Total Utility and Marginal Utility:

People buy goods because they get satisfaction from them. This satisfaction which the consumer experiences when he consumes a good, when measured as number of utils is called utility. It is here to necessary to make a distinction between total utility and marginal utility.

Total Utility (TU) - Definition and Explanation:

Total utility is the total satisfaction obtained from all units of a particular commodity consumed over a period of time. For example, a person consumes eggs and gains 50 utils of total utility. This total utility is the sum of utilities from the successive units (30 utils from the first egg, 15 utils from the second and 5 utils from the third egg). Sunning up total utility is the amount of satisfaction (utility) obtained from consuming a particular quantity of a good or service within a given time period. It is the sum of marginal utilities of each successive unit of consumption. By formula:

TUx = MUx

Marginal Utility (MU) - Definition and Explanation:

Marginal utility means an additional or incremental utility. Marginal utility is the change in the total utility that results from unit one unit change in consumption of the commodity within a given period of time. For example, when a person increases the consumption of eggs from one egg to two eggs, the total utility increases from 30 utils to 45 utils. The marginal utility here would be the15 utils of the 2nd egg consumed. Marginal utility, thus, can also be described as difference between total utility derived from one level of consumption and total utility derived from another level of consumption. By formula: MU = TU / Q It may here be noted that as a person consumes more and more units of a commodity, the marginal utility of the additional units begins to diminish but the total utility goes on increasing at a diminishing rate. When the marginal utility comes to zero or we say the point of satiety is reached, the total utility is the maximum. If consumption is increased further from this point of satiety, the marginal utility becomes negative and total utility begins to diminish. The relationship between total utility and marginal utility is now explained with the help of following schedule and a graph.

Schedule a showing marginal utility and total utility

Units of apples consumed daily 1 2 3 4 5 6 Total utility in utils per day Marginal utility in utils per day 7 7 11 4 (11 - 7) 13 2 (13 - 11) 14 1 (14 - 13) 14 0 (14 - 14) 13 -1 (13 - 14)

The above table shows that when a person consumes no apples, he gets no satisfaction. His total utility is zero. In case he consumes one apple a day, he gains seven units of satisfaction. His total utility is 7 and his marginal utility is also 7. In case he consumes second apple, he gains extra 4 utils (MU). Thus given him a total utility of 11 utils from two apples. His marginal utility has gone down from 7 utils to 4 utils because he has a less craving for the second apple. Same is the case with the consumption of third apple. The marginal utility has now fallen to 2 utils while the total utility of three apples has increased to 13 utils (7 + 4 + 2). In case the consumer takes fifth apple,, his marginal utility falls to zero utils and if he consumes sixth apple also, the total showing total utility and marginal utility is plotted in figure below:

i. ii. iii.

iv.

The total utility curves starts at the origin as zero consumption of apples yield zero utility. The TU curve reaches at its maximum or a peak of M when MU is zero. The MU curve falls through the graph. A special point occurs when the consumer consumes fifth apple. He gains no marginal utility from it. After this point, marginal utility becomes negative. The MU curve can be derived from the total utility curve. It is the slope of the line joining two adjacent quantities on the curve. For example, the marginal utility of the third apple is the slope of line joining points a and b. The slope of such given by the formula; MU = TU / Q Here MU = 2.

Explanation and Example of Law of Diminishing Marginal Utility:

This law can be explained by taking a very simple example. Suppose, a man is very thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives him immense pleasure or we say the first glass of water has great utility for him. If he takes second glass of water after that, the utility will be less than that of the first one. It is because the edge of his thirst has been blunted to a great extent. If he drinks third glass of water, the utility of the third glass will be less than that of second and so on. The utility goes on diminishing with the consumption of every successive glass water till it drops down to zero. This is the point of satiety. It is the position of consumers equilibrium or maximum satisfaction. If the consumer is forced further to take a glass of water, it leads to disutility causing total utility to decline. The marginal utility will become negative. A rational consumer will stop taking water at the point at which marginal utility becomes negative even if the good is free. In short, the more we have of a thing, ceteris paribus, the less we want still more of that, or to be more precise.

In given span of time, the more of a specific product a consumer obtains, the less anxious he is to get more units of that product or we can say that as more units of a good are consumed, additional units will provide less additional satisfaction than previous units. The following table and graph will make the law of diminishing marginal utility more clear.

Schedule of Law of Diminishing Marginal Utility: Total Utility Units 1st glass 2nd glass 3rd glass 4th glass 5th glass 6th glass 20 32 40 42 42 39 20 12 8 2 0 -3 Marginal Utility

From the above table, it is clear that in a given span of time, the first glass of water to a thirsty man gives 20 units of utility. When he takes second glass of water, the marginal utility goes on down to 12 units; When he consumes fifth glass of water, the marginal utility drops down to zero and if the consumption of water is forced further from this point, the utility changes into disutility (-3). Here it may be noted that the utility of then successive units consumed diminishes not because they are not of inferior in quality than that of others. We assume that all the units of a commodity consumed are exactly alike. The utility of the successive units falls simply because they happen to be consumed afterwards. Curve/Diagram of Law of Diminishing Marginal Utility: The law of diminishing marginal utility can also be represented by a diagram.

In the figure (2.2), along OX we measure units of a commodity consumed and along OY is shown the marginal utility derived from them. The marginal utility of the first glass of water is called initial utility. It is equal to 20 units. The MU of the 5th glass of water is zero. It is called satiety point. The MU of the 6th glass of water is negative (-3). The MU curve here lies below the OX axis. The utility curve MM/ falls left from left down to the right showing that the marginal utility of the success units of glasses of water is falling.

Assumptions of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is true under certain assumptions. These assumptions are as under: (i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational. He aims at maximization of utility subject to availability of his income. (ii) Constant marginal utility of money: It is assumed in the theory that the marginal utility of money based for purchasing goods remains constant. If the marginal utility of money changes with the increase or decrease in income, it then cannot yield correct measurement of the marginal utility of the good. (iii) Diminishing marginal utility: Another important assumption of utility analysis is that the utility gained from the successive units of a commodity diminishes in a given time period. (iv) Utility is additive: In the early versions of the theory of consumer behavior, it was assumed that the utilities of different commodities are independent. The total utility of each commodity is additive. U = U1 (X1) + U2 (X2) + U3 (X3). Un (Xn) (v) Consumption to be continuous: It is assumed in this law that the consumption of a commodity should be continuous. If there is interval between the consumption of the same units of the commodity, the law may not hold good. For instance, if you take one glass of water in the morning and the 2nd at noon, the marginal utility of the 2nd glass of water may increase. (vi) Suitable quantity: It is also assumed that the commodity consumed is taken in suitable and reasonable units. If the units are too small, then the marginal utility instead of falling may increase up to a few units. (vii) Character of the consumer does not change: The law holds true if there is no change in the character of the consumer. For example, if a consumer develops a taste for wine, the additional units of wine may increase the marginal utility to a drunkard. (viii) No change to fashion: Customs and tastes: If there is a sudden change in fashion or customs or taste of a consumer, it can than make the law inoperative. (ix) No change in the price of the commodity: there should be any change in the price of that commodity as more units are consumed.

A. The Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price,

the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C). B. The Law of Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.) Time and Supply Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent. Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand. Equilibrium When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity. In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

Exceptions to the Law of Demand and its Determinant.

Marshall the great economist has assumed the following main factors as a constant one for the validity to its law of demand. Income of the consumer Tastes, preferences, habits and customs Population Price of related goods Expectation regarding future prices Level of taxes or Government's policy Weather conditions No new product Distribution of income and wealth and Advertisements. Exception to the Law: Some times, we find that with a fall in the price demand also falls and with a rise in price demand also rises. These cases are referred to as exceptions to the general law of demand. The demand curve in these cases will be an upward sloping. Some of these exceptions are:

1.
2. 3. 4.

Giffen goods or Inferior goods. Prestige goods Speculation Price Illusion

These different types of exceptions are described in brief explanation as follows:-

Inferior goods: Some goods like potato, bread, vegetable oil etc. are called inferior goods. In the case of these goods when their price falls, the real income or the purchasing power of the consumer increases, this purchasing power is used to buy other superior goods. Such inferior goods are named as 'Giffen goods'. An Irish economist Sir Robert Giffen observed this tendency of the individuals in the 19th century.

Expectations and speculations: When people expect a rise or fall in price in the near future, the law of demand does not hold good. If a price rise is expected by next week, then they will buy more now itself though at present the prices are quite high.

Prestige goods: Rich people like to show off their economic status. SO they buy prestige goods like colour T.V., diamond etc. even at a higher price.

Price illusion: There are certain consumers those who are always guided by the price of the commodity. They always believe that higher the price, better the quality. Hence they purchase larger quantities of high priced goods.

Demonstration effect: It refers to a tendency of low income groups to imitate the consumption pattern of high income groups. They will buy a commodity to imitate the consumption of their neighbors even if they don't have the purchasing power.

Ignorance:

Sometimes due to ignorance of existing market price, and people buy more at a higher price.

Quality and Branded Goods: Commodities of good standard and quality give proper value for money. They last long and give good service. So people prefer to buy them even at a higher price.

In the above exceptional cases, the demand graph curve slopes upward showing a positive relationship between price and demand. Determinants of Demand: The determinants of demand have been explained in brief as follows:

Price: The price of a commodity is an important determinant of demand. price and demand are inversely related. Higher the price less is the demand and vice versa.

Price of related goods: The price of related goods like substitutes and complementary goods also affect the demand. In the case of substitutes, rise in price of one commodity lead to increase in demand for its substitute. In the case of complementary goods, fall in the price of one commodity lead to rise in demand for both the goods.

Income: This is directly related to demand. If the disposable income increases, demand will be more.

Taste, preference, fashions and habits: These are very effective factors affecting demand for a commodity.

Population: If the size of the population is more, demand will be more for goods.

Money Circulation: More money in circulation, more will be the demand and vice versa.

Weather Condition: It is also an important factor to determine the demand for certain goods.

Advertisement and Salesmanship: If the advertisement is very attractive for a commodity, demand will be more and if the salesmanship and publicity is effective then the demand for the commodity will be more.

Speculation: If the consumers expect a change in price in near future then their present demand will not vary inversely with the present change in price.

Government policy: High taxes will increase the price and and reduce demand, while low tax will reduce the price and extend the demand.

Three broad types of elasticity of demand 1. Price elasticity = the usual one, it deals with 1 good.

2. Cross elasticity = a special one, it deals with 2 goods.

3. Income elasticity = a special one and it deals with changes in incomes.

1. Price Elasticity of Demand Definition: "Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a small change in price". Learn this by heart! [In simpler terms, is the proportional change in quantity greater or lesser than the change in price? As an example, if the price was 20 and it falls by 2, the fall is 10% (2 times 100, all divided by 20); and if quantity then increases from 100 to 200, the increase is 100%. We can see that the increase in Q is greater (100% compared with 10%) - i.e., it stretches out a lot - it is elastic!]

2. Cross Elasticity of Demand Definition: "Cross elasticity of demand is a measure of the responsiveness of the quantity demanded of one good or service to a small change in price of another". Learn this! It is virtually the same as the definition of price elasticity earlier - go on, compare them now! Cross elasticity measures substitutes and complements (note the spelling; it is not compliments) If the supply of beef increases so the equilibrium price falls, it may induce some people to switch from eating chicken or pork to eating the now cheaper beef. The fall in price of beef causes a decrease in quantity demanded of chicken or pork. %Qd of good A %P of good B Note the A and B difference: we are dividing the percentage change in the quantity of A by the change in the price of B. If the price of beef fell and the quantity of chicken fell the answer will be positive, because two negatives make a positive, so any items with a positive cross elasticity are substitutes. If the price of heating oil falls it may induce some to install oil generated central heating in houses. We see that a fall in the price of A means an increase in the quantity of generators, so the answer is negative (one plus and one minus) so these two goods are complements. Cross elasticity does not seem to be used much in economics, except in exams. 3. Income Elasticity of Demand Now this is most important! Incomes keep increasing over time, so the demand pattern for various goods and services keeps changing. This matters for new firms looking to move into the market and produce something: the market for what goods or services is likely to grow the fastest? Thats the area to be in! It matters for existing firms looking to diversify, or be concerned about the prospects for the future in the area they produce and sell in. Definition: "Income elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to a small change in income". Learn! Income elastic: a given change in income leads to a greater than proportionate increase in demand for the good or service. Examples of income elastic goods: foreign travel, good wines, smart motor cars, eating in restaurants, and currently well-regarded brands, e.g., Adidas sportswear or Rolex watches. Income inelastic: a given change in income leads to a less than proportionate increase in demand for the good or service. Examples: bread, staple foods generally, cheap stores, and all lowly-regarded brands. If our income happens to double (lucky us!) we do not spend twice as much on such items. Income neutral elastic: should it just happen that, say, a 5% increase in income leads to a 5% increase in demand for a good or service, then it is income neutral elastic. This is not really an interesting case, merely a bit strange. Oddly enough, Pizza Hut in Australia claimed in the 1990s that they were like this: in a recession some people stopped eating out so stopped going to Pizza Hut, but other people switched from proper restaurants to Pizza Hut which cancelled things out, so the company did not suffer! Income negative elastic: this is most interesting! This happens when an increase in income causes a fall in demand. Really it indicates that we dislike this product but for some reason we must consume it at the time. When we can afford not to consume it, then we stop buying it. Examiners like this concept! 27 Examples are scarce, but it is suggested that probably potatoes were like this in Ireland during the Nineteenth century. Currently, the demand for mealies (sweet corn) in some African countries may be income negative elastic. It is a rare event anyway. Negative income elasticity means that it is an inferior good.