Module 2- Utility Concepts

Mr. Deepak Kulkarni

 The very concept of utility
Meaning: The quality in a good or service
which has the capacity to satisfy the basic
purpose which it is meant for i.e the
satisfaction of the human wants.
Ex: The satisfaction derived on driving Maruti
Sx4 car.
The quality/attributes of the aforesaid car have
satisfied a human want.
 Features of Utility
1) Subjective in nature:
- concerned with the mental satisfaction
of a human mind.
- unique for every individual
Ex: A laptop has utility for an MBA student
but it has no utility for a UG student.
2) Relative in nature:
- inconsistency of utility with respect to
time and place
Ex: An umbrella has high utility during
rainy season but less useful during other
seasons.
3) Utility and usefulness:
- are not necessarily inter-related
- commodity having utility may not be
useful
Ex: consumption of liquor has no use but it
can satisfy the want of an addict.
4) Utility and Morality:
- independent of morality

Ex: Consumption of marijuana is immoral

but it can satisfy the want of an addict.
 Concepts of utility
1) Initial utility:
- Utility derived upon the consumption of
the first unit of the commodity.
- always positive in nature giving the
highest amount of satisfaction for the
human mind.
Ex: your first bike you brought in the college.
2) Total Utility:
- sum total of the utility derived from
different units of a commodity consumed
by a household.
- entire amount of satisfaction obtained
from consuming various quantities of a
commodity.
Formula:
TU=U1+U2+U3+ …….. +Un
Where, TU= Total utility
U1,U2= utilities derived from the
consumption of individual units of a
commodity
3) Marginal Utility:
- utility derived upon consumption of an
additional unit of a commodity.
- change taking place in the total utility by
the consumption of an additional unit of a
commodity.
Formula:
MU nth = TU n – TU n-1
Where, MU nth= Marginal utility of nth unit
TU n = Total utility of ‘n’ units
TU n-1 = Total utility of ‘n-I’ units
 Types of marginal utility
a) Positive Marginal utility
- if total utility increases upon
consumption of an additional unit

b) Zero Marginal utility

- if there is no change in the total utility
upon consumption of an additional unit
c) Negative Marginal utility
- if there is a fall in total utility as a result
of consumption of an additional unit of a
commodity.
Relation between Total utility
and Marginal utility
Graphical depiction of the relation
assoc files\Total and Marginal utility.xlsx
Interpretation:
1)Total utility increases initially with consumption of
additional units
2) Marginal utility continuously decreases
3)Total utility increases as long as MU is positive or
zero, is highest when MU is zero, and falls when
MU is negative
 Law of Diminishing Marginal
Utility
Definitions:
1)According to Marshall, “ The additional
benefit which a person derives from a
stock of a thing diminishes with every
increase in the stock that he already has.”
2)According to Samuelson, “As the
amount consumed of a good increases,
the marginal utility of the goods tends to
decrease.”
Explanation of the Law
 Diagrammatical representation
of the Law

..\assoc files\Total and Marginal utility.xlsx

Reason for decrease in Marginal Utility
1)Intensity of desire in man decreases with
continuous consumption of the same
good.
2)Satisfaction of man’s needs in degrees
 Assumptions of the Law
Other things being equal the law works upon
the following assumptions.
1)Utility can be measured in cardinal number
system 1 2 3 ….. Etc
2)Consistent income of the consumer
3)Marginal utility of money remains constant.
4)Quality of the units consumed is constant.
5) Commodity is consumed continuously
without time lag.
6) Marginal utility of every commodity is
constant.
7) Attributes of the units consumed are
constant i.e no change in size and quality
8)No change in the tastes and preferences
of the consumer
9) Price of the commodity and its substitutes
remains constant.
 Equimarginal principle.
• This concept was originally associated with the
consumption theory and the law is called the
“law of marginal utility”.
• This law was applied to the allocation a
resources between their alternative uses view to
maximizing profit in case of firm carrying out
more than one business activity.
• This principle suggests that the available
resources should be so allocated between the
alternative options that the marginal productivity
gains from the various activities are equalised.
• Say if the marginal productivity of three different
projects A, B and C are MPa, MPb and MPc
then according to this principle MPa=MPb=MPc.
• This principle suggests that a profit maximizing
firm , allocate its resources in a proportion such
that;
MPa=MPb=MPc……..MPn.
• If costs of projects (COP) varies from projects to
projects then resources are allocated in such a
way that as shown below:
MPa/COPa=MPb/COPb=MPc/COPc....MPn/COPn
 Consumer equillibrium
Equillibrium: A balanced state of any
phenomenon

Consumer equillibrium: A point of

satisfaction where consumer would be
indifferent to any further good consumed.
 The Concept
2 Constraints:

a) Consumer income

b) Price of the good

 Definition
• Consumer Equilibrium
When consumers make choices about the quantity of
goods and services to consume, it is presumed that their
objective is to maximize total utility. In maximizing total
utility, the consumer faces a number of constraints, the
most important of which are the consumer's income and
the prices of the goods and services that the consumer
wishes to consume. The consumer's effort to maximize
total utility, subject to these constraints, is referred to as
the consumer's problem. The solution to the
consumer's problem, which entails decisions about how
much the consumer will consume of a number of goods
and services, is referred to as consumer equilibrium.
Assume 2 goods are purchased
Good 1 and Good 2

Point of consumer equillibrium would be

MU g1/ P g1 = MU g2/P g2
 Illustration
Price of good 1 = AUD 2
Price of good 2 = AUD 1
Budgetary Constraint = AUD 5
 Importance of the Law of Equi
Marginal Utility
1) Consumer Satisfaction:
- As suggested by the law, if the
consumer spends his income in such a
way that, the units of money spent on
each good yields equal marginal utility for
him, this leads to maximum satisfaction
2) Maximum Profit:
- utilize each factor of production in such
a way that marginal productivity of each
factor is equal leading to max. profit
3) Substitution between commodities:
- consumer substitutes goods with more
utility to the one’s giving less utility till
marginal utility becomes equal
4) Distribution of national income:
- distribution of national income among
factors of production can be done in such
a way that every factor gets its share out o
national income according to its marginal
productivity.
5) Imposition of taxes:
- FM levies taxes in such a way that the
marginal sacrifice of each tax payer is
equal to ensure least burden on all tax
payers.
 Criticisms of the Law of equi
marginal utility
1) Cardinal measurement of utility is not
possible
2) Consumers are not fully rational
3) Shortage of goods having more utility
4) Ignorance of the consumer
5) Influence of fashion, customs and habits
6) Constant income and price
7) Constant marginal utility of money
8) Indivisibility of goods
 Indifference Curve

An indifference curve is a locus of all such

points which show different combinations
of two commodities which yield equal
satisfaction to the consumer.
 Indifference Schedule
An indifference schedule refers to a
schedule that indicates different
combinations of two commodities which
yield equal satisfaction. A rational
consumer places equal importance to
each of the combinations.
 Indifference map

An indifference is nothing but a

diagrammatical representation of the
indifference schedule.
Properties of indifference curves
1) Slope downwards from left to right/
has a negative slope:
- the consumer will have to curtail the
consumption of one commodity if he
wants to consume large quantity of
another commodity to maintain the same
level of satisfaction.
2) Convex to the point of origin:
- A consumer needs to maintain the
balance of the combination to maintain
satisfaction levels.
3) Two indifferent curves never intersect:
- each curve represents different levels of
satisfaction
4) Indifference curve touches neither x axis
nor y axis.
5) Indifference curves need not be perfectly
parallel to each other.
6) Indifference curves become more
complex incase of more than 2
commodities.
 Income, substitution and price
effect
1) Income effect:
- the effect on the consumption of two
goods caused by a change in income, if
the prices of goods remain constant.
- income effect is defined as the effect on
the purchases of the consumer caused
by a change in income with the price
remaining constant.
- Income effect indicates that, other things
being equal increase in income increases
the satisfaction of the consumer and vice-
versa thus resulting in a shift in the
equilibrium point.
- The locus of all equilibrium points on the
price line is called as the income
consumption curve.
 ic1
ic2
ic3
 Substitution Effect
2) Substitution effect shows the change in the
quantity of the goods purchased due to the
change in the relative prices alone while the
real income remains constant.
- if with the change in the price of the goods
the money income of the consumer changes
in such a way that his real income remains
constant, the consumer will substitute
cheaper goods for the dearer ones.
Example:
Income of the consumer: Rs. 100
rice : Rs 10 per kg (less nutritious)
wheat : Rs 20 per kg (more nutritious)
Consumption combination:
6 kg of rice and 2 kg of wheat
Crash in the price of wheat to Rs. 10 per kg
New consumption combination:
6kg of wheat and 4 kg of rice.

Consumer will substitute less nutritious rice for more

nutritious wheat and the equilibrium of the consumer
shifts.
 Price Effect
Price effect means change in the
consumption of goods when the price of
either of the two goods changes, while the
price of the other good and the income of
the consumer remain constant.