UTILITY THEORY

Two types of utility theory:

1.Law of Diminishing Marginal
utility
2.Law of Equi Marginal utility

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 UTILITY

Utils:

'Utils' is considered as the measurable 'unit' of

utility.

UTILITY: The consumption of various unit of

commodity X.

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 MEASUREMENT OF UTILITY
1. INITIAL UTILITY

2. TOTAL UTILITY

3. MAGINAL UTILITY

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INITIAL UTILITY: Initial utility is the utility derived from the
consumption of the first unit of a commodity.

MARGINAL: The term marginal refers to the effects of

a small change in consumption.

'Marginal considerations are considerations which concern a

slight increase or reduction of the stock of anything which we
possess.’

TOTAL UTILITY(TU): The sum total of satisfaction which a

consumer receives by consuming the various unity of the
commodity.

(The more unit of a commodity we consumes, the greater will

be our total utility) 4
 RELATIONSHIP B/W TOTAL UTILITY
& MARGINAL UTILITY
QUANTITY TOTAL UTILITY *MARGINAL UTILITY Utility Type

1 10 10 INITIAL UTILITY

2 18 18-10=8

3 24 24-18=6 POSITIVE

4 28 28-24=4

5 30 30-28=2

6 30 30-30=0 ZERO

7 28 28-30=-2 NEGATIVE

*MU(x) = TU(x) – TU(x – 1) 5

 Marginal utility(MU)
The concept of marginal utility grew out of attempts by
economists to explain the determination of price.

•Marginal utility can be defined as a

measure of relative satisfaction gained
or lost from an increase or decrease in
the consumption of that good or service.
•Examples- A motor vehicle or A haircut

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 Definition
• The law of diminishing marginal
utility describes the fundamental
tendency of human behaviour.
• The law of diminishing marginal utility
states that, “as a consumer consumes
more and more units of a specific
commodity, utility from the successive
units goes on diminishing”.
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 Assumptions of the Law:-
These assumptions are –
•Various units of goods are homogenous.
•There is no time gap between consumption of the
different units.
•Consumer is rational (So aims at maximization of utility of
the product)
•Tastes, preferences, and fashion remain unchanged.
•Consumers posses perfect knowledge of the price in the
market
•No price change
•It assumes Law of marginal diminishing Utility
•Utilities of different commodities are independent of each
other
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 Law based upon three facts:
The law of diminishing utility is based upon three facts.
•Firstly
The wants of a man are unlimited but single want can be
satisfied. As a man gets more and more units of a
commodity, the desire of his want for that good goes on
falling. A point is reached when the consumer no longer
wants any more units of that good,

•Secondly
Different goods are not perfect substitutes for each other
in the satisfaction of various particular wants.

•Thirdly
There is no change in the tastes of the consumers. 9
•
Example
Explanation of the Law:

Suppose a person is thirsty and the price of water is zero. He takes one
glass of water which gives him great satisfaction. We can say the first
glass of water has great utility for him.
He then takes second glass of water. The utility of the second glass of
water is less than that of first glass of water. The utility declines
because the edge of his thirst has been blunted to a great extent.
If he drinks third glass of water, the utility of the third glass will be less
than that of second and so on. The utility goes on diminishing with the
consumption of every successive glass of water till it drops down to
zero.
It is the position of consumer’s equilibrium or maximum satisfaction.
If the consumer is forced further to take a glass of water, it leads to
disutility causing total utility-to decline. The marginal utility will
become negative. A rational consumer will stop taking water at the
point at which marginal utility becomes negative even if the good is
free.
In short, when a good is free, a consumer increases consumption of a
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good so long its additional units provide him positive marginal utility.
 The following table will make the law of
diminishing marginal utility more clear.

Units Total Utility Marginal Utility

1st glass 20 20
2nd glass 32 12
3rd glass 40 8
4th glass 42 2
5th glass 42 0
6th glass 39 –3

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 From the above
It is clear that in a given span of time :-
table,
•The first glass of water to a thirsty man gives 20 units of
utility.

•When he takes second glass of water, the marginal utility

goes down to 12 units.

•When he consumes fifth glass of water, the marginal

utility drops down to zero and if the consumption of water
is forced further from this point, the utility changes into
disutility (–3).
•Here it may be noted that the utility of the successive
units consumed diminishes not because they are of
inferior in quality than that of others. We assume that all
the units of a commodity consumed are exactly alike.
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 The graph will make the law of
diminishing marginal utility more
clear.

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 In the above figure,

OX we measure units of a commodity consumed and OY is shown

the marginal utility derived from them. The marginal utility of the first
glass of water is called initial utility. It is equal to 20 units. The MU of
the 5th glass of water is zero. It is called the satiety point. The MU of the
6th glass of water is negative –3.

Tie MU curve here lies below the OX axis. The utility curve MM falls
from left down to the right showing that the marginal utility of the success
units of glasses of water is falling.

•When a good is scarce and so priced the consumer will increase

the consumption of a commodity up to the extent where his marginal
utility for the good equals the price which he has to pay, i.e. Mu = P.

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•
Limitations
Case of intoxicants.
of the law
(Consumption of liquor defies the law for a short period.
The more a person drinks, the more he likes it)
• Application to money.
(The law equally holds good for money. It is true that more
money the man has the more greedy)
• Rare collections.
(If there are only two diamonds in the world, the
possession of 2 diamond will push up the marginal
nd
utility.)
Example: collection of the rare stamps and coins
• Utility is subjective
• Cardinal measurement of utility is not possible
• Every commodity is not an independent commodity
• Marginal utility can’t be estimated for all commodities
• Doesn’t explain Giffen paradox
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 Elasticity
Elasticity is a measure of a variable's sensitivity to a
change in another variable, most commonly this
sensitivity is the change in quantity demanded
relative to changes in other factors, such as price.
In business and economics, price elasticity refers to
the degree to which individuals, consumers, or
producers change their demand or the amount
supplied in response to price or income changes. 16
 Types of Elasticity of Demand
Price Elasticity
The price elasticity of demand is the response of the quantity
demanded to change in the price of a commodity. It is assumed that
the consumer’s income, tastes, and prices of all other goods are
steady. It is measured as a percentage change in the quantity
demanded divided by the percentage change in price.

Income Elasticity
The income elasticity of demand is the degree of responsiveness of
the quantity demanded to a change in the consumer’s income.

Cross Elasticity
The cross elasticity of demand of a commodity X for another
commodity Y, is the change in demand of commodity X due to a
change in the price of commodity Y.
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Price Elasticity

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 Price Elasticity of Demand
It is Measured as a Percentage Change in Quantity
Demanded Divided by the Percentage Change
in Price, Other things Remaining Same.

% Change in Q.D.
Ep =
% Change in Price
Change in Quantity Original
Ep = 
Price Change in Price Original18
 Price Elasticity of Demand
Ep = Q P


Where, Ep P Price
QElasticity Very
∆ P Q Small Change Price
Quantity Demanded

Note: Ep is (-)ve due to Inverse

Relationship Between Price & Quantity
Demanded. 20
 Degrees of Price Elasticity of
Demand

More Less than

Perfectly Perfectly Unit than Unit Unit
Elastic Inelastic Elastic Elastic Elastic
E=∞ E=0 E=1 (Elastic) (Inelastic)
E>1 E<1

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 Perfectly Elastic Demand
Y • A Perfectly Elastic Demand
6
is one in which a Little
Change in Price will
D
E = infinite
D
an
CauseInfinite Change
4 Demand.
in
•A very little Rise in Price
causes the Demand to Fall
to Zero and a very little Fall
in Price causes Demand to
0 10 20 30 X
Extend to Infinity.
Quantity
•Under Perfect
Competition, Demand
Curve of a Firm is
Perfectly 22
 Perfectly Inelastic Demand
Y • Perfectly
E=0 D Inelastic Demand
6
whichis a one
Price Produces
Change in
Change in in
4
No the
Quantity Demanded.
2 •In this case,
D
Elasticity of Demand
0 2 4 6
X is Zero.
Quantity 23
 Unitary Elastic Demand
• Unitary
Y
Elastic Demand is
D
one a % Change
which in in
P Price Produces an
E=1
Equal % Change in
Demand.
T D
• This type of Demand
Curve is
X
Rectangula
called
O M N
rHyperbola.
Quantity (%)General Economics: Law of Demand and
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Elasticity of Demand
 Greater than Unitary Elastic
Demand
Y • Greater than
D Unitary Demand is one
Elastic
P
E>1
in a
which
%Change Given
T
D in
Relatively
more
Produces%ChangePrice in
Demand.
• In this case Elasticity of
O M
X Demand is Greater than
N
Unitary.
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 Less than Unitary Elastic
Demand
Y
• Less than
D UnitaryDemand is one
Elastic
P in which a given %
E< 1
Change in Price
Produces
T Less % Change in
Relatively
D
Demand
•In this case, Elasticity
M N
X of Demand is Less then
O
Unitary.
Quantity (%) 26