Utility

UTILITY & CONSUMER EQUILIBRIUM

Ut ility : Us e satis faction deriv ed f rom consum pt ion. Tot al ut ili ty: Tot al psy cholo gic al sat isfaction ob tained by a cons umer from consum ing given am ount of a part icular com modity is call ed t otal utility. Inc rea se in to tal ut ilit y bu t de crea se in margi nal (ad ditional) utili ty. By consum ing succ essi ve unit s of a part ic ular com modity, the tot al util it y go es on increasing, rem ains constan t at zero level and goes on

Margi nal Utility : The ut ili ty deriv ed from the consum pt ion of last unit is term ed as margi nal utility. It is the ut ility deriv ed from the consum pt ion of the ad ditional u nit. The tot al utility ut ilitie s.

is the sum tot al of marginal

La w of dim inishing m arginal u til it ies : The pat tern of de clining the margin al utili ty with the cons umption of suc cess ive uni ts is call ed t he la w of dim inishing m arginal u til it y.

Units (T)

Total Utility

Marginal Utility

1

20

20

2

38

18

3

53

15

4

64

11

5

70

6

6

70

0

7

62

-8

8

46

-16

Tot al ut il ity is maxim um (7 0) when margina l ut ility is zero i.e. at the 6 th un it. Mars ha ll sta tes t he law : The add itional be nefit whic h a person derives from a given inc re as e of his stock of a thing dim inishes with every increase in stock that he already h as .

22 20 18

Q R

16 S 14 12 T 10 8 6

W

4 2 0 -2 -4 -6 -8 -10 -12 -14 -16 -18

MU

Lim ita tions o f law : 1. Suitable units 2. Suitable tim e 3. No change in consum ers t aste 4. Con stant incom e 5. Rare c ollectio ns 6. Cha nge in oth er p eoples stock 7. Othe r poss essions 8. Fashion 9. Not app licable to money 10. Norm al person

Ma rginal u ti lit y o f m oney: Does th e la w of dimi nish ing MU apply to mo ney? Ma rginal u ti lit y a nd price : Ma rginal u ti lit y i ndica te p rice. Pr ice and ma rginal util ity mo ves togeth er up and d own Ma rginal u ti lit y a nd su pply: MU i s a f uncti on of s upp ly Mo re th e su pply, th e l ess wil l b e MU MU va ri es i nversely w ith su pply

Margi nal Utility (M U) and Sub stitut es : Tea & Co ffe e, Rail and Road, A ir Transport MU of Tea de creases as the quan tity coff ee increases with th e custom er.

of

Com plem ent ary good s: Paper, Pen and ink. Stock of on e increases the M U of ot hers. MU or increases

rare go ods as its stock go

(Gif fens down.

Parad ox )

Prac tical im portan ce: Taxation Pri ce d eterm ination Hou se hold p urc has e Down ward sloping dem an d curve Value in us e – value in e xchang e Soc ialis m Bas is of som e Econom ic L aw: La w of Dem an d Con sum er Su rplus Elasticity of dem and La w of subs titut ion

Indiffe rence Cu rv es : •Cons umers pref er ma ny things . •His re sourc es are li mit ed •He pic k and choos e more urgent desires for sati sf ac tion. •His choi ce is bas ed on his relat iv e ev aluati on of th e ut ili ti es of t he commodi ti es •He has a def ini te sc al e of pre ferenc e in hi s purc hase plan •Ut ili ty is subjec tiv e and henc e ev aluat ion is by th e cons umer •Cons umer preferenc e of vari ous comb inati on of goods depends on eac h one.

•On the bas is of cons umers scale of preferenc e, we c an draw the i ndif ferenc e c urv e. •An indi ff erence cu rve represent s sati sf ac ti on of a cons umer from two comm odit ies . On all point s of the curv e, the total sati sf ac ti on or ut il it y remain the sam e. Sinc e the cons um er gets the same sat is fac ti on fro m any point on the curv e, th e curv e i s call ed i ndiff erenc e c urv e.

Combination

Oranges

1

15

1

MRS

16

15A + 1 M

2

11

2

4:1

15

A

3

8

3

3:1

4

6

4

2:1

5

5

5

1:1

14 13 12

11A + 2 M

11

B

10 Oranges

Mangoes

9

8A + 3 M

8

C

7

6A + 4 M

6

D

5

E

5A + 5M

4 3 2 1 0 1

2

3

4 Mangoes

5

6

7

Oranges IC5 IC4 IC3 IC2 IC1

Mangoes

In differenc e curv es showing gr eater and les ser sati sf ac tion. IC1 is the leas t sa ti sf ac tion, where as IC5 gi ve s the hig hest amount of sati sf ac ti on. A se t of indif fere nce curv e is call ed an

Margi nal Rat e o f S ubstitut ion : MRS shows how much of one com mod ity is substitut ed for how muc h of an othe r or at wha t rat e a consum er is will ing to subs titute on e com modi ty for anoth er in his consum pt ion pa tte rn. The law of dim inishing marg inal ra te of substitut ion. More and more of a goo d X is substitu ted for a good Y, the marginal rate of sub stitution dim inishes. At 1 st sta ge, he was prepared to giv e up 4A

Pri ce L ine or Bu dget Line : Rat ional consum er tri es to maxim iz e his satisfaction from his available re sou rc es He wi ll try to reach the highest possi ble indiff erence curv e. In th is h e is governe d by t wo con stra ints: 1. The mone y h e ha s 2. The pric e of goo ds Suppose consum er has Rs.15 /- an d mang oes in the mark et is Rs.1 .50 and app le is Rs.1 pe r unit. He can buy 10 mang oes and 0 ap ples or 15 app les and 0 m angoes.

16 15 14 13 12 11 10 Oranges

9 8 7 6 5 4 3 2 1 0 1

2

3

4

5

6

7

8

9

10

11

Mangoes

By joi ning A and M, we get what is called pr ice li ne, or pric e oppor tunit y line. Pri ce – inc ome li ne, Budget li ne, Budget cons train line.

Con sum er Eq uil ibr ium: A consum er is said to be in equil ibr ium, when he obtains the maxim um pos sible satisfaction from his pu rc ha ses given the prices in the mark et and th e a mount of m on ey he has. The cons umer will maxim iz e his satisfaction an d be in equili brium at a po int wher e the price line touches (or is tan gent to) an indiff erence curv e.

16 15 14 13

S

12 11

N

10 Oranges

9 8 7 6 H

P IC4

5 4 3

IC3

K

IC2

2 1

L

0

IC1

R 1

2

3

4 Mangoes

5

6

7

8

9

10

11

P is the equ ilibrium poin t. At point “P” the margi nal rate of sub stitutio n (M RS ) of mangoes fo r apples is eq ual to the pric e ratio be tween the se two goods. The in di ffere nc e curve IC3 and the pric e line AM has the sam e slope a t p oint P. i.e. MRS for mang oes for apples = Price of Mangoes Pri ce o f a pples

Inc ome E ffe ct: Inc ome ef fect is the eff ec t on the quan tity de mande d excl usively as a resul t of change in mon ey incom e. As a result of change in incom e sat is fac tion will eit her increase or de crea se. He wil l have a new budge t line an d hence the equilibri um po int P will shift to a dif fere nt indif ferent curv e eith er to right (highe r sat isf ac tion) or to the lef t (lower satisfaction) .

ICC

13 12 11 10 9 8 Oranges

7 IC4

6 5 C3

4 3 C2

2 1 C1 2

4

6

8 Mangoes

10

The incom e con sum ption curve shows ho w the consum pt ion of two good s is aff ec ted by chang e in inc ome when pric es of bot h go ods are giv en an d consta nt. An incom e consum pt ion curv e thu s traces out the incom e ef fect as th e con sum ers incom e chang es , cetirus pa ri bas . For norm al goods, the shape of the curve is slop ing upwa rds to the ri ght. This means as a rule, a ris e in consum ers incom e wi ll make him buy mor e of ea ch of any two go ods he is consum ing .

Inferior good s: Those goods of wh ic h th e qu antit y th at the consum er would buy les s, as his incom e ris es, are call ed infe rior goo ds For exam ple a poo r villager as his incom e ris es wi ll buy less of coa rs er grains lik e millet and buy m ore whea t a nd ri ce.

Su bs titut ion ef fect : Su bs titut ion eff ect mean s the change in th e qua ntity of a good purchased wh ich is due only to th e change in relat iv e pric es, money incom e rem aining con sta nt. Whe n the pric e of the good X fa ll s, the real incom e of the consum er would increase. Even aft er com pen sat ing this variat ion in incom e, the consum er wo uld still buy more of X, because X has becom e relat iv ely cheaper . This increase in the am ount purchased of X, because of the fa ll in its relat ive price, is th e

Inc ome chang es , rel ativ e prices rem ai ning constan t. Inc ome rem aini ng th e sam e, the prices of good s change. The firs t is incom e eff ect. The secon d is subs titut ion ef fe ct.

of go ods relativ e

Pri ce e ffe ct: Wha t hap pens to consum ers equilibrium as a result of a change in th e price of one of the go ods, wh ile his incom e an d the pric e of th e oth er go od re main the sam e (i.e. the price ef fect ) There are two compone nts fo r price ef fect: 1. In com e ef fe ct 2. Su bs titut ion ef fect

Whe n th e price of a good X fall, incom e of the cons umer will go up .

th e rea l

The substitut ion eff ec t wil l be po sitive, i. e. if the pr ice of a good fal ls, more of it wil l be pur cha sed and substitut ed for the ot her goo ds whose p ri ce has not f all en. Bu t wh at about incom e eff ect? Mor e of such goods may be purc has ed if the incom e go es up in most goods. But in cases of som e goods, the inc rease in incom e will lead to les s p urchase.

The situ ation is : Bo th sub stitut ion and incom e eff ect will be positive and bot h in crea se th e dem and of goo d wh os e pric e has f allen d own. Su bs titut ion eff ect and incom e ef fe ct wil l pu ll in oppo site direction. i.e. substitu tion effect will be po sitive bu t incom e eff ec t will be neg ative. The dem and fo r good whose price has fallen will be altered very little or it can be even neg ative ou tweighing th e incom e eff ect.

Ordinary In ferior Goo ds : If the pos it iv e subs ti tut ion negati ve eff ec t, the net inc reas e in the quanti ty when its pric e fal ls . This ordinary i nferi or goods .

ef fec t o ver weighs th e resu lt woul d be an of the good bought , wi ll be so in cas e of

On the ot her hand, the negat iv e incom e eff ec t fo r a good is so powerful that it more than of fs et s the posi tiv e subst it ut ion ef fec t, res ult ing th e fal l of the quanti ty purc hased, when th e pric e fal l. Suc h goods are known as “Gif fen Goods ”.

In ordinary inf erior goods , the negati ve inc ome ef fec t is weak er than the pos iti ve subs tit ution ef fec t, re sul ti ng i n dem and i ncreas e. Gift en goods are spec ial type of inf erior goods wher e negati ve inco me ef fec t is stronger than th e pos iti ve subs ti tut ion ef fec t. Where th ere is a fa ll in demand when pri ce falls . The fol lowing 3 condi ti ons are es senti al to put a good i n the category of Gif ten goods . •It should be an inf er ior good hav ing a lar ge negati ve i nc ome eff ec t.

•The subs ti tu ti on effect of a pric e change would be s mall . •It mus t be an inf erior good, whic h abs orbs a large pr oportion of a co nsum ers inc ome . Named aft er Sir Rober t Gif te n, wh o obs erve d th at the poor brought more bread when its pri ce rose . The poor in India buy les s of coarse grain as it s pric e fal l and buy wheat or ric e. Fall in pric e of ant iques demand.

wo uld reduc e it s

Elasticity: The quanti tat iv e rel ati onshi p bet ween pri ce and quanti ty purc hased is analy zed us ing th e conc ept of “ Ela st ic it y” . Price el ast ic ity o f demand. This is the percenta ge change in quant it y demanded di vi ded by the perc ent age change in pric e. ED = Perc enta ge change demanded Perc ent age c hange in pr ice

in

quant it y

Cat egories of

P ri ce Elastici ty:

When a 1% ch ange in pric e cal l for mor e than 1% change in demand, the good is said to have pric e elas ti c dem and. When a 1% change in pric e res ult in le ss than 1% change in quant it y dem anded, the good has pric e in elas ti c dema nd. When perc ent change in quant it y is ex ac tl y same as perce ntage ch ange in demand, th e good i s s ai d t o hav e unit el as ti c demand.

Cas e A : Cas e B :

Price = 90; Price = 110;

Qty = 240 Qty = 160

Perc ent age pri ce change = ∆P/ P = 20/ 100 = - 2 0% Perc ent age Qty change = ∆Q/Q = 80/ 200 = 40% (ignore t he negati ve s ign) ED =

40/2 0 =

2

160 150 140 130 P2 120 110 100 90 P1 80 70 60 50 40 30 20 10 40

D B

A

D

Q2 Q1 80 120 160 200 240 280 320 360

UNIT ELASTIC ELASTIC DEMAND

1 1000

0.5

500

1

2

3

1

IN-ELASTIC

5

10

15

2

Dr aw the Dema nd Curv e and calc ulat e the ED. Calc ulat e Pric e elas tic it y f or t he f oll ow ing:

P

Q

6

0

6

4

10

4

2

20

2

0

30

0

Elastic Unit Elastic In-elastic 10

20

30

40

Pri ce E las tic ity o f S upply: The perc ent age change in quant ity supplied div ided by the per cent age change in pric e. Es = Perc ent age c hange in quanti ty supplied Perc ent age c hange in pr ice

Consum er Su rplus : The Economi c val ue of many goods and serv ic es wil l be much more than the ac tual pr ice we pay . For ce rtain comm odit ies , we will be prepare d to pay muc h mor e than we ac tuall y pay if alt ernati ve i s to go without them . Exam ple: Wat er – Ess ent ial commodi ti es – nec ess iti es In t he words of Mars hall : “ The ex ces s of the pr ice whi ch he (i. e. Consu mer) would be wil li ng to pay rat her than go wit hout the thing ov er that whic h he act uall y does pay is the eco nomic meas ur e of thi s

Consu mer surplu s is what we are prepar ed to pay m inus what we ac tual ly pay. The gap between the tot al ut il it y of a good and it s tot al ma rket value is ca lled consum er sur plus . The sur pl us aris es bec aus e we “ rece iv e more th an we pay for” , as a res ult of dim inis hin g margin al util it y We pay the same pric e for the 1 st unit and th e las t uni t though we get hi gher ut il it y for the 1 st unit , and th e leas t from the last unit for whi ch

Price MU

10 9 8 7 6 5 4 3 2 1

Consumer Surplus

1

2

3

4 5 6 Quantity of Water

7

8

He get s a to tal s urplus u ti lit y of : 8+7+6+ 5+4+3+2+1 = 36 Price i s equal to t he m arg inal pric e i .e. Rs. 1/-

The co ncept is us ed for: 3. Econom ic cost benefi t anal ysi s in publi c inv es tment ; lik e roads , educ at ion, park s, rese arc h, env ironm ent, health et c. 4. Prici ng t he public goods 5. Tax ati on 6. Welf are ec onomi cs/ welf are state 7. To br ing equity