Utility
Utility is usefulness, the ability of something to satisfy needs or wants.
Utility is the quality in commodities that makes individuals wants to buy them, and the fact
that individuals want to buy commodities shows that they have utility.
In the simplest sense, economists consider utility to be revealed in people's willingness to pay
different amounts for different goods.
Quantifying utility
It was recognized that utility could not be measured or observed directly
Economists devised a way to infer underlying relative utilities from people's willingness to pay.
The measure is found in the price which a person is willing to pay for the fulfillment or
satisfaction of his desire.
There is a certain threshold of satisfaction, the consumer will no longer receive the same
pleasure from consumption once that threshold is crossed.
Marginal Utility
The additional satisfaction a consumer gains from consuming one more unit of a good or
service.
Marginal utility, then, asks how much a one-unit change in a variable will impact our level of
happiness.
o Marginal utility is an important economic concept because economists use it to
determine how much of an item a consumer will buy.
o Positive marginal utility is when the consumption of an additional item increases the
total utility.
o Negative marginal utility is when the consumption of an additional item decreases the
total utility.
Law of Diminishing Marginal Utility
A person increases consumption of a product there is a decline in the marginal utility from
consuming each additional unit. This tendency on the part of a marginal utility to diminish with
every increase in the stock of a thing is called law of diminishing marginal utility.
The law says- marginal utility decreases as the supply increases (and vice versa);
For example,
● drinking water when thirst
● the first cup of coffee in the morning
Assumptions:
● All the units must be same- For example, If first mango taken is not better, while the
second is better, then the utility will not decrease and the utility of second will be greater
than first.
● The unit must be standard- if the units are too small then this law will not operate
● There must be continuity in consumption- If there is interval between the
consumption the same two units then the law will not be applicable.
● No change in taste during consumption
● No change in income
● No change in the price of the substitute goods
Explanation:
As more and more quantity of a commodity is consumed, the intensity if desire decreases.
● Here, from the MU curve we can
see that MU is declining as
consumer consumes more of the
commodity.
● When TU is maximum, MU is
Zero.
● After that, TU starts declining
and MU becomes negative.
Exceptions: Some products or services may have some increasing marginal utility at first
(second shoe of a pair), but every good or service at some point provides decreasing additional
utility (a second pair of shoes doesn't add as much utility as the first pair).
⮚ Money: This law is not applicable in case of money with an increase in wealth man
wants to get more and more.
⮚ Hobby: In case of hobby also this law can not operate. For example , as the collection
of tickets increases, its utility also increases.
⮚ Knowledge: Some experts say that man wants to get more and more knowledge so
the law can not be applied in this case.
⮚ Sometimes an increase in the stock of a commodity increases the marginal utility. For
example the number of telephone increases in the city, but the utility of our
telephone increases.
⮚ If a consumer has been told that mango is a tonic for health, then marginal utility
will increase instead of falling.
Budget Constraint
A budget constraint represents all the combinations of goods and services that a consumer
may purchase given current prices within his or her given income.
⮚ A budget constraint occurs when a consumer is limited by a certain income.
⮚ Temporary budget constraints can be overcome by borrowing,
⮚ The long term budget constraints are determined by income such as rent and wages.
A budget constraint shows the limits of consumption given the consumer's income and the
prices of goods.
For an example, assume that we have two
goods and two prices: roses have a price = pr
and pizza has a price = pp. Next we have an
income, I, to spend on roses and pizza.
A rose costs $1 each and a slice of pizza $2. Let's assume that it is $200 during the time period
under consideration.
Consumed with romance, at Point A, one can purchase 200 roses and no pizza. In contrast, at
Point B, one loads up on 100 slices of pizza and shows no interest in the delicate roses.
✔ This information gives us the end points along the x and y axis for one's budget
constraint.
✔ Connecting the two endpoints gives us one's budget line.
✔ The budget line shows the different combinations of roses and pizza that can be
consumed for a given level of income.
Indifference curve
An indifference curve is a graph showing different bundles of goods between which a
consumer is indifferent.
At each point on the curve, the consumer has no preference for one bundle over another.
In other words an indifference curve is the locus of various points showing different
combinations of two goods providing equal utility to the consumer.
❖ The diagram shows the indifference
curve showing bundles of goods A and B.
❖ To the consumer, bundle A and B are the
same as both of them give him the equal
satisfaction.
❖ Point A gives as much utility as point B
to the individual.
❖ The consumer will be satisfied at any
point along the curve assuming that other
things are constant.
PROPERTIES OF INDIFFERENCE CURVES
The main attributes/ properties/ characteristics of indifference curves are as follows:
⮚ Indifference curves are negatively sloped- As consumer increases the consumption
of cooking oil, he has to give up certain units of wheat in order to maintain the same
level of satisfaction.
⮚ Higher indifference curve represents higher satisfaction- The higher you go the
greater the level of utility.
Lack of intersection- It represents a fixed utility value and therefore can never intersect
another indifference curve.
Indifference Curves do not Touch the Horizontal or Vertical Axis- One of the basic
assumptions of indifference curves is that the consumer purchases combinations of different
commodities. He is not supposed to purchase only one commodity. In that case indifference
curve will touch one axis. This violates the basic assumption of indifference curves.
Indifference Map
A collection of (selected) indifference curves, illustrated graphically, is referred to as an
indifference map.
A graph of indifference curves for an individual consumer associated with different utility
levels is called an indifference map.
Consumer’s Equilibrium through Indifference Curves Analysis
The term consumer’s equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market.
The aim of the consumers is to get maximum satisfaction from his money income.
Consumer’s equilibrium shows a situation in which one gets the maximum satisfaction.
Given the price line (budget line) and the indifference map, a consumer is said to be in
equilibrium at a point where the price line is touching the highest attainable indifference curve
from below.
In the diagram 3.11, there are three indifference curves IC1, IC2 and IC3. The price line PT is
tangent to the indifference curve IC2 at point C. The consumer gets the maximum satisfaction
or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with
the given money income.
Economists assume the consumer is rational and will thus maximize his or her total utility by
purchasing a combination of different products rather than more of one particular product.
Thus, instead of spending all of your money on three chocolate bars, which has a total utility
of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps
a glass of milk, which has a utility of 50. This combination will give you a maximized total
utility of 120 but at the same cost as the three chocolate bars.
The paradox of water and diamonds
⮚ The "paradox of water and diamonds" is the apparent contradiction
⮚ Water possesses a value far lower than diamonds,
⮚ Water is far more vital to a human being.
⮚ Price is determined by both marginal utility and marginal cost,
⮚ The key to the "paradox" is that the marginal cost of water is far lower than that of
diamonds.
