Utility Analysis

Chapter 3
Learning Objectives
1. To introduce the crux of consumer
behavior, choices and preferences.
2. To understand the meaning of utility
analysis, total utility, marginal utility and
diminishing marginal utility.
3. To explain the differences between
cardinal and ordinal utility analyses of
consumer behavior.
 Consumer Demand
“Demand is the mother of all production”

Quantity Demanded refers to the amount

(quantity) of a good that buyers are willing
and able to purchase at alternative prices for
a given period.

High demand means high business prospects in

future and vice versa.
 Consumer Demand
Therefore it is essential for business managers to
have a clear understanding of the following
aspects of demand for their products:
1. What is the basis of demand for their
commodity?
2. What are the determinants of demand ?
3. How do the buyers decide the quantity of a
product to be purchased?
4. How do the buyers respond to change in the
product prices, their incomes and prices of the
related goods?
5. How can the total or market demand for a
product be assessed and forecasted ?
 Law of Demand
The Law of Demand states that “ as price
of the commodity increases, the quantity
demanded reduces and vise versa.
Factors Behind the Law of Demand :
1. Substitution Effect.
2. Income Effect
3. Utility-Maximizing Behavior
 Law of Demand
Exceptions to the Law of Demand :

1. Expectations of further price rise in

future.
2. Status Goods.
3. Giffen Goods
Basis of the Consumer Demand:
Utility
Consumer's demand a product because they
derive or except to derive utility from the
consumption of that commodity.

Utility is the power of a Commodity to

satisfy human wants.

Utility has a specific meaning and use in the

analysis of consumer demand .
Basis of the Consumer Demand:
Utility
The concept of utility can be looked upon from 2
angles:
1. Product Angle: Utility is a want satisfying
property of a commodity or product.
2. Consumer’s Angle: Utility is a psychological
feeling of satisfaction, pleasure, happiness and
well-being, which a consumer derives from the
consumption, possession or the use of a
commodity.
Total and Marginal Utility
Total Utility: is defined as the sum of the
utility derived by a consumer from various
units of goods and services consumed at a
point or over a period of time . For Eg : A
consumer consume 4 units of a commodity,
X, at a time and derives utility from the
successive units of consumption as U1, U2,
U3 & U4. His total utility (Ux) from
commodity X can be then measured as
follows:
Ux= U1 +U2 + U3 + U4
Total and Marginal Utility
If a consumer consumes n number of
commodities, his total utility, TUn is the
sum of the utility derived from each
commodity. For instance, if the
consumption goods are X,Y and Z and
their total respective utilities are Ux, Uy
and Uz, then
TUn = Ux + Uy + Uz
 Total and Marginal Utility
Marginal Utility : may be defines in number of
ways. “ It is defined as the utility derived from the
marginal or one additional unit consumed” or It
may be defined as “ the addition to the total
utility resulting from the consumption of one
additional unit”

Marginal Utility (MU) thus refers to the change in

Total Utility (∆ TU) obtained from the
consumption of an additional unit of a commodity,
say X. It may be expressed as :
MUx = ∆ TUx
∆Qx
Marginal Utility of Money
 Money is a general purchasing power. It
enables a purchaser to buy anything he
likes. That is why it is said one can never
reaches a stage where money eases to be
desired. That is the marginal utility of
money goes on increasing with its
increase. This is opposite to the law of
diminishing marginal utility.
Marginal Utility and Price
The consumer stops where the price and
marginal utility are equal. All units of a
commodity being interchangeable, what is
paid for the marginal unit is paid for every
unit. Therefore can say that marginal utility
determines price. It is marginal utility and
not Total Utility that determines price,
other wise the price of water should have
been high and that of gold is low.
Marginal Utility and Supply
Marginal Utility is a function of supply i.e it
varies with supply. In case of a free good
where supply is unlimited, the marginal
utility is zero. Only in the case of scare
goods the marginal utility is positive. It
increases as supply contracts and
decreases as supply increases.
Law of Diminishing Marginal Utility
The "law" states that the more we have of a
given product the less satisfaction (or
utility) we receive from each additional
unit (for example, the first slice of pizza
delivers more pleasure than the second
and this decreases with each additional
slice).
Law of Diminishing Marginal Utility
Unit of Commodity Total Utility Marginal Utility
X (TUx) (MUx)

0 0 0

1 4 4

2 7 3

3 8 1

4 8 0

5 7 -1
Total and Diminishing Marginal
Utility of Commodity X
Assumptions to Law
1. The unit of the consumer good must be
standard one, eg a cup of tea, a bottle of
cold drink, a pair of shoes etc. If the units
are excessively small or large, the law may
not hold.
2. The consumer taste, preference must
remain the same during the period of
consumption.
3. There must be continuity in consumption.
Where a break in continuity is necessary,
the time interval between the consumption
of two units must be appropriately short.
Assumptions to Law
4. The mental Condition of the consumer
must remain normal during the period of
consumption.

In cases like accumulation of money,

collection of stamps, old coins, rare
paintings or melodious songs, the marginal
utility may initially increase rather than
decrease.
CARDINAL APPROACH
This school believes that Utility is measurable
and is a quantifiable entity.

Cardinal Utility Approach attributed to Alfred

Marshal and his followers, is also called the
neo-classical approach, which gives exact
measurement by assigning definite numbers
such as 1,2,3, etc.
Examples are temperature can be measured in
degrees, distant can be measure in
kilometers, weight, height, length and air
pressures.
Derivation of demand Curve in acse
of a single commodity
Dr. Alfred Marshall-was of the view that
the law of demand and so the demand
curve can be derived with the help of
utility analysis.
 He explained the derivation of law of
demand (i) in the case of a single
commodity and (ii) in the case of two or
more than two commodities: In the utility
analysis of demand, the following
assumptions are made.
Derivation of demand Curve in case of a
single commodity – Law of Diminishing
Marginal Utility
 Dr. Alfred Marshall derived the demand
curve with the aid of law of diminishing
marginal utility. The law of diminishing
marginal utility states that as the consumer
purchases more and more units of a
commodity, he gets less and less utility from
the successive units of expenditure.
 At the same time, as the consumer
purchases more and more units of one
commodity, then lesser and lesser amount of
money is left with him to buy other goods
and services
Derivation of demand Curve in case of a
single commodity – Law of Diminishing
Marginal Utility
 A rational consumer, therefore, while
purchasing a commodity compares the price
of the commodity which he has to pay with
the utility of the commodity he receives
from it.
 So long as the marginal utility of a
commodity is higher than its price MUx > Px,
the consumer would demand more and
more units of it till its marginal utility is
equal to its price MUx = Px or the
equilibrium condition is established.
Derivation of demand Curve in case of a
single commodity – Law of Diminishing
Marginal Utility
 To put it differently, as the consumer
consumes more and more units of a
commodity, its marginal utility goes on
diminishing. So it is only at a diminishing
price at which the consumer would like
to demand more and more units of a
commodity.
 This is explained with the help of the
following diagram:
Derivation of demand Curve in case of a
single commodity – Law of Diminishing
Marginal Utility
Derivation of demand Curve in case of a
single commodity – Law of Diminishing
Marginal Utility
 In figure the Mux is negatively sloped. It
shows that as the consumer acquires
larger quantities of good x, its marginal
utility diminishes.
 Consequently, at diminishing price, the
quantity demanded of the good x
increases as is shown in figure.
 At x, quantity the marginal utility of a
good is Mu1. This is equal to p1 by
definition.
Derivation of demand Curve in case of a
single commodity – Law of Diminishing
Marginal Utility
 The consumer here demands Ox1
quantity of the commodity at P1 price.
 In the same way x2 quantity of the good is
equal to p2. Here at P2 price, the
consumer will buy ox2 quantity of
commodity.
 At x3 quantity the marginal utility is Mu3,
which is equal to p3. At p3, the consumer
will buy ox3 quantity and so on.
Derivation of demand Curve in case of a
single commodity – Law of Equimarginal
utility
 The law of equi-marginal utility explains
the consumer's equilibrium in a multi-
commodity model. The law states that a
consumer consumes various goods in
such quantities that MU derived per unit
of expenditure from each good is the
same.
Derivation of demand Curve in case of a
single commodity – Law of Equimarginal
utility
 When a consumer has to spend a certain
given income on a number of goods, he
attains maximum satisfaction when the
marginal utilities of the goods are
proportional to their prices as stated
below.
Derivation of demand Curve in case of a
single commodity – Law of Equimarginal
utility
Derivation of demand Curve in case of a
single commodity – Law of Equimarginal
utility
1. In the figure, given the money income, the
price of x commodity (Px) and the price of Y
commodity (Py) and constant marginal utility
of money (MUm), the demand curve derived
is illustrated.
2. The consumer allocates his money income
between X and Y commodities to get OQ1
units of good x and OY unit of good Y
commodities because the combination
corresponds to at the OM level (constant).
Derivation of demand Curve in case of a
single commodity – Law of Equimarginal
utility
3. Let us assume that money income and the
price of Y commodity remain constant but
the price of X commodity decreases. As a
result of this money expenditure on
commodity X rises resulting MUx/Px curve
to shift to the right.
4. The consumer now allocates his income to
OQ2 quantity of X commodity and OY
quantity of Y commodity because the
combination corresponds to MUx/Px =
MUy/Py=Mum (Constant).
Derivation of demand Curve in case of a single
commodity – Law of Equimarginal utility
5. Thus in response to decrease in the price
from Px to Px1, the quantity demanded of
a good X increases from OQ1 to OQ2.
The DD is a negatively sloped demand
curve.
Ordinal Utility Approach
According to this theory, utility cannot be
measured in physical units rather the
consumer can only rank utility derived
from various commodities. Thus according
to the ordinal utility approach is not
additive.
Hick used a different tool of analysis called
“Indifferent Curve” to analyze consumer
behaviour.
Ordinal Utility Approach
This approach is based on the following
assumptions:
1. Rationality: The consumer is assumed
to be a rational being. Rationality means
that a consumer aims at maximizing his
total satisfaction given his income and
prices of commodities that he consumes
and his decisions are consistent with this
objective.
Ordinal Utility Approach
2. Ordinal Utility: Indifference curve analysis
assumes that utility is only ordinally
expressible. That is, the consumer is only
able to express the order of his preference
for different baskets of goods.
3. Transitivity and Consistency of choice:
Consumer’s choice are summed to be
transitive. Transitivity of choice means that a
consumer prefers A TO B and B to C, he
must prefer A to C, or if he must treat A=B
and B=C, he must treat A=C.
Ordinal Utility Approach
4. Nonsatiety: It is also assumed that consumer is
never over-supplied with goods in question. That
is, he has not reached the point of saturation in
case of any commodity. Therefore, a consumer
always prefers a larger quantity of all goods.
5. Diminishing Marginal Rate of Substitution:
This is a rate at which a consumer is willing to
substitute one commodity (X) for another
commodity (Y) so that his total satisfaction
remains the same. If the marginal rate of
substitution is given as DY/DX , the ordinal utility
approach assumes that DY/DX goes on
decreasing when consumer continues to
substitute X for Y.
 The End

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