Utility Theory

Utility Theory Dr. Kishor Bhanushali Faculty – Economics IBS-Ahmedabad

Utility By utility we mean then extent of satisfaction obtain from the consumption of goods and services preferred by the consumer Place, Form, Time utility Cardinalist approach & Ordinalist approach Total utility received from the good is the total satisfaction enjoyed from the consumption of that good Marginal utility Law of diminishing marginal utility

Marginal Utility Analysis Marginal utility analysis explains the consumers’ demand for a commodity and derives the law of demand which shows an inverse relationship between quantity demanded and the price of the commodity

Utility Function ∆ TU MUx = ∆ X ∆ TU MUy = ∆ y

Numerical Marginal utilities for good A and B are 600 and 900, and the price of good B is Rs. 120. If the consumer is in equilibrium, the price of good A is____ Price of good A = Rs. 80

Basic Assumptions Cardinal measurement of utility Utilities are independent (additive) Constant marginal utility of money Introspection

Law of Diminishing Marginal Utility The additional benefits which a person derives from a given increase in his stock of a think diminishes with every increase in the stock of what he already has Units

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

Total Utility

TU

Q

0

Marginal Utility MU

0

Q

Why ? 1. Even though human wants are unlimited, yet particular want can almost be fully satisfied. Hence when consumer consumes more and more of a commodity, his want is satisfied and he does not desire further increment of the commodity 2. Goods are imperfect substitutes for one another. Different commodities satisfy different wants. When a consumer goes on consuming a commodity, the marginal utility falls as his want is satisfied. But if the commodity could be substituted for other commodities, it would have satisfied other wants. Hence its marginal utility would not have decreased even though its quantity increases.

Limitations Suitable units Suitable time Normal persons Rare collections Not applicable to money

Consumer’s Equilibrium (One commodity) Consumer will purchase the successive units of a commodity till marginal utility of the commodity becomes equal to price The equality between marginal utility and price indicates the position of consumer’s equilibrium when only one commodity is being purchased and consumed

Equilibrium Conditions (More than one commodities) For a rational consumer, utility gets maximized only when he chooses that bundle of goods from the available alternatives, which gives him highest level of satisfaction Consumer allocates his total income is purchasing of various goods in such a manner that he acquires the same level of marginal utility per rupee he spends on every good MU1 = MU2 = MU3 = …….MUn = Mum P1 P2 P3 Pn

Diagrammatic Representation MU

Loss Gain

MUa A

MUb a a’

O

b b’

B

Why Demand Curve Slopes Downward ? When the price of the good falls, the consumer buys more of the good so as to equate the marginal utility to lower price. A price falls, consumer can afford to buy more. He is able and willing to buy more because things being cheaper, his real income increases When the commodity become cheaper, it tends to be substituted wholly or partly for other commodities. A commodity tends to put to more uses or less urgent uses when it becomes cheaper Old buyer buy more and new buyer enter the market

Substitute and Complementary Goods

Substitute goods are those that serves the same purpose to the consumer Complementary goods are those whose demand pattern are so related to each other that an increase in the price of the first good will cause a decrease in the demand for the other good

Derivation of Market Demand Market Demand is nothing but horizontal summation of the quantity demanded by different individual at each prices Quantity demanded at each market price is the summation of the individual demands of all customers at that price.

Types of Demand Direct and derived demand Domestic and Industrial demand Autonomous and induced demand Perishable and durable goods’ demand New and replacement demand Final and intermediate good demand Individual and market demand Total market and segmented market demand Short run and long run demand Company and industry demand

The Paradox of Value Items of great values e.g. water, air etc. are often sold at negligible prices or are costless, where as items like jewelry with very little use to mankind are sold at exorbitant prices. Paradox of value deals basically with the reason why consumer pay zero or very less amount of money for certain items with very high benefits. Diamond-Water Paradox: Adam Smith The relative abundance of water in most places brings its marginal utility very close to zero. On the contrary, due to scarcity of diamond all over the world its marginal utility is always maintained at very high level. So the willingness of the consumer to sacrifice more units of money in the case of diamond is solely contributed to its availability constraints which is manifested through higher marginal utility.

Water – Diamond Paradox Water

Price MU

Diamond W

D

Price MU P

P

MU

MU 0

W

0

D

Consumer Surplus First introduced by Marshall Consumer surplus measures the difference between what a person is prepared to pay for a commodity and the amount he actually pay. Price & MU

A p1 p2 P

0

r1

q1

r2

q2

N B

Q

Quantity

Application of the Consumer Surplus The concept of consumer surplus is useful in designing various government policies and programs It is used to evaluate the effects of various policies on consumers

Application of Consumer Surplus Price D

P1

P0

Producer Surplus

A

Dead Weight Loss

B E

Loss in consumer surplus = P1ABP0 Producers surplus = P1P0EA Dead weight loss = AEB D’

0

Q1

Q0

Quantity

Numerical Consumption

TU Cheese

TU Fish

TU Meat

1

70

80

160

2

130

160

290

3

170

210

410

4

205

250

510

5

230

285

590

6

250

315

650

7

260

335

680

Monthly Budget = Rs. 340 Price of Cheese = Rs 20 Price of Fish = Rs 40 Price of Meat = Rs 50

Numerical Consum ption

MU Cheese

MU/P Cheese

MU Fish

MU/P Fish

MU Meat

MU/p Meat

2

60

3

80

2

130

2.6

3

40

2

50

1.25

120

2.4

4

35

1.75

40

1

100

2

5

25

1.21

35

0.875

80

1.6

6

20

1

30

0.75

60

1.20

7

10

0.5

20

0.50

30

0.6

1