Utility Analysis

A.MEENAIAH
LECTURER IN ECONOMICS
N.G COLLEGE
9490138118
 CARDINAL AND ORDINAL UTILITY
Cardinal Utility: The numbers 1, 2, 3, 4 are cardinal
numbers. For example the number 2 is twice the size
of 1. In the same way, the number 4 is four times the
size of number 1.
Alfred Marshall developed cardinal utility analysis.
According to cardinal approach, utility can be
measured.
Ordinal utility: The numbers 1st, 2nd, 3rd, and 4th,
are ordinal numbers. These ordinal numbers are
ranked or ordered. This ranking does not explain the
actual size relation of the numbers. The second one
might or might not be twice as big as the first one.
Hicks and Allen used ordinal utility approach for
analyzing the consumer behavior. This analysis is
known as indifference curve analysis.
TYPES OF UTILITY.
The want satisfying power
contained in a good is said to be its
utility. In economics the term utility
is used to denote the satisfaction or
welfare. Utility derived from a good
are of different form such as 1)
Form utility, 2) Place utility, 3) Time
utility, and 4) Service utility.
The Law of Diminishing Marginal
Utility
1. It is a psychological fact that when a person
acquires more and more units of the same
commodity during a particular time, the utility he
derives from the successive units will diminish. In
other words, the additional satisfaction derived
from the additional units of a commodity goes on
decreasing.
2. H.H Gossen was the first economist to explain the
law of diminishing marginal utility, and the law of
equi marginal utility in 1854. W.S Jevons named
them as Gossen first and second laws of
consumption (1871). In 1890 Marshall in his
Principle of Economics developed this analysis in
a refined manner
Assumptions of the Law:
1. The law of diminishing marginal utility is based on
the cardinal measurement of utility.
2. Utility is measured in terms of money. The law
assumes that the marginal utility of money is
constant.
3. There should not be any time gap between the
consumption of one unit and the other unit.
4. The units of the commodity are homogeneous.
5. The consumer is assumed to be a rational
economic man. He has the knowledge about the
market.
Definition of the Law
Alfred Marshall defines the Law of
Diminishing Marginal Utility 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.
In the words of K.E Boulding As
a consumer increases the consumption of
any one commodity, keeping constant the
consumption of all other commodities the
marginal utility of the variable commodity
must eventually decline
Total and Marginal Utilities
Total Utility: Total utility means the total
satisfaction attained by the consumer from all
the units of a commodity taken together in the
consumption of a certain thing at a time.
Marginal Utility: Marginal utility is the
additional utility obtains from an additional unit
of any commodity consumed or acquired. It is
measured the difference between the utility of
the total units of stock of consumption of a given
commodity and that of consuming one unit less
in the stock considered. In symbolic terms:
MUx = Tux - TUx-1
Explanation of the Law of
Diminishing Marginal Utility
We can explain the law with the help of the table. In
the table a consumer goes on increasing X goods, the
additional utility derived from an additional X goods
declining. The law is clear from the following table. We
can observe that as the units of the commodity X is
increase, the marginal utility derived from each success
units tends to diminish. The total utility increases at
diminishing rate till the 6th X. At that level total utility
becomes maximum, and marginal utility is zero. After
this level total utility declines and marginal utility
becomes negative. Zero marginal utility implies the
point of satiety which indicates the complete
satisfaction of a given want. The law of diminishing
marginal utility can also be represented
diagrammatically through the marginal and total utility
curves.
 Diagram & Table Explanation

The Law of Diminishing Marginal

X Units Total Marginal
35
Utility
Utility Utility
30

25
TUC 1 10 -
Total/Marginal Utilities

20 2 18 8
3 24 6
15

10

5 4 28 4
5 30 2
0

-5
1 2 3 4 5 6 7 MUC
X goods
6 30 0
7 28 -2
The relationship between total utility
and marginal utility

1. When total utility increases at

diminishes rate, marginal utility
diminishes.
2. When total utility is maximum,
marginal utility becomes zero.
3. When total utility decreases,
marginal utility becomes negative.
Importance of the Law:

1. Useful to Finance Minister.

2. Basis for the theory of value.
3. Basis for the Demand and explains
the negative slope of demand
curve.
4. Determination of optimum
consumption.
5. Useful in the distribution of wealth.
 The Law of Equi Marginal Utility:
1. The law of equi marginal utility explains as to how a
consumer distributes his limited income among various
commodities
2. He will spend his income in such away that the last rupee
spent on each of the commodity gives him the same marginal
utility.
3. Therefore, this law is known as the Law of Equi-Marginal
Utility.
4. In order to get maximum satisfaction out of his limited
income, the consumer carefully weighs the satisfaction
obtained from each rupee that he spends. If he thinks that a
rupee spent on one commodity has greater utility than
spending it on another commodity, he will go on spend his
money on the former till the satisfaction derived from the last
rupee spent in the two cases equal
Assumptions of the Law:
1. The utility is cardinally measurable.
2. The marginal utility of money remains constant.
3. Consumer has a limited amount of income and
he spends the entire amount.
4. The wants and habits of the consumer remain
constant.
5. The consumer is rational. He tries to get
maximum satisfaction.
6. The consumer spends his income in small
quantities while purchasing the commodities.
 Illustration of the Law
The law of equi-marginal utility has been stated by
Marshall as follows If a person has a thing which
can be put to several uses, he will distribute it
among the uses in such a way that it has the
same marginal utility in all.

The law can be explained with the help of a

numerical example suppose a consumer has Rs
5/- which he wants to spend on two types of
commodities namely X and Y so that he obtains
maximum utility. The following table shows the
marginal utilities of successive rupees of income
when spends on X and Y.
 Figures in the brackets shows as Units Mux Muy
to how the consumer spent his Rs
5/- on two types of commodities.
Let us assume that the price of 1 10(1) 8 (2)
each commodity is one rupee. The
consumer starts spending his first
rupee on X because the highest 2 8 (3) 6 (4)
marginal utility on X is 10 utils. In
the same way he spends his 2nd,
3rd, 4th and 5th rupee on the 3 6 (5) 4
commodities which gives highest
utility. Thus the total utility obtain
from X and Y will be 38, i.e. from 4 4 2
X (10+8+6=24) and from Y
(8+6=14). In this way the
consumer spends his entire
5 2 0
income on X and Y in such way
that the last rupee spent on X and
Y gives the same marginal utility.
Thus the consumer gets maximum
Total 30 20
satisfaction
 Equi-Marginal Utility
Money expenditure and
quantity of demand is shown on
12
X axis and the marginal utility
derived from the commodities X 10
and Y is shown on Y axis.
Marginal utility of X is shown by 8
the curve MUx, and marginal
utility of Y is shown by the 6

Marginal Utility
curve MUy. Marginal utilities of
4
both the commodities are equal
at 6 utils. The consumer is in 2 mux
equilibrium by purchasing the
muy
combination of 3 units of X and 0
2 units of Y as he obtains the 1 2 3 4 5
maximum total utility at that
Quantity of commodities
purchase.
 Importance of the Law:
1. The law explains as to how a consumer
maximizes his satisfaction from his limited
recourses.
2. Optimum allocation of the recourses can be
possible by applying this principle.
3. While imposing taxes, the government is
cautious that the marginal sacrifice of all the
taxpayers is the same.
4. The law guides an individual in the allocation
of his time between work and leisure.
CONSUMER SURPLUS
1. The concept of consumer surplus
originally devised by Dupuit a French
engineer in his paper On the
measurement of public works in 1844.
2. Marshall introduced Dupuits relative
utility concept as Consumers Rent in
his Pure theory of Domestic values in
1879.
3. Marshall named it as consumers surplus
in the third edition of Principles of
Economics in 1895.
Consumer surplus Meaning
The price which a consumer pays for a commodity
is always less than what he is willing pay for it, so
that the satisfaction which he gets from its
purchase is more than the price paid for it and
thus he derives a surplus satisfaction which
Marshall calls Consumers Surplus. Instances of
commodities from which we derive consumers
surplus in our daily life are salt, news papers,
postcard, matches, etc.
consumers surplus can be defined as the
difference between what a consumer is willing to
pay for a commodity and what he actually does
pay for it.
 Table: Explaining Consumers
Surplus
X Price willing Actual price Consumer
units to pay Surplus
1 10 4 6

2 8 4 4

3 6 4 2

4 4 4 0

Total 28 16 12
Consumer Surplus (DPR)
Consumers surplus is
represented
D diagrammatically in figure
DD is the demand curve for
the commodity. If OP is the
price, OQ units of the
commodity are purchased
R and the price paid is OQ X
P OP= area OQRP. But the
total amount of money, he
is prepared to pay for OQ
units is OQRD. Therefore,
Consumers Surplus=
D
OQRD-OQRP=DPR.
O Q
Engle Consumption Curve (Engle 1821-1896)

Germany statistician Ernet Engle studied many house

holds incomes and budgets and revealed relation
between income level and spending on the consumption
of some goods , at a given price. He proposed three
important points in his study.

3. When income increases the expenditure proportion on

food items will decreases

5. When income increases the expenditure proportion on

house facilities and cloths items will constant
6. When income increases the expenditure proportion on
education, health and entertainment items will increases.