Utility Analysis Of Demand

UTILITY ANALYSIS OF DEMAND

Basic assumptions of Marginal Utility AnalysisCardinal measurement of utility:- It is

assumed that utility can be measured and can be given definite quantity like 1,2 or 3.This means that a person can express the satisfaction derived from consumption of commodity in quantitative term.

Utilities are independent:-Marginal utility assumes that utility of different commodities are independent to each other.

Constant Marginal utility of money:-Another important assumption is that the marginal utility of money remains constant.

Introspection:-The Marginal utility also assumes that from one’s experience ,it is possible to draw inference about other person.

BASIC LAWS OF MARGINAL UTILITYLAW OF DIMINISING MARGINAL UTILITY

LAW OF EQUI-MARGINAL UTILITY

LAW OF DIMINISHING MARGINAL UTILITYThis law can be stated as the fall in marginal

utility of any good due to successive consumption of that good.

For ex:- Suppose a person starts eating toast, the first toast gives him great pleasure. By the time he taking second he yield less satisfaction ;the satisfaction of third is less than that of second and so on. the additional satisfaction goes on decreasing with every successive toast till it drops down to zero; and if the consumer forced to take more the satisfaction may become zero.

This can also be shown by graph

1 2 3 4 5 6 7 8

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-15

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0

5

10

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Units of commodity consumed

Units of utility

Diminishing marginal utility curve

LIMITATIONS OF THE LAWSuitable units:- It is assumed that the

commodity is taken in suitable units.Suitable time:-It is further assumed that the

commodity is taken within a certain time, otherwise law will not apply.

No change in consumer’s tastes:-Another assumption is that the character of the consumers does not change.

Normal persons:- The law of diminising marginal utility applies to normal persons and not to eccentric or abnormal persons like misers.

Constant income:-it is also essential that the income remains the same. Any change in income will falsify the law.

Rare collections:- In case of rare collections ,the law does not hold good.

Fashion:- Further, fashion utility depends on fashion too.

Marginal utilityMarginal utility can be defined as the change

in the total utility resulting from a one-unit change in the consumption of a commodity per unit of time.

Marginal utility= Change in total utilty Change in quantity

consumed

Marginal utility of MoneyMoney is a general purchasing power . It

enables the purchaser to buy anything he likes. That is why it is said one can never reaches the stage where money ceases to be desired. That is , the marginal utility of money goes on increasing with its increase . This is oppose to the law of diminishing marginal utilty.

Marginal utility and priceThe consumer stops where the price and

marginal utility are equal. All units of commodity being interchangeable , what is paid for the marginal unit is paid for every unit. Therefore , we can say that marginal utility determines price. It is marginal utility and not the total utility that determines price, other wise the price of water should have been high and that of gold is low.

Marginal utility and supplyMarginal utility is a function of supply, i.e., it

varies with supply . In the case of a free good, where the supply is unlimited , the marginal utility is zero. Only in the case of scare goods is the marginal utility is positive . It increases as the supply contracts and decreases as the supply increases.

Marginal utilities of related goodsThere are two types of relationship between

goods:

1.They may be substitutes

2.They may be complementry

In case of substitutesThe substitutes are capable of satisfying

same want.eg tea and coffee, rail transport and road transport. In case of such goods ,other things being equal , the marginal utility of any such goods decreases as the quantity of the sustitute goods with the consumer increases.

In case of complementary goodsComplementary goods are such goods which

are wanted together for the satisfaction of a want e.g., paper ,pen and ink for writing. In such cases other things remaining the same, marginal utility increases as the quantities of the complementary goods with the consumer increase .

Practical importance of law of diminishing TaxationPrice determinationHousehold expenditureSocialismDownward sloping demand curve

Law of equimarginal utilityEvery prudent person wants to make the best

of his or her resources. This is necessary because resource are scarce in relation to wants ,a fundamental proposition with which we started the study of economics . Every consumer aims at getting the maximum possible satisfaction for this purpose he will be substitute the more useful for the less useful thing when he has done so, it will be found that marginal utilities in each direction of his purchases have been equalized.

Diagrammatic representation

Limitations of the lawThe law of equimarginal utility involves very

careful calculations of the expected satisfaction and its comparisons with the amount of money spent as well as with the satisfaction which may be derived by spending by the same amount of money on some other things. But how many of us are capable of making such fine calculations.

Only in case of big expenditure, a prudent person goes through a certain amount of thinking .

Ignorance of consumers imposes another limitations.

People are sometimes slave of fashion and customs and are incapable of rational consumption. Without being rational and calculating, a consumer cannot substitute one thing for other. This is another limitation of law.

Another limitation arise from the fact that goods are not divisible into small bits to enable consumer to equalize marginal utilities.

The law of substitution has no place when the resources are unlimited as in the case of free goods. In such cases , there is no need to rearrange expenditure because no price is to be paid whatever the quantity used.

Practical importance of the lawIt applies to consumptionIts application to productionIts application to exchange Price determinationIts application to distributionPublic finance

Consumer's equilibrium

When the consumer attains the position of maximum satisfaction and would have no further incentive to make any change in the quantity of the commodity purchased

Equilibrium with one commodity purchaseThe law of diminishing marginal utility tells

us the position of a consumer’s equilibrium in the case of one-commodity purchase . He will go on buying successive units of the commodity till the marginal utility of the commodity becomes equal to the price. If the price falls ,he will buy more and the marginal utility will come down to the level of price. On the other hand the price goes up , naturally less will be purchased and the marginal

Equilibrium with two commodity purchaseIn case of the consumer is buying two commodity

X and Y , the position of equilibrium will be determined according to the law of equimarginal utilities . It has already been stated that a consumer derives maximum satisfaction when the marginal utilities of two commodities are equal. In case they are not equal , adjustment will be made in the matter of quantities purchased, more of the commodity with higher marginal utility and buying less of the lower marginal utility till the marginal utilities of the commodities are equalized. This is a position of maximum satisfaction.

MUe= Mux Px

Where MUe= Marginal utility of expenditure MUx= marginal utility of commodity X Px = price of commodity X

From the above , we can derive a formula for a consumer’s equilibrium in respect of two goods X and Y by him as under:

MUx = MUy Px Py