginal utility may be explained with the Table 1 and Figure 1: Table 1: Difference between total utility and marginal utility Quantity
Total utility
Marginal utility
Conclusion
0 1 2 3 4 5
6 7
Following observations can be made about the difference between total utility and marginal utility: (i) (ii)
Total utility is the sum of utility derived from all theu units of a commodity consumed. Marginal utility, on the other hand, is additional utility due to the consumption of an additional unit of the commodity. Total utility is the sum total of marginal utilities of the various units of the commodity consumed, TU = MU TU = total utility; =summation; MU = marginal utility TU6 = MU (1st) + MU (2nd) + MU (3rd) + MU (4th) + MU (5th) + MU (6th) 18 = 8 + 5 + 4 + 2 + 0 + (-2) Marginal utility, on the other hand, refers to change in total utility due to a unit change in the consumption of a commodity. It is the difference between two successive total utility figures. Symbolically,
(iii) 2.6 Relation between total utility and marginal utility
2.7 Significance of the difference between total utility and marginal utility (i) The diamond-water paradox (ii) Consumer’s surplus 2.8 Basic laws of utility analysis Utility analysis has two main laws: (i) (ii) 2.9
The law of diminishing marginal utility The law of equi-marginal utility
