Utility Analysis
contents
Utility: Concept and Properties
Cardinal and Ordinal Utility
Consumer Equilibrium:
◼ Total and Marginal Utility Analysis
◼ Indifference Curve Analysis
Utility
Utility is the quality of the good to satisfy a want
OR wants satisfying power of a commodity is
utility.
The more satisfaction a product gives, the
higher price buyers are willing to pay.
Students who like butter are willing to pay
more for buttered popcorn than non-buttered
popcorn because it offers more total utility.
utility
◼Subjective
◼Relative
◼Not essentially useful
◼Ethically neutral
Utility
◼ Consumers, however, cannot have every thing
they wish to have. Consumers’ choices are
constrained by their budget/incomes.
◼ Utility Maximization –people try to allocate their
incomes to maximize their satisfaction/utility
◼ Within the limits of their incomes, consumers
make their consumption choices by evaluating
and comparing consumer goods with regard to
their “utilities.”
Cardinal vs Ordinal Utility
Cardinal utility:
Marshalling Approach: Satisfaction provided by any
bundle can be assigned a numerical value by a utility
function: Total and Marginal Utility Analysis
Ordinal utility:
Hickson Approach: People are able to rank each
possible bundle in order of preference-
Indifference Curve Analysis
Total and Marginal Utility
Total Utility refers to the total satisfaction
derived by the consumer from the consumption
of a given quantity of a good.
TUn= U1+U2+U3+U4+…..+Un
Marginal utility is the change in total utility
resulting from a one-unit change in
consumption of a good
MU = TUn- TUn-1
Total utility and marginal
utility from consumption
Commodity A Total utility Marginal utility
(Commodity A/hour) (utils/hour) (utils/Commodity
A) __
0 0
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10
6 140 -10
Total and Marginal Utility
Law of Diminishing Marginal
Utility
The law of Diminishing Marginal Utility
states that for a given time period, the
marginal utility gained by consuming
equal successive units of a good will
decline as the amount consumed
increases.
The more of a good an individual
consumes per time period, other things
constant, the smaller the increase in total
utility from additional consumption.
Exceptions to Law of
Diminishing Marginal Utility
Money
Hobbies and Rare Things
Liquor and Music
Things of Display
Utility and Choice
The Logic of Consumer Choice: Based on
Marginal utility per rupee of expenditure
Each consumer allocates a specific budget to
expenditure, and then allocates the
expenditure to maximize utility.
Consumers allocate their income among
goods and services in order to maximize
utility according to the equi-marginal
principle.
Utility and Choice
Equi-marginal principle: To maximize utility,
consumers allocate their incomes among goods
so as to equate the marginal utilities per rupee
(MU/P) of the expenditure on the last unit of
each good purchased.
MUCD MUgas MUmovie MU X
= = ==
PCD Pgas Pmovie PX
Utility and Choice
A change in the price of any good disturbs the
consumer’s equilibrium—the ratio of MU to P on the
last unit of each good will no longer be equal.
The consumer must reallocate income across goods.
With income fixed, if the price of one good rises, the
consumer is able to buy fewer goods and services,
causing demand to fall.
Rational Spending Rule
What should you do if: MUc/Pc > MUs/Ps ?
E.g. you get 20 units of utility per rupee spent on C
and only 16 units of utility per rupee spent on S.
You should buy more C and less S to increase total
utility without spending any more money.
But, what happens when you do this??
Rational Spending Rule
As you buy more of the higher MU/P good its
MU decreases (law of DMU).
As you buy less of the lower MU/P good its MU
increases (law of DMU in reverse).
Eventually, the MU/P will be equal. Equilibrium
will be achieved when there is no way to
increase utility by relocating the budget.
Diamond-Water Paradox
◆ Diamonds
◆ Not a necessity; expensive; relatively scarce
◆ Water
◆ Necessity; cheap; abundant
◆ Diamonds-Water paradox
◆ TUwater >TUdiamonds
◆ Last gallon of water MUwater very low
◆ Last diamond MUdiamond high
◆ Pdiamond > Pwater
◆ Total utility of water is high but marginal
utility of diamond is high; value/price is
according to marginal utility
Marshallian Consumer’s Surplus
Marshall defined Consumer’s Surplus as “the excess
of the Price which a Consumer would be willing to Pay
rather than go without the thing”.
Consumer surplus- consumer willing to pay according
to total utility but actually pay according to marginal
utility.
CS= What a Consumer is Willing to Pay – What he Actually
Pays.
18
Consumer Surplus
Rs8 At P=Rs. 4:
•1st commodity valued at Rs. 7
7
•2nd commodity valued at Rs. 6
Price per unit
6
•3rd commodity valued at Rs. 5
5 •4th commodity valued at Rs. 4
4 •Willing to pay Rs. 22 for 4 subs
3 •Pays only Rs.16 for 4 subs
2 •Consumer surplus
1 Rs.22- Rs.16 = Rs.6
D
0 1 2 3 4 5 6 7 8 Commodity
Criticism of Cardinal
Approach
➢ Satisfaction derived from various commodities cannot
be measured objectively
➢ Money used for measurement is not correct as it is not
constant and the value of money keeps fluctuating.
➢ It is psychological concept, therefore the very law is
questionable.
Indifference Curves
Marginal utility analysis requires some
numerical measure of utility in order to
determine the optimal consumption
combinations
Hicks and Allen have developed another,
more general, approach to utility and
consumer behavior
This approach does not require that
numbers be attached to specific levels of
utility
Indifference Curves
All this new approach requires is that
consumers be able to rank their preferences
for various combinations of goods
Specifically, the consumer should be able to
say whether
◼ Combination A is preferred to
combination B
◼ Combination B is preferred to
combination A. or
◼ Both combinations are equally preferred
Indifference Curves
Indifference curve shows all
combinations of goods that
provide the consumer with the
same satisfaction, or the same
utility
Thus, the consumer finds all
combinations on a curve equally
preferred
Since each of the alternative
bundles of goods yields the same
level of utility, the consumer is
indifferent about which
combination is actually consumed
Properties of
Indifference Curves
A particular indifference curve reflects
a constant level of utility ➔ the
consumer is indifferent among all
consumption combinations along a
given curve
Higher indifference curves represent
higher levels of utility
If total utility is to remain constant, an
increase in the consumption of one
good must be offset by a decrease in
the consumption of the other good ➔
indifference curves slope downward
Properties of
Indifference Curves
Indifference Curve are Convex to Origin: Marginal rate
of substitution (MRS) between the two Goods
Decreases as a Consumer moves along an
Indifference Curve
The MRS measures the consumers willingness to trade
commodity A for commodity B ➔ depends on the
amount of each good the consumer is consuming at
the time
Diminishing MRS
In general, people tend to value more what
they have less of:
◼ I. e) If a person has 25 burger and 1
fanta, he/she is willing to give up burgers
for another fanta. If he/she has 10
burger and 2 fanta, he/she is less willing
to give up burger for fanta
Therefore MRSx,y diminishes as x increases
along the indifference curve
Properties of Indifference Curves
Indifference Curves Do Not Intersect
• If indifference curves
crossed, such as point i,
then every point on
Commodity A
indifference curve I and k
every point on curve I'
would have to reflect the j
same level of utility as at i
point i I'
• But point k is a
combination with more
commodity A and more I
commodity B than point j
and must represent a higher 0
level of utility Commodity B
• If indifference curves
crossed, it would violate the
“prefer-more-to-less”
principle.
Indifference Curves and Budget
Constraints
A consumer will maximize her utility by
consuming on the highest indifference curve
as possible, given her budget constraint.
The best combination is the point where the
indifference curve and the budget line are
tangent.
Budget Line
• Depicts all possible combinations of commodity
A and B, given prices and budget or income
P1X1 + P2X2 = Y
• Suppose coke price is Rs.4, pizza sells for Rs. 8,
and the budget is Rs 40
• If entire Rs. 40 spent on coke, consumer can
purchase 10 cokes (Y/Pc)
• If spent only on pizzas person can afford 5
(Y/Pp)
BUDGET LINE
Budget line: all combinations of pizza and coke that
Y/P 10 can be purchased at fixed prices with a given income.
c
coke
Slope = -pp / pv = -Rs.8/Rs.4 = -2
5
Slope = -2: the price of 1 pizza is 2 coke.
0 5 10
Y/P Pizzas
p
Utility Maximization
• The utility-maximizing
consumer will select a
combination along the budget
line that lies on the highest
attainable indifference curve
• Given prices and income,
this occurs at point e, where
I2 just touches or is tangent
to the budget line
•Other attainable
combinations along the
budget line reflect lower
levels of utility
Consumer Equilibrium
Consumer equilibrium occurs where the
slope of the indifference curve is equal to
the slope of the budget line
The absolute value of the slope of the
indifference curve is the marginal rate of
substitution, and the absolute value of
the slope of the budget line equals the
price ratio. Thus, MRS = Pp / Pv
Further, the marginal rate of substitution
of pizzas for coke can be found from the
marginal utilities of pizza and coke➔ MRS
= MUp / MUv
Consumer Equilibrium
In fact, the absolute value of the slope of the
indifference curve equals MUp/MUv and the slope
of the budget line equals pp / pv ➔ the
equilibrium condition for the indifference curve
approach can be written as
MUP = MUV
PP PV
A consumer is in equilibrium when he or she derives
the same marginal utility per rupee for both goods.
Income and Substitution Effects
Income and Substitution Effects
When the price of one good falls while
everything else is constant, two things occur:
1. Other goods become relatively more
expensive. So consumers buy more of the
less expensive good and less of the more
expensive goods. This is called the
substitution effect.
2. The consumer can buy more total goods with
the same income. This is called the income
effect.
Normal Good: goods whose demand
increases when there is an increase in the
income of consumer
Inferior Good: goods whose demand
reduces when there is an increase in the
income of consumer.
Giffen Good: goods whose demand
increases even when there is an increase
in the price of the commodity
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Effect of a Drop in Price of One commodity
(Pizza)
❖If the price of pizza falls from $8 to
$6 per unit, other things constant, the
consumer could purchase 6.67 pizzas
(40 / 6) if the entire budget was used for
pizza
❖Since the rental price of videos has
not changed, the maximum number of
videos that can be rented remains at 10
❖As a result of the price change, the
lower end of the budget line rotates
rightward from 5 to 6.67
❖After the price change, the new
equilibrium is at e”, where pizza
purchases increase from 3 to 4 and
video rentals remain at 4
❖The demand curve in panel b shows
how price and quantity demanded are
related
Income and Substitution
Effects-Normal Good
❖To derive the
substitution effect,
assume that you
must maintain the
same level of utility
after the price
change as before ➔
consumer’s utility
has not changed,
but the relative
prices faced have
changed
Income and Substitution Effect-
Inferior Good
Income and Substitution Effect-
Giffen Good
Difference among three goods
Basis Normal Goods Inferior Goods Giffen Goods
These are the goods
These are the goods whose These are the goods
whose demand increases
demand increases when there is whose demand reduces
Meaning even when there is an
an increase in the income of when there is an increase
increase in the price of the
consumer. in the income of consumer.
commodity.
There is an inverse There is a direct
There is a direct relationship
relationship between the relationship between the
between the income of the
Relation income of the consumer price of the commodity
consumer and demand for
and demand for inferior and demand for Giffen
normal goods.
goods. goods.
The income effect of normal The income effect of The income effect of Giffen
Income Effect
goods is positive. inferior goods is negative. goods is negative.
Substitution The substitution effect of normal The substitution effect of The substitution effect of
Effect goods is positive. inferior goods is positive. Giffen goods is positive.
The price effect for inferior The price effect for Giffen
The price effect for normal goods goods is positive because goods is negative because
is positive because both the the positive substitution the negative income effect
income and substitution effect, in effect for it is stronger for it is stronger than the
Price Effect
this case, is positive. Therefore, than the negative income positive substitution effect.
with a fall in price, its demand effect. Therefore, with a Therefore, with a fall in
will rise. fall in price, its demand price, its demand will also
10/6/2025 41
will rise. fall.
Thank you