UNIT 7

UTILITY
Utility means satisfaction. More precisely, it refers to how consumers rank different goods & services. In economics, utility is measures in Units.

TOTAL UTILITY
Total Utility is the total benefit that a person gets from the consumption of goods & services.

MARGINAL UTILITY
The expression marginal is a key term in economics and always means additional or extra. Marginal Utility denotes the additional utility you get from the consumption of an additional unit of a commodity.
MARGINAL UTILITY = CHANGE IN TOTAL UTILITY CHANGE IN QUANTITY

16 14 12

Darrens utility from consuming crisps (daily) TU

DTU = 2 DQ = 1

Utility (utils)

10 8 6 4 2 0 0 -2 1 2

MU = DTU / DQ = 2/1 = 2

MU

fig Packets of crisps consumed (per day)

THE LAW OF DIMINISHING MARGINAL UTILITY

This law states that, as the amount of a good consumed increases, the marginal utility of that good tends to diminish. (Law was proposed and developed by A. Marshall)

What is the reason for this law?

Utility tends to increase as you consume more and more of a good.

However, according to the law of diminishing marginal utility, as you consume more and more, your total utility will grow at a slower rate.
Growth in TU slows because your MU (the extra utility added by the last unit consumed of a good) diminishes as more of the good is consumed. The diminishing marginal utility results from the fact that your enjoyment of the good drops off as more and more of it is consumed.

1
Quantity Of Good Consumed ( Q )

2 Total Utility ( U )

3 Marginal Utility ( MU )

1
2 3 4 5

4
7 9 10 10

4
3 2 1 0

U 10 9 8 7 6

TOTAL UTILITY

5
4 3 2 1 Q 0 1 2 3 4 5

MU

MARGINAL UTILITY

5 4

3
2 1 Q 0 1 2 3 4 5

EQUIMARGINAL PRINCIPLE / MAXIMIZING UTILITY

The fundamental condition of maximum satisfaction or utility is the equimarginal principle. It states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good. Utility per dollar of the commodity: MU P

Utility maximization rule: Utility will be maximized at the point where: MU of good A Price of A = MU of good B Price of B

The following table shows the utility schedules of a consumer who devotes his weekly income of $9 to fish and vegetables. The price of fish is $2 per Kg. While the price of vegetables is $1 per Kg. How much should he consume in order to maximize his utility and how much is his maximum utility?

Total Utility Quantity (Kg) 1 2 3 4 5 6 Fish 50 80 100 110 115 119 Vegetables 30 45 55 60 62 63

Quantity of F & V (Kg) 1 2 3 4 5 6

MU of F TU of F MU of F P of F 50 80 100 110 115 119 50 30 20 10 5 4 25 15 10 5 2.5 2

TU of V 30 45 55 60 62 63

MU of V 30 15 10 5 2 1

MU of V P of V 30 15 10 5 2 1

Units Consumed

Expenditure
1 2 2 1 2 1 9

Units derived for consumption

30 50 30 15 20 10 155

1V 1F 1F 1V 1F 1V 3V,3F

3 units of vegetables and 3 units of fish is being purchased, when the price of fish is $2 and price of vegetables is $1 and the income to be spent is $9

P r i c $3 e

$2

D for Fish

Quantity

The Optimal Purchase Rule

Px = MUx If marginal utility is greater than price, the consumer can improve her well-being by purchasing more.

If marginal utility is less than price, the consumer can improve her well-being by purchasing less.

The Demand Curve?

The demand curve is downward sloping because marginal utility declines.
Recall that a utility maximizing consumer always sets P = MU Let P rise. Then MU must rise to maintain the equality. Then quantity purchased must fall.

Negative relationship between price and quantity demanded.

Demand is Downward sloping

Quantity Total Utility Marginal Utility

0 1 2 3 4 5 6 7 8

0.00 6.00 11.60 16.00 19.60 21.40 22.20 22.60 22.60

6.00 5.60 4.40 3.60 1.80 0.80 0.40 0.00

P .40 .80 1.80 3.60 4.40 5.60 6.00 Q7 6 5 4 3 2 1

Why is the price of diamonds higher than the price of water?

Why is the price of diamonds is higher than the price of water?

The marginal utility approach implies that when one commodity is in abundance, its MU is low as MU is inversely related to Quantity and incase of a scarce commodity the MU is high.
MUWater < MUDiamnonds No doubt the TUwater > TUdiamonds as humans cannot live without water for more than a couple of days. But the price of a commodity is determined on the basis of MU and not TU.

Exercise
1. Differentiate between TU & MU with the help of an example & a diagram. 2. Why is the price of diamond is higher than the price of water? 3. Define Equimarginal Utility. Calculate equimarginal utility for the given TU below, if the price per unit is $2.

1
Quantity Of Good Consumed ( Q )

2 Total Utility (TU )

1
2 3 4 5

4
7 9 10 10

Q.4. Anita consumes both pizza and Pepsi. The following table shows the amount of utility she obtains from different amounts of these two goods:

Pizza Quantity 4 slices 5 slices 6 slices 7 slices TU 115 135 154 171

Pepsi Quantity 5 cans 6 cans 7 cans 8 cans TU 63 75 86 96

Suppose Pepsi costs $0.50 per can, pizza costs $1 per slice, and Anita has $9 to spend on food and drink. What combination of pizza and Pepsi will maximize her utility?