UTILITY ANALYSIS

DR. DEEPTI
 WHAT IS UTILITY
 Utility is defined as the want satisfying power of a
commodity. When a commodity is consumed the want
of a person is satisfied. That is


U  (Q1 , Q 2,Q 3,Q 4,  Q n )
 Utility does not mean usefulness, as is generally
assumed. Therefore utility is subjective concept and not
objective. Utility resides in the mind of the consumer.
 The term Utility is commonly used as equivalent to
satisfaction.
 Utility function is regular strictly quasi concave
(RSQC), if this function follows these conditions.
i U0

U
ii  1  MU1  0
Q1
U
  2  MU 2  0
Q 2
These are first degree derivations of utility function

 2U
iii 2
 11  0
Q1
 2U
2
  22  0
Q2
These are second degree derivations of utility function
 2
 U
iv  12  0
Q1Q2
2
 U
  21  0
Q2 Q1

11 12 - 1

v D   21  22 -  2  0

- 1 -  2 0
  22 -  2  21 -  2  21  22
 11 - 12 - 1 0
- 2 0 - 1 0 - 1 -  2

    
 11 -  2  2  12  2  2 - 1 -  2  21   22 1  0 
2 2
 - 11  2  2 12 1  2 -  22 1 0
i if 11 and  22  0 then Utility function will be RSQC.

ii if D  0 but 11 and  22  0

Then Utility function will be quasi concave but not
strictly quasi concave.

iii if U 
 0
Then Utility function is not Quasi concave
 MEASUREMENT OF UTILITY
TOTAL UTILITY – TOTAL UTILITY IS THE SUM OF THE UTILITIES
OBTAINED FROM EACH UNIT CONSUMED. THE MORE OF THE
COMMODITY A CONSUMER CONSUMES PER UNIT OF TIME THE MORE
WILL BE TOTAL UTILITY UP TO A CERTAIN POINT.

WHERE TUN = TOTAL UTILITY OF N UNITS AND XI = UTILITY OF

ITH UNIT.
MARGINAL UTILITY – MARGINAL UTILITY IS DEFINED AS THE
CHANGE IN TOTAL UTILITY RESULTING FROM A ONE UNIT CHANGE IN
CONSUMPTION OF THE COMMODITY PER UNIT OF TIME.
MUN = TUN – TUN-1/QN – QN-1
WHERE MUN= MARGINAL UTILITY OF N UNITS, TUN = TOTAL UTILITY
OF N UNITS
TUN-1 = TOTAL UTILITY OF N-1 UNITS.
 UTILITY ANALYSIS HAS THE FOLLOWING
APPROACHES

1.CARDINAL APPROACH AS DEVELOPED BY

H.H.V.GOSSEN AND ALFRED MARSHAL.

2.ORDINAL APPROACH AS DEVELOPED BY

PARETO, HICKS AND SLUTSKY.

3.BEHAVIOURAL APPROACH (REVEALED

PREFERENCE THEORY) AS DEVELOPED BY
SAMUELSON.
CARDINAL APPROACH: UTILITY IS MEASURABLE
CARDINALLY OR NUMERICALLY.

UNDER THE CARDINAL APPROACH THERE ARE

FOLLOWING LAWS

1.GOSSEN’S FIRST LAW (LAW OF DIMINISHING

MARGINAL UTILITY)

2.GOSSEN’S SECOND LAW (PRINCIPAL OF EQUI-

MARGINAL UTILITY)

3.GOSSEN’S THIRD LAW

 LAW OF DIMINISHING MARGINAL
UTILITY
AS A CONSUMER(FIRST LAW OFTHE
INCREASES GOSSEN )
CONSUMPTION
OF ANY ONE COMMODITY, KEEPING CONSTANT
THE CONSUMPTION OF ALL OTHER COMMODITIES,
THE MARGINAL UTILITY OF THE VARIABLE
COMMODITY MUST EVENTUALLY DECLINE.
THIS TENDENCY TOWARDS DIMINISHING UTILITY
FORM SUCCESSIVE UNITS OF A COMMODITY IS
OPERATIVE IN ALL TYPES OF COMMODITY AND
SERVICES.
THE RATE OF DIMINISHING UTILITY IS DIFFERENT
FOR DIFFERENT COMMODITIES.
 ASSUMPTIONS OF THE LAW
THE UNITS OF THE COMMODITY MUST BE
RELEVANTLY DEFINED.

THE TASTES ARE GIVEN AND UNCHANGED.

THE UNITS OF THE COMMODITY ARE HOMOGENEOUS.

THERE IN NO TIME – LAG BETWEEN THE

CONSUMPTION OF THE TWO UNITS OF A COMMODITY.

THE INCOME AND PRICES OF THE COMMODITY AND

ITS SUBSTITUTES ARE GIVEN.
Applicability of Law of Diminishing Marginal Utility

No. of Units TU MU
1 10 10
2 19 9
3 27 8
4 34 7
5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1
11 55 0
12 54 -1
Law of Diminishing Marginal Utility
 Law of Equi-Marginal Utility
(Second law of Gossen)
THE LAW EXPLAINS THE EQUILIBRIUM OF THE CONSUMER SO AS
TO THE MAXIMIZE THE SATISFACTION THAT A CONSUMER
DERIVES FROM HIS LIMITED INCOME. THE CONSUMER IS IN
EQUILIBRIUM AT A POINT WHERE THE RATIO BETWEEN THE MU
AND THE PRICE OF A COMMODITY IS EQUAL THE RATIO BETWEEN
THE MU AND THE PRICE OF OTHER COMMODITY.
IF THERE ARE MORE THAN TWO GOODS ON WHICH THE
CONSUMER IS SPENDING HIS INCOME , THEN

MU Q1 MU Q 2 MU Q n
    
P1 P2 Pn
WHERE Λ IS MARGINAL UTILITY OF THE MONEY EXPENDITURE.
 ASSUMPTIONS OF EQUI MARGINAL
UTILITY
UTILITY IS MEASURABLE IN TERMS OF MONEY.

THE INCOME OF THE CONSUMER IS LIMITED AND

REMAINS CONSTANT.

THE MARGINAL UTILITY OF MONEY REMAINS

CONSTANT.

THERE IS PERFECT COMPETITION IN THE MARKET.

THE LAW OF DIMINISHING MARGINAL UTILITY

HOLDS.
APPLICABILITY OF PRINCIPLE OF EQUI MARGINAL
UTILITY
No. of Unit of MU from A MU from B MU from C MU from D
the money
1 40 50 60 70
2 36 40 52 59
3 28 35 40 48
4 20 27 33 40
 MaxU   (Q1,Q2 )
Sub.To Y  P1Q1  P2Q2
from Lagrange - Multiplier method
L   (Q1,Q2 )   (Y  P1Q1  P2Q2 )
first order condition
L
 1   ( P1 )  0 (1)
Q1
L
  2  ( P2 )  0 (2)
Q2
L
 Y  P1Q1  P2Q2  0 (3)

 from eq(1) and (2)
1  P1
MU Q1  P1
MU Q1

P1
 2  P2
MU Q2  P2
MU Q2

P2
MU Q1 MU Q2
    MU Y
P1 P2
 Explanation of 
U   (Q1 , Q2 )

U U
dU  dQ1  dQ2
Q1 Q2

dU  1 dQ1   2 dQ2

from eq(1) & (2) 1  P1 ,  2  P2 

dU  P1dQ1  P2dQ2

dU    P1dQ1  P2 dQ2  and

 Y  P1Q1  P2Q2

dY  P1dQ1  P2 dQ2 then

dU   P1dQ1  P2 dQ2 

dY  P1dQ1  P2 dQ2 

dU

dY
 11 12 - P1

D   21  22 - P2  0

- P1 - P2 0
 THIRD LAW OF GOSSEN
Gossen’s third law is applicable because sacristy is a pre
condition for economic value. Since MU of a good
decreases with its stock it can have MU>0 so long as its
supply falls short of its demand(D>S). In case supply is
able to satisfy demand or the want fully the MU of it will
fall to zero.