Chapter 4

Utility

 What is utility? (mark -3)

- Utility refers to the total satisfaction received from consuming a good or service.
- It is the power of a good or the service by which it can satisfy a human want.
- Utility can be two types such as cardinal utility that can be directly observable and
ordinal utility that cannot be directly observable.

 What are the features of utility? (marks- 3)

1) Utility depends upon human wants.
2) Utility depends upon use.
3) Utility depends upon time. For example-electric light gives a lot of utility at night not
at day time
4) Utility depends upon place. For example-Woolen clothes do not give utility in the
equator region but gives a lot of utility in the cold region.
5) Utility is different from usefulness.
6) Utility is base of demand.
7) Although total utility usually increases as more of a good is consumed, marginal
utility usually decreases with each additional increase in the consumption of a good
 Cardinal vs. ordinal utility (mark-2)

Cardinal Utility
- Cardinal utility states that the satisfaction the consumer derives by consuming goods
and services can be measured with numbers.
- Cardinal utility is a quantitative measure.
- Using Cardinal utility a customer can assign a number to a product that when
consumed was able to satisfy their needs.
- In cardinal utility it is assumed that consumers derive satisfaction through
consumption of one good at a time.

Ordinal Utility
- Ordinal utility states that the satisfaction the consumer derives from the consumption
of goods and services cannot be measured in numbers.
- Ordinal utility is a qualitative measure..
- Using ordinal utility a customer can rank the products according to the level of
satisfaction that was derived.
I- n ordinal utility it is assumed that a consumer may derive satisfaction from the
consumption of a combination of goods and services, which will then be ranked
according to preference.
 Explain the derivation of demand curve from utility curve or indifference curve. (mark-4)

A demand curve shows how much quantity of a good will be purchased at various prices
assuming that tastes and preferences of a consumer, his income, prices of all related
goods remain constant.
This demand curve showing relationship between price and quantity demanded. It can be
derived from utility curve or indifference curve analysis.

In Figure money is measured on the Y-axis, while the quantity of the good X whose
demand curve is to be derived is measured on the X-axis. An indifference map of a
consumer is drawn along with the various budget lines showing different prices of the
good X. Budget line BL1 shows that price of the good X is Px1
As price of good X falls from Px1 to Px2, the budget line shifts to BL2
Tangency points between two budget lines and indifference curves (IC1 and IC2) are Q1
and Q2 respectively.
In equilibrium position at Q1 the consumer is buying OX1 units of the good X.
When price falls to Px2 and the budget line BL2 is tangent to indifference curve IC2 at
point Q2, the consumer is buying OX2 units of good X.
By joining the points K and L, we get the required demand.
Assumptions:
- utility was cardinally measurable and
- Marginal utility of money remained constant with the change in price of the good.
Explain the law of diminishing marginal utility with assumption. (Mark-5)
- The law of diminishing marginal utility explains the downward sloping demand
curve.
- The Law of Diminishing Marginal Utility states that as a person increases
consumption of a product, there is a decline in the marginal utility (that person
derives from consuming each additional unit of that product) while keeping
consumption of other products constant.

According to Marshall, “The additional benefit a person derives from a given increase
of his stock of a thing diminishes with every increase in the stock that he already has”

Explanation:
As more and more quantity of a commodity is consumed, the utility derived from the
additional unit decreases.

Suppose a person eats Bread and 1st unit of bread gives him maximum satisfaction.
When he will eat 2nd bread his total satisfaction would increase. But the utility added by
2nd bread (MU) is less than the 1st bread. His Total utility and marginal utility can be put
in the form of a following schedule.

Plotting the above data on a graph gives

 Here, from the Marginal utility curve we can see

that Marginal utility is declining as consumer
consumes more of the commodity.
 When Total utility is maximum, Marginal Utility
is Zero.
 After that, Total Utility starts declining and
Marginal Utility becomes negative.

Assumptions:
 All the units of a commodity must be same in all
respects.
 The unit of the good must be standard
 There should be no change in taste during the
process of consumption
  There must be continuity in consumption
There should be no change in the price of the substitute goods.

Explain the relationship between total utility and marginal utility.

Total utility is the total satisfaction received from consuming a given total quantity of a
good or service, while marginal utility is the satisfaction gained from consuming
another quantity of a good or service.

Suppose a person eats Bread.1st unit of bread gives him maximum satisfaction. When he
will eat 2nd bread his total satisfaction would increase. But the utility added by 2nd bread
(MU) is less than the 1st bread. His Total utility and marginal utility can be put in the
form of a following schedule.

Plotting the above data on a graph gives

 Here, from the Marginal utility curve we can see

that Marginal utility is declining as consumer
consumes more of the commodity.
 When Total utility is maximum, Marginal
Utility is Zero.
 After that, Total Utility starts declining and
Marginal Utility becomes negative.
Explain the law of Equi-Marginal utility. How does it explain consumer
equilibrium? (mark-6)
According to the law of equi-marginal utility-

“A person can get maximum utility with his given income when it is spent on different
commodities in such a way that the marginal utility of money spent on each item is equal".

According to the law of equi-marginal utility, the consumer will be in equilibrium at the
point where the utility derived from the last rupee spent on each is equal.

Symbolically the consumer will be in equilibrium when

MUx / Px =MUy / Py = MUx

Where MUx = Marginal utility of commodity X

MUy = Marginal utility of commodity Y
Px = Price of commodity X
Py = Price of commodity Y
MUm = Marginal utility of money.

MUx / Px and MUy / Py are known as marginal utility of money expenditure.

Let us suppose that the price of goods 'x' and 'y' are Tk. 5/- and Tk.4/-. And the given income
of a consumer is Tk.50/-

The consumer will buy 6 units of commodity ‘x’ and 5 units of commodity ‘y’.

His total expenditure will be (Tk 5 x 6) + (Tk 4 x 5 ) = Tk 50/- and marginal utility will be 5
on both commodities
 At this point of expenditure his satisfaction is maximized and therefore he will be
in consumer’s equilibrium.

Assumptions:

1. There is no change in the prices of the goods.

2. The income of consumer is fixed.
3. The marginal utility of money is constant.
4. Consumer has perfect knowledge of utility obtained from goods.
5. Consumer is normal person so he tries to seek maximum satisfaction.
6. The utility is measurable in cardinal terms.
7. Consumer has many wants.
8. The goods have substitutes.

Indifference curve

What is indifference curve? What are the characteristics or assumptions of it?

An indifference curve is a graph showing combination of two goods that give the consumer
equal satisfaction and utility.
 Characteristics/ Properties:
Property I. Indifference curves slope downward to the right.
Property II: A higher indifference curve represents a higher level of satisfaction than a
lower indifference curve.
Property III: Indifference curves cannot intersect each other.
Property IV: Indifference curves are convex to the origin.

Some other properties are:

V: Indifference curves are not necessarily parallel to each other.
VI: An indifference curve cannot touch either axis.

Prove the properties of indifference curve.

Property I. Indifference curves slope downward to the right:
An indifference curve has a negative slope and the indifference curves must slope
downward from left to right. As the consumer increases the consumption of X
commodity, he has to give up certain units of Y commodity in order to maintain the same
level of satisfaction.

In Figure (A) combination B of OX1 + OY1 is more preferable than combination A which
has a smaller amount of the two goods. So, the indifference curve cannot slope upward
from left to right since it shows equal satisfaction.

Similarly, in Figure (B) combination B is more preferable than combination A.

combination B has more of X and the same quantity of Y. So the indifference curve
cannot be horizontal.

In Figure (C) the indifference curve is shown as vertical and again combination B is more
preferable as the consumer has more of Y and the same quantity of X. So, the
indifference curve cannot be vertical either.

Consequently, the indifference curve will be of negative slope as shown in Figure (D)
where A and B combinations give equal satisfaction to the consumer. As he moves from
combination A to B he gives up less quantity of Y in order to have more of X. (proved)
(2) Higher Indifference Curve Represents Higher Level of Satisfaction:

Indifference curve that lies above of another indifference curve represents a higher level of
satisfaction. The combination of goods which lies on a higher indifference curve will be
preferred by a consumer rather than the combination which lies on a lower indifference curve.
Diagram:

In this diagram, there are three indifference curves, IC1, IC2 and IC3 which represents different
levels of satisfaction. The indifference curve IC3 shows greater amount of satisfaction and it
contains more of both goods than IC2 and IC1.
IC3 >IC2>IC1.

(3) Indifference Curves are Convex to the Origin:

Indifference curves are convex to the origin. As the consumer substitutes commodity X for
commodity Y, the marginal rate of substitution diminishes. It means that as the amount of X is
increased by equal amounts that of Y diminish by smaller amounts.
Diagram:
In the above diagram, as the consumer moves from A to B
to C to D, the willingness to substitute good X for good Y
diminishes. The slope of IC is negative. In the above
diagram, diminishing MRSxy is described as the consumer
is giving AP>BQ>CR units of Y for PB=QC=RD units of
X. Thus indifference curve is convex to the origin.
If the indifference curve is concave, MRSxy increases.
If the indifference curve is straight line then MRSxy
remains constant.
(4) Indifference Curves cannot Intersect Each Other:

The indifference curves cannot intersect each other.

In the above diagram, two indifference curves intersect
each other at point B.
The combinations represented by points B and F given
equal satisfaction to the consumer because both lie on
the same indifference curve IC2.
Similarly the combinations shows by points B and S on
indifference curve IC1 give equal satisfaction top the
consumer.
If combination F is equal to combination B in terms of
satisfaction and
Combination S is equal to combination B in satisfaction.
It follows that the combination F will be equal to S in terms of satisfaction.
But it is not possible because S lies on IC1 and F lies on IC2.
So it is proved that the indifference curves cannot intersect each other.

Budget line

What is Budget line?

- Budget line is a graphical representation of all possible combinations of two goods which
can be purchased with given income and prices.
- Suppose there are two goods for consumption. Good x and good y and given income is
m. The budget line equation will be

Where:

The price of x good

The price of y good

Amount purchased of x good

Amount purchased of y goods

 Budget line’s intercept on x axis means consumer will buy all the x goods
And he will not buy Y good.
Budget line’s intercept on Y axis means consumer will buy all the Y goods
And he will not buy x good.

Explain the shift in Budget line.

A new budget line shifts when
(a) Income of the consumer changes, or
(b) Price of the commodity changes.
Let us understand this with the example of apples and bananas:

Effect of a Change in the Income of Consumer:

 If there is any change in the income, assuming no change in prices of apples and bananas,
then the budget line will shift. When income increases, the consumer will be able to buy
more bundles of goods, which were previously not possible. It will shift the budget line to
the right from ‘AB’ to ‘A1B1‘, as seen in Figure.
The new budget line A1B1 will be parallel to the original budget line AB.
Similarly, a decrease in income will lead to a leftward shift in the budget line to A2B2.
 Effect of change in the relative Prices (Apples and Bananas):
If there is any change in prices of the two commodities, assuming no change in the
money income of consumer, then budget line will change. It will change the slope of
budget line.
 When the price of apples falls, then new budget line is represented by a shift in budget line
to the right from AB to A1B. The new budget line meets the Y-axis at the same point B,
because the price of bananas has not changed.
But it will touch the X-axis to the right of A at point A1, because the consumer can now
purchase more apples, with the same income level.
 Similarly, a rise in the price of apples will shift the budget line towards left from AB to
A2B

Similarly the change in price of bananas shift budget line

Short note

Marginal rate of substitution (MRS)

- Marginal rate of substitution (MRS) is the amount of a good that a consumer is willing to
give up for another good, as long as the new good is equally satisfying.
- It is used to analyze consumer behavior in indifference theory.
- The marginal rate of substitution (MRS) can be defined as how many units of good x
have to be given up in order to gain an extra unit of good y, while keeping the same level
of utility.
- The marginal rate of substitution is calculated using the following formula:

Engle curve
- An Engel curve describes how a consumer's purchases of a good vary as the consumer's
total income varies.
- Engel curves may also depend on demographic variables and other consumer
characteristics.
 - A good's Engel curve determines its income elasticity.
Indifference map

- An indifference map is the collection of indifference curves owned by an individual.

- The family of indifference curves is called indifference map.

· IC1, IC2 and IC3 are three indifference curves.

· All the points on IC2 will give higher satisfaction than the points on IC1 and
· All the points on IC3 will give lesser satisfaction than the points on IC1
Producer surplus and consumer surplus

 Producer surplus is the additional private benefit to producers, in terms of profit.

It is gained when the price they receive in the market is more than the minimum they would be
prepared to supply for.
In other words they received a reward that more than covers their costs of production.

 Consumer surplus is the additional private benefit to consumers.

It is gained when consumer actually pays is less than they are prepared to pay.

Types of goods

 Inferior Good: In case of inferior good, an increase in income causes a fall in demand.
 Normal Good/Superior good: In case of normal good an increase in income causes an
increase in demand.
 Luxury Good. A luxury good means an increase in income causes a bigger % increase in
demand.
 Complementary Goods. Goods which are used together, e.g. Tea and Sugar.
 Substitute Goods. Goods which are alternatives, e.g. Pepsi and Coca-cola.
 Giffen good: A special type of inferior good which would disobey the "law of demand".
When the price of a Giffen good increases, the demand for that good increases.