Theory of Marginal Utility Analysis

Hand-out - 2 PROGRAMME COURSE TITLE

:

FIRST YEAR –  YEAR –  FIRST  FIRST SEMESTER BACHELOR OF COMMERCE (SPECIAL) DEGREE ECONOMICS FOR ENTERPRISES

COURSE CODE

:

COM 11032

COURSE STATUS

:

COMPULSORY

HAND-OUT TITLE

:

THEORY OF MARGINAL UTILITY

:

LECTURER

B.PRAHALATHAN, DEPARTMENT OF COMMERCE

Learning Objectives:      

define total utility and marginal utility understand law of diminishing marginal utility describe relationship between total and marginal utility demonstrate demand curve define marginal utility of money illustrate consumer equilibrium

Introduction Two questions arise with regard to consumer’s behavior. The first one is: why does a consumer demand a good or service. The second question: how should a consumer spend his limited income on different goods and services so that the consumer may get maximum satisfaction or that he may be in equilibrium? The traditional approach in this context is the Cardinal Utility Approach. Marginal utility analysis (Cardinal Utility Approach) was developed by Alfred Marshall to explain consumer demand. This approach is based on the fact that utility can be measured in some units. The unit for measurement of util ity is known as utils.

Concepts of Utility Analysis and Relationship 1. Initial Utility 2. Total Utility 3. Marginal Utility

Initial Utility The utility derived from the first unit of a commodity is cal led initial utilit y. It is always positive.

Marginal Utility The additional satisfaction gained by the consumption of one more unit of something. In other words of Chapman,” Chapm an,” Marginal utility is the addition made to total utility by consuming one more unit of the commodity. MUn = TUn –  TU  TUn-1

Marginal utility can be a. Positive Marginal Utility  b. Zero Marginal Utility c.  Negative Marginal Utility

Total Utility The total satisfaction derived from the consumption of all the units of a commodity is called TOTAL UTILITY. UTILITY . Consumption of “n” units of commodity, then the total utility (TU), TUn = U1 + U2 + U3 + ……….. ……….. +Un OR TUn = MUn

Relationship between Total Utility and Marginal Utility a. When marginal utility is positive total utility increases  b. When marginal utility zero total utility is at maximum. It is also known as ‘point of maximum satisfaction’ c. When marginal utility is negative total utility utilit y diminishes.

Law of Diminishing Marginal Utility The law of diminishing marginal utility explains the relation between utility and quantity of a commodity. It is a psychological fact that when a consumer gets more and more units of a commodity, during a particular time, the utility from the successive units will diminish.

 Assumptions 1. 2. 3. 4. 5. 6. 7.

Utility is cardinal The consumer is rational Commodity is consumed are homogeneous Constant marginal utility of money The consumer’s income is limited and constant The tastes and preferences of the consumer remain unchanged Diminishing marginal utility

Consumer’s Equilibrium Consumer’s equilibrium refers to a situation wherein a consumer gets maximum satisfaction out of his limited income and he has no tendency to make any change in his existing expenditure  pattern.

Consumer’s Equilibrium –  A single commodity When a consumer is purchasing a commodity, he will be in equilibrium position at a point where marginal utility of a commodity is equal to its price. The consumer is in equilibrium when the marginal utility of a good(x) is equal to its it s market price (Px).

MUx = Px Supposing, if MU P, there can be two possibilities. 1. MU > P 2. MU < P If MU > P, he will buy more, and marginal utility will come down to the level of price. On the other hand, if MU < P, he will purchase less and the marginal utility goes up. 2

Law of Equi - Marginal Utility The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one commodity. Further, it explains how the consumer spends his limited income on various commodities to get maximum satisfaction. The law states that a consumer maximizes his total utility by distributing his entire income optimally among the various goods consumed by him.

Assumptions 1. 2. 3. 4. 5. 6. 7.

The consumer is rational so he wants to get maximum satisfaction Cardinal measurement of utility is possible Marginal utility of money remains constant The income of the consumer is given and remain constant Fashions, tastes and preferences remain constant Prices of the commodities are given and remain constant Consumption takes place at a given time period

Consumer’s Equilibrium –  a  a Several Commodities When a consumer is consuming several commodities [suppose there are two goods X and Y] with different prices simultaneously, he will be in equilibrium at the point where the utility derived from the last rupee spent on each is equal. M Ux

M Uy 

Px



Py

M Um

MUx: Marginal utility of commodity X MUy: Marginal utility of commodity Y Px: Price of X Py: Price of Y MUm: Marginal utility of money M Ux Px

and

M Uy Py

 are known as marginal utility of money expenditure. This explains the marginal

utility of one rupee spent on good X and the marginal utility of one rupee spent on good Y The position of consumer’s equilibr ium ium thus can be stated in following ways 1. The consumer is in equilibrium when the marginal utility of last rupee spent on each commodity is equal 2. A consumer will be in equilibrium position where the ratios of marginal utilities of goods to the ratios of corresponding prices for each pai r of goods are equal.

When a consumer is at Equilibrium: 

He maximizes his satisfaction



He spends his entire income



He attains optimum allocation of expenditure



He consumes optimum quantity of each good. 3

Derivation of the Demand Curve If the marginal utility is measured in monetary moneta ry units the demand curve for a good(X) is identical to the positive segment of the Marginal utility curve.

M Um

M Ux 

Px

Px x M Um

Px





M Ux

M Ux

Constancy of the Marginal Utility of Money This is one of the important assumptions of the marginal utility analysis. This means, marginal utility of money remains constant throughout when the individual is spending money. Measurement of marginal utility of goods in terms of money is only possible if the marginal utility of money itself remains constant. If the marginal utility of money varies, it is not possible to correct measurement of the marginal utility of the good.

Marginal Utility of Money and Price change When the price of a good falls  –  the   the real income of the consumer rises  –  the   the marginal utility of money will fall. On the other hand, when the price of a good rises  –   the real income of the consumer falls –  falls –  the  the marginal utility of money will rise. But Marshall ignored this and assumed that marginal utility of money did not change as a result of price change. Due to this assumption 

Marshall ignored the income effect of the price change



Marshall could not provide a satisfactory explanation of ‘Giffe ‘ Giffen n Paradox’



Due to this assumption marginal utility curve becomes the demand curve of the good.

Demerits of Marginal Utility Analysis 1. Cardinal measurement is unrealistic 2. Assumption of constant marginal utility of money is not valid. 3. Cardinal utility analysis does not split up the price effect into substitution and income effect. 4. Marshall could not explain Giffen Paradox. 5. Cardinal utility analysis assumes too much and explains littl e.

References:

1. H. L. Ahuja ; Principles of Microeconomics, 18th Edition; S.Chand Publishing 2.  N. Gregory Mankiw; Principles of Microeconomics; Microeconomics;

4