Concept of Utility
It is want satisfying capacity of a commodity. Utility only refers to satisfaction. It
may or may not be useful.
Cardinal Utility [ 1,2,3…]
UTILITY
Ordinal Utility [ preferences]
Consumer Theory or Utility Theory
1. Cardinal Utility Theory [ Given by Marshall and measures the utility in
numbers like 1,2,3 …..]
2. Ordinal utility Theory [ Given by Hicks. Indifference curve analysis.]
3. Revealed preference [ Given by Samuelson. Based on observed market
behavior of the consumer. Theory also known as Behavioristic Ordinalist
Approach ]
Revealed Preference Theory
Assumptions
1. Rationality
2. Consistency
3. Transitivity
4. Axiom of revealed preference
Cardinal Utility Analysis
● Dupit, Gossen , Walras and Jevons [ Neo -Classical economists] 19th
century.
● Pigou and Marshall 20th century
● Fisher used the term “util” as measure of utility.
Total Utility: The total amount of satisfaction obtained from consumption of a
good or service.
TUx= f(Qx)
Marginal Utility: The additional satisfaction obtained from consumption of a good
or service.
ΔTU
MU=
ΔQ
OR
MUnth =TUn - Tun-1
Marginal Utility can
● Positive TU , MU +ve
● Zero TU max. , MU = 0
● Negative TU , MU -ve
Paradox of Value/ Water Diamond Paradox
Goods which give more TU should have more value and goods which give less TU
should have less value………. Is it so in real life?
No
More utility from water than from diamond yet the value of water is far less than
that of Diamond……….. Paradox Of value
Adam Smith formulated water Diamond Paradox
Jevons explained this paradox with the help of difference
between MU and TU
● Scarcity of commodity determined it’s Value in use
● Value of commodity is determined by its MU and not it’s TU
● Water is available in abundance so its TU reaches saturation point very soon
● Its MU becomes zero very soon
● Availability of diamond is rare, TU never reaches saturation point and MU
remains high
Consumer surplus, TU and MU
Law of Diminishing Marginal Utility
Other things being equal the MU of a good diminishes as more as more of it is
consumed in a given time period.
Jevon …….. This law is based on Weber-Fechner psychological law.
Prof. Boulding call it Law of Eventually Diminishing Marginal Utility
Marshall; The additional benefit which a person derives from a given stock of a
thing diminishes with every increase in the stock that he already has.
ASSUMPTIONS
1. Commodity is consumed in some standard units such as a cup of tea, a glass
of water and so,on.
2. There is continuous consumption of the commodity.
3. Utility of one commodity is independent of the other.
Exceptions to the law
1. Rare and curious things
2. Good book or poem
3. Miser
4. Drunkards
Derivation Of Demand Curve
Through law of diminishing marginal utility
Budget Line
The line which shows all the different combinations of the two commodities that a
consumer can purchase given his money income and price of two commodities.
Budget Constraint : The limit imposed on household choices by income, wealth
and product prices.
Choice Set: The set of Option that is defined and limited by a budget constraint.
Real Income : Set of opportunities to purchase real goods and services available
to a household as determined by prices and money income.
Equation of Budget Line
Px Qx + P y Qy ≤ M
Where,
M is the total income of the consumer
Px Qx is expenditure on good X
Py Qy is expenditure on good Y
EXAMPLE
Properties Of Budget Line
1. It will always be a straight line.
2. It will have a negative slope.
3. Its slope will be equal to negative of the ratio of prices of two commodities.
Px
i.e, Slope of budget line = (-)
Py
4. Two budget line involve the same commodity prices but represent the
different levels of income .
Shifting of Budget Line
Position and slope of budget line depends on:
1. Change in income.
2. Price of two goods that the consumer wants
Ordinal Utility Theory: Indifference Approach
Edgeworth (1881) Mathematical Psychics
Pareto ( 1906 )
Allen and Hicks (1934) A Reconsideration Of Theory Of Value
Hicks : Value And Capital (1939), Revision In Demand Theory (1956)
Indifference Curve : Represent all combinations of two commodities that provide
the same level of satisfaction to a person
Indifference Schedule
It is the schedule of various combinations of goods that
will be equally satisfactory to the individual concerned.
Combination of Good X Good Y
two goods
A 1 10
B 2 7
C 3 5
D 4 4
Indifference Map
The graph which represents a group of indifference curves each of which
expresses a given level of satisfaction.
Assumption of Indifference curve analysis
1. Non- Satiety
2. Transitivity
3. Diminishing MRS
4. Two commodities Ordinal Utility
5. Positive MU
6. Divisibility
7. Rationality
Properties of IC
1. Indifference curve slopes downward from left to right
2. Convex to the origin
3. Two Indifference curve never intersect each other.
4. Higher Indifference curve indicates higher satisfaction.
5. IC never touches X axis or Y axis.
6. Indifference curve need not be parallel to each other.
Consumer Equilibrium
❖ The consumer is in
equilibrium where he
maximises the satisfaction
subject to his budget or
income constraint.
Two Basic condition of consumer equilibrium :
1. Budget line should be tangent to the IC i.e, the MRS of X for Y is equal to the ratio
of their prices.
Px
MRSxy =
Py
2. Indifference curve must be convex to the origin
Price Effect
The change in consumption of goods
when the price of either of two goods
changes while the price of other good
and income of the consumer remains
constant.
Price Consumption curve
The curve represents the points of
consumer equilibrium when only the
price of one commodity [ for example , X
while price of other commodity (Y) and
income of the consumer remains
constant
Price effect = substitution effect + income effect
Income effect : the change quantity demanded when
due to change in the price of the commodity, real income
of consumer changes.
Substitution effect :the change in quantity demanded
when due to change in price of the commodity, it
becomes cheaper or dearer in relation to the other
commodity.