CONCEPT OF

UTILITY
By
 UTILITY
• Utility is the want-satisfying power of a good or
service.
• Usually referred to as "satisfaction" derived from
consumption.
• Utility is subjective, based on whims and fancies
of consumers.
• But early Neo-classical economists assumed that
it can be measured - called Cardinal Utility
Analysis.
• Walras, called the want satisfying power of goods
as utils.
 CARDINAL UTILITY
THEORY
• Assumes that utility can be measured in cardinal
units.
• The consumer is rational, wants to maximise U
• Ceteris Paribus - wants, tastes, income, etc are all
constant.
• Static analysis, no change in time,
• Consumer is independent, not influenced by other
factors (snob effect, bandwagon effect).
• Law of satiety applies.
 TOTAL UTILITY
• Total utility: the aggregate utility that the
consumer gets from the total number of units he
consumes.
• At a given moment of time, as the consumer
increases his consumption, his TU also increases.
• But this increase is at a diminishing rate,
• After reaching the level of maximum satisfaction,
point of satiety, TU starts decreasing.
• Over consumption.
MARGINAL UTILITY
• MU is the extra or additional satisfaction from
consuming an additional unit of a commodity.
• MU = change in TU divided by the change in
quantity of the commodity consumed.
• MUx = ΔTU/ΔQx
• As consumption increases, MU decreases.
• Law of Diminishing MU: As the consumption of
any commodity increases, the MU will start
decreasing, ceteris paribus.
TOTAL AND MARGINAL
UTILITY
 GRAPHICAL
REPRESENTATION
• When TU is rising, MU > 0.
• When TU is max, MU = 0
• When TU is falling, MU < 0
 CONSUMER’S
EQUILIBRIUM
• How much will a rational consumer consume?
• Rationality implies, maximising satisfaction or
utility, i.e. 6 X, when TU is maximum.
• Free goods, no prices.
• When TU is maximum, MU is zero. Beyond 6 X,
there is disutility.
• So consumer will stop his consumption when TU
is max, or MU = 0, assuming P = 0.
 CONSUMER’S
EQUILIBRIUM
•
WITH P
But the P may not be zero.
• Assume that the P of an apple is Rs.6.
• Assume that the utility of a rupee is 1 util.
• Now a rational consumer will try to equate the
utility of the apple consumed with the value of
the money he is giving in exchange.
• In other words, he will equate the P of the apple
with the MU of the apple that he is consuming.
EQUILIBRIUM WITH PRICE
• At a, the MU of X = price
(6). Consumer stops at this
point.
• Beyond this his MU < P. If
he consumes 4x, then his
MU = 4, and P = 6.
CONSUMER’S SURPLUS
• According to Marshall, consumer's surplus is the
excess of TU over the expenditure on buying the
product.
• Assumption: MU of money is constant, and equal
to 1.
• Consumer's surplus = ∑MUx - ([Link]) When P
falls, consumer's surplus increases, i.e. the
consumer gets more U than the total
expenditure on the commodity.
 CONSUMER’S SURPLUS
• At price Rs.6, he buys 3x, and his
a total expenditure = Rs.18.
U=2 • But his total utility from consuming 3x
4 was 24.
utils • Consumer's surplus is = 24 -186, i.e.
TU TU > total expenditure on 3x.
x • TU = aQ, expenditure is bQ, so CS =
b ab.
P= • If P falls, CS increases,
6
• If P increases, CS falls.
0 Q= • This concept is used in the case of
3 monopolies and taxation.
MU AND DEMAND CURVE
• MU is the basis of the shape of demand curve.
• As QT, MU↓. Inverse relationship.
• Consumer equates MU with P.
• If P increases, Q decreases, for MU = P.
• If P falls, then Q increases.
• At each equilibrium point, P = MU.
• The schedule of Ps, and Qs actually depicts the
MU at each Price.
• Instead of depicting MU and Q, we can depict P
and Q relationship → the Demand curve.
MU AND DEMAND
CURVES
 ORDINAL UTILITY
ANALYSIS
Hicks and Allen pointed out that:
• Utility is not measureable,
• Consumers do not consume just one commodity,
but a group or set of commodities.
• Utility can be ranked or ordered one combination
of goods may give greater/lesser satisfaction than
others.
• When price changes, it leads to both a
substitution effect and an income effect. Marshall
had ignored the income effect
 INDIFFERENCE CURVE
ANALYSIS
• An indifference curve shows the various combinations
of 2 goods (A and B) that yield the same level of total
utility to a consumer.
• Based on the following assumptions:
a. Two goods which are close but not perfect
substitutes.
b. Both goods are consumed together in different
combinations.
c. Prices are given, also utility is known.
d. The consumer orders his consumption based on the
utility he gets - ordinal utility.
DIAGRAM OF IC
• Any two points on an
indifference curve provide
the same level of utility.
 PROPERTIES OF ICs
• ICs slope down to the right, showing that A and B
are substitutes.
• ICs are convex to the origin, showing that the rate
of substitution is not constant, but decreasing.
• Higher indifference curves give higher levels of
utility.
• Indifference curves cannot cut each other
 BUDGET CONSTRAINT
• The amount of A and B
A consumed depends on
their two prices and
Income of consumer.
• Qa . Ра + Qв . 0РВ =
consumer's income Y

0 B
CONSUMER’S
EQUILIBRIAM
• Is at the point where the budget line is
a slope to the highest indifference
curve.
THANK YOU