Concept of Utility

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Concept of Utility

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Utility is defined as

• "The power of a commodity or service to satisfy human want".

• Utility is thus the satisfaction which is derived by the consumer by consuming the goods.

For example, cloth has a utility for us because we can wear it. Pen has a utility who can write with it. The utility is subjective in nature. It differs from person to person. The utility of a bottle of wine is zero for a

person who is non drinker while it has a very high utility for a drinker.

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Dr. Marshall states the law thus:

“The additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock that he has.” In this statement of the law, the word “Additional” is very

important. It is only additional (marginal) benefit which decrease and not the total benefit

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(1) No. of Rasgullas (3) Marginal Utility Total Utility (2)

1 15 15

2 13 28

3 10 38

4 8 46

5 4 50

6 2 52

7 0 52

8 -2 50

9 -5 45

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OX and OY are the two axes. Along OX are represented the units of the commodity,

‘rasgullas’, and along OY is measured the marginal utility corre sponding to the

consumption of each unit; UU’ is the utility curve.

AB is the utility when one ‘rasgulla’ is taken. CD is the additional utility when two of them are

taken: CD is less than AB. The additional utilities of other successive Units are EF, GH. KL and MN.

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• Initial Utility:

It is the utility of the initial or the first unit. In the table given on the previous page, the initial utility is 15.

• Total Utility:

Look at column 3 of the table. It gives the total utility at earn step. For example, if you consume one

‘rasgulla’, the total utility is 15; if you consume two, the total utility is 28, and so on.

• Zero Utility:

When the consumption of a unit of a commodity makes no addition to the total utility, then it is the point of zero utility. In our table, the total utility, after the 6th unit is consumed, is 52. At the seventh also it is 52.

Thus, the seventh ‘rasgulla results’ in no increase whatsoever. This is the point o’ zero utility, it is thus seen that the total utility is maximum when the marginal utility is zero.

• Negative Utility:

If the consumption of a commodity is carried to excess, then instead of giving any satisfaction, it may cause dissatisfaction. The utility in such cases is negative. In the table given above the marginal utility of the 8th and the 9th units is negative

CLASSIFICATIONS OF UTILITY

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Characteristics of Utility:

• 1. Utility has no Ethical or Moral Significance:

• 2. Utility is Psychological

• 3. Utility is always Individual and Relative

• 4. Utility is not Necessarily Equated with Usefulness

• 5. Utility cannot be Measured Objectively

• 6. Utility Depends on the Intensity of Want

• 7. Utility is Different from Pleasure

• 8. Utility is also Distinct from Satisfaction

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Types of utility

• 1. Form Utility: This utility is created by changing the form or shape of the materials. For example—A cabinet turned out from steel furniture made of wood and so on. Basically, from utility is created by the manufacturing of goods.

• 2. Place Utility: This utility is created by transporting goods from one place to another. Thus, in marketing goods from the factory to the market place, place utility is created. Similarly, when food-grains are shifted from farms to the city market by the grain merchants, place utility is created.

• 3. Time Utility: Storing, hoarding and preserving certain goods over a period of time may lead to the creation of time utility for such goods e.g., by hoarding or storing food-grains at the time of a bumper harvest and releasing their

stocks for sale at the time of scarcity, traders derive the advantage of time utility and thereby fetch higher prices for food-grains. Utility of a commodity is always more at the time of scarcity. Trading essentially involves the creation of time utility.

• 4. Service Utility: This utility is created in rendering personal services to the customers by various professionals, such as lawyers, doctors, teachers, bankers, actors etc.

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CARDINAL UTILITY

• The Cardinal Utility approach is propounded by neo-classical

economists, who believe that utility is measurable, and the customer can express his satisfaction in cardinal or quantitative numbers, such as 1,2,3, and so on.

• And to do so, they have introduced a hypothetical unit called

as “Utils” meaning the units of utility. Here, one Util is equivalent to one rupee and the utility of money remains constant.

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The two laws

With the above basic premises, the founders of cardinal utility analysis have developed two laws which occupy an important place in economic theory and have several applications and uses.

These two laws are:

• Law of Diminishing Marginal Utility; and

• Law of Equi-Marginal Utility.

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Law of Diminishing Marginal Utility

Marshall who has been a famous exponent of the cardinal utility analysis has stated the law of diminishing marginal utility as follows:

“The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in

the stock that he already has”.

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Utility Schedule

Units of Commodity Total Utility Marginal Utility

1 20 20

2 37 17

3 49 12

4 58 9

5 64 6

6 64 0

7 62 -2

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Graphical representation

Marginal utility curve Total utility curve

Utilit y

Quantity

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Limitations or Exceptions

• Dissimilar Units

• Very Small Units

• Too Long an Interval

• Rare Collections

• Abnormal Persons

• Changes in Income, Habits and Tastes

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EQUI MARGINAL UTILITY

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Other names

• Gossens law

• Law of maximum satisfaction

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The law

• The law of equi-marginal utility states that the consumer will

distribute his money income between the goods in such a way that the utility derived from the last rupee spend on each good is equal.

• In other words, consumer is in equilibrium position when marginal utility of money expenditure on each goods is the same.

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Utils Marginal utility Units Good day (Re 10) Dairy milk (Re 5) Mux/Px Muy/Py

1 100 35 10 7

2 90 30 9 6

3 80 25 8 5

4 70 20 7 4

5 60 15 6 3

6 50 10 5 2

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ORDINAL UTILITY

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Ordinal Utility is propounded by the modern economists, J.R. Hicks, and R.G.D. Allen.

 It states that, it is not possible for consumers to express the satisfaction derived from a commodity in absolute or numerical terms, and thus it cannot be measured quantitatively, theoretically and conceptually.

However, a person can introspectively express whether a good or service provides more, less or equal satisfaction when compared to one another.

In this way, the measurement of utility is ordinal, i.e. qualitative.

Ranking of preferences for commodities.

For example: Suppose a person prefers tea to coffee and coffee to milk.

Hence, he or she can tell subjectively, his/her preferences, i.e. tea > coffee

> milk.

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INDIFFERENCE CURVE ANALYSIS

• The indifference curve analysis approach was first introduced by Slustsky, a Russian Economist in 1915. Later it was developed by J.R.

Hicks and R.G.D. Allen in the year 1928

• The indifference curve indicates the various combinations of two goods which yield equal satisfaction to the consumer.

• By definition: "An indifference curve shows all the various combinations of two goods that give an equal amount of satisfaction to a consumer".

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For example, a person has a limited amount of income which he wishes to spend on two commodities, rice and wheat. Let us suppose that the following commodities are equally valued by him:

Various Combinations:

a) 16 Kilograms of Rice Plus 2 Kilograms of Wheat b) 12 Kilograms of Rice Plus 5 Kilograms of Wheat c) 11 Kilograms of Rice Plus 7 Kilograms of Wheat d) 10 Kilograms of Rice Plus 10 Kilograms of Wheat e) 9 Kilograms of Rice Plus 15 Kilograms of Wheat

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An Indifference Map

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Characteristics of Indifference Curves

Slopes downwards from left to right

Convex to origin

Parallel to each other

Do not touch the axis

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Marginal Rate of Substitution (MRS)

• An indifference curve is formed when one good is substituted for other. Marginal Rate of Substitution (MRS) refers to a rate at which one good is substituted for other, while keeping the level of

satisfaction of a consumer constant. In other words, MRS between two goods X and Y is defined as the quantity of X which is required to replace Y or quantity of Y required to replace X, so that the total

utility remains same.

It is expressed as:

MRS x,y = ∆Y/∆X MRS is called the slope of indifference curve.

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MARGINAL RATE OF SUBSTITUTION

Combinatio

ns Units of

Y + Units of

X = Total

Utility

A 25 + 3 = U

B 15 + 6 = U

C 8 + 10 = U

D 4 + 17 = U

E 2 + 30 = U

Suppose a consumer makes five combinations A,B,C,D & E, of two substitute products X and Y, the following table shows the possible combinations

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Combinat

ions Units of Y + Units of

X Change

in Y Change in

X MRS

Y/ X

A 25 + 3 - - -

B 15 + 6 -10 3 -3.33

C 8 + 10 -7 4 -1.75

D 4 + 17 -4 9 -0.44

E 2 + 30 -2 13 -0.15

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Budget line or the Price line

Choice of the combination depends in the

1. Price of the commodities

2. Income of the consumer

Assume that a consumer has Rs. 100 and the price of M is Rs. 5 and price of N is Rs.

10, then

Combination Units of commodity M Units of commodity N

A 20 0

B 14 3

C 10 5

D 0 10

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Indifference Curve

Commodit y Y

Commodity X - A 20

- B

- C

- D 10 k

z

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Changes in the budget line

Changes due to price effect

Changes due to income effect

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Changes due to price effect

Oranges

Mango es

- A - B - C

IC 1 IC 2

IC 3

m m 3 1

m 2

o

P C C

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Changes due to income effect

Oranges

Mango es

- A - B - C

IC 1 IC 2

IC 3

m m 3 1

m 2 o 3

I C C

o 2 o 1

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Consumer Surplus

A consumer may be willing to pay for a

commodity till the point where marginal utility derived is higher than the price paid for the

commodity.

Therefore the CP is the difference between the maximum price the consumer is willing to pay and the actual price of the product

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Consumers Equilibrium

P

X

- R

Q

P

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Figure

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References

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