Defining Utility

Utility is an economic measure of how valuable, or useful, a good or service is to a consumer.

Utility is a term used by economists to describe the measurement of “useful-ness” that a consumer obtains from any good or service. Utility may measure how much one enjoys a movie or the sense of security one gets from buying a deadbolt. The utility of any object or circumstance can be considered. Some examples include the utility from eating an apple, from living in a certain house, from voting for a specific candidate, or from having a given wireless phone plan. In fact, every decision that an individual makes in their daily life can be viewed as a comparison between the utility gained from pursuing one option or another.

Utility may be positive or negative with no effect on its interpretation. If one option gives −15 utility and another gives −12 utility, selecting the second is not, as it might seem, the “lesser of two evils,” but can only be interpreted as the better option.

We use the concept of utility to derive demand curve. Utility simply means the satisfaction that a consumer gains through consuming goods. The consumer is assumed to be rational. Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. This is the axiom of utility maximization. In the traditional theory it is assumed that the consumer has full knowledge of all the information relevant to his decision that is he has complete knowledge of all the available commodities, their prices and his income. In order to attain this objective the consumer must be able to compare the utility (satisfaction) of the various 'baskets of goods' which he can buy with his income. There are two basic approaches to the problem of comparison of utilities, the cardinalist approach and the ordinalist approach.

Utility can be measured in one of two ways:

• Ordinal utility ranks a series of options in order of preference. This ranking does not show how much more valuable one option is than another, only that one option is preferable over another. An example of a statement reflecting ordinal utility is that “I would rather read than watch television.” Generally, ordinal utility is the preferred method for gauging utility.
• Cardinal utility also ranks a series of options in order of preference, but it also measures the magnitude of the utility differences. An example of a statement reflecting cardinal utility is “I would enjoy reading three times more than watching television.” Given how difficult it is to precisely measure preference, cardinal utility is rarely used.

• Utility is measured by comparing multiple options.
• Utility can be positive and negative.
• Ordinal utility ranks a series of preferences without measuring how much more valuable one option is than another. Cardinal utility measures how much more preferable one option is in comparison to another.
• Ordinal utility is generally the preferred method of measuring utility.
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• ordinal: Of a number, indicating position in a sequence.
• cardinal: Describing a “natural” number used to indicate quantity (e.g., one, two, three), as opposed to an ordinal number indicating relative position.

Theory of Utility

The theory of utility states that, all else equal, a rational person will always choose the option that has the highest utility.

The theory of utility is based on the assumption of that individuals are rational. Rationality has a different meaning in economics than it does in common parlance. In economics, an individual is “rational” if that individual maximizes utility in their decisions. Whenever an individual is to choose between a group of options, they are rational if they choose the option that, all else equal, gives the greatest utility. Recalling that utility includes every element of a decision, this assumption is not particularly difficult to accept. If, when everything is taken into account, one decision provides the greatest utility, which is equivalent to meaning that it is the most preferred, then we would expect the individual to take that most preferred option. This should not necessarily be taken to mean that individuals who fail to quantify and measure every decision they make are behaving irrationally. Rather, this means that a rational individual is one who always selects that option that they prefer the most.

?Assumptions

I. Rationality. The consumer is rational. He aims at the maximization of his utility subject to the constraint imposed by his given income.

2. Cardinal utility. The utility of each commodity is measurable. Utility is a cardinal concept. The most convenient measure is money: the utility is measured by the monetary units that the consumer is prepared to pay for another unit of the commodity.

3. Constant marginal utility of money. This assumption is necessary if the monetary unit is used as the measure of utility. The essential feature of a standard unit of measurement is that it be constant. If the marginal utility of money changes as income increases (or decreases) the measuring-rod for utility becomes like an elastic ruler, inappropriate for measurement.

4. Diminishing marginal utility. The utility gained from successive units of a commodity diminishes. In other words, the marginal utility of a commodity diminishes as the consumer acquires larger quantities of it. This is the axiom of diminishing marginal utility

 

It is important to emphasize how rationality relates to a person’s individual preferences. People prioritize different things. For example one person may prioritize flavor while another person may value making healthy choices more. As a result the first person may choose a sugary cereal while the second may choose granola. Based on their preferences, both made the economically rational choice.

The rationality assumption gives a basis for modeling human behavior and decision making. If we could not assume rationality, it would be impossible to say what, when presented with a set of choices, an individual would select. The notion of rationality is therefore central to any understanding of microeconomics.

Marginal Utility

Marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of that good or service.

In economic terms, marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of that good or service. The idea of marginal value is an important consideration when making production or purchasing decisions. A person should produce or purchase an additional item when the marginal utility exceeds the marginal cost.

Marginal utility is measured on a per unit basis. When evaluating the marginal utility of any item, it is important to know in what unit utility is measured. The unit is based on the type of activity that you are trying to measure. If you are a consumer of potato chips, you might measure utility based on whether to buy another bag or have another hand full with your lunch. If you are a producer of potato chips, your marginal value might be defined by a pallet of potato chips. In general, marginal value should be measured based on the smallest unit of consumption or production related to the product in question.

It is also important to remember that utility is difficult to quantify since preferences vary based on the individual. Utility is rarely measured in terms of magnitude; utility is normally just about determining which option is the best choice. Since utility is rarely measured using cardinal means, it may seem difficult to determine a product’s marginal value. Economists get around this by substituting dollar values. While this may fail to capture a specific individual’s preferences and utility, it offers a good approximation based on everyone’s collective preferences as defined by the market.

• Marginal utility is measured on a per unit basis.
• Since an individual’s utility is rarely measured using cardinal means, calculating a product’s marginal value for an individual may be difficult.
• Instead of trying to calculate a product’s marginal value for an individual, economists assign dollar values to products based on their market price. This allows economists to estimate a product’s marginal value based on all the consumer’s preferences.
• The idea of marginal value is an important consideration when making production or purchasing decisions. A person should produce or purchase an additional item when the marginal utility exceeds the marginal cost.
• marginal: Of, relating to, or located at or near a margin or edge; also figurative usages of location and margin (edge).
• cardinal: Describing a “natural” number used to indicate quantity (e.g., one, two, three), as opposed to an ordinal number indicating relative position.

MARGINAL UTILITY AND DEMAND:

An explanation of the law of demand and the negatively-sloped demand curve based on utility analysis and the law of diminishing marginal utility. The law of diminishing marginal utility states that marginal utility declines as consumption increases. Because demand price depends on the marginal utility obtained from a good, price also declines as consumption increases, meaning price and quantity demanded are inversely related, which is the law of demand.

Marginal utility and the law of diminishing marginal utility can be used to provide insight into market demand, the law of demand, and the demand curve. This insight rests on two propositions.

• One, the law of diminishing marginal utility means that the marginal utility obtained from consuming a good decline as the quantity consumed increases.

 

• Two, the marginal utility of a good underlies the demand price that buyers are willing and able to pay for a good.

When combined, these two propositions indicate the demand price that buyers are willing and able to pay for a good declines as the quantity demanded (and consumed) increases, which is the law of demand.

There are two major approaches of consumer behavior

The first approach is the marginal utility or cardinalist approach.

Secondly, we get out ordinalist or indifference curve approach. At the end of this section we shall consider Samuelson’s revealed preference approach.

Principle of Diminishing Marginal Utility

The principle of diminishing marginal utility states that as more of a good or service is consumed, the marginal benefit of the next unit decreases.

The principle of diminishing marginal utility states that as an individual consumes more of a good, the marginal benefit of each additional unit of that good decreases.

The concept of diminishing marginal utility is easy to understand since there are numerous examples of it in everyday life. Imagine it is a hot summer day and you are hungry, so you get some ice cream. The first bite is great and so is the second. But with each spoonful, your hunger decreases and you become cooler. So while the last bite might still be good, it is probably not as satisfying as the first. This is a simple illustration of diminishing marginal utility.

Other things being constant, as more and more units of a commodity are consumed, the additional satisfaction or utility derived from the consumption of each successive unit will decrease. This is only true if all other factors such as income, time, etc. remain unchanged.

In the 19th century, many economists, including Marshall, believed that it was possible for utility to be measured in cardinal numbers. Hence, these economists are termed cardinalists. For example, we might say that a consumer derives 20 utils of utility from consuming the first unit of a commodity, 18 utils from the second, and so on.

In fact, it is impossible to measure utility in this manner since it is a matter of subjective judgment as to how much utility a person is deriving from his consumption.

Economists sometimes speak of a law of diminishing marginal utility also known as Gossen’s First Law, meaning that you derive less value the more you consume. The law of diminishing marginal utility is similar to the law of diminishing returns which states that as the amount of one factor of production increases as all other factors of production are held the same, the marginal return (extra output gained by adding an extra unit) decreases. The use of fertilizer is an excellent example of diminishing returns. Initially the application of fertilizer improves crop production but at some point adding more fertilizer provides less benefit per unit of fertilizer and eventually adding more fertilizer can reduce the yield or even kill the plant.

The Paradox of Water and Diamonds

The “paradox of water and diamonds”, most commonly associated with Adam Smith is the apparent contradiction that water possesses a value far lower than diamonds, even though water is far more vital to a human being. Price is determined by both marginal utility and marginal cost, and here the key to the “paradox” is that the marginal cost of water is far lower than that of diamonds. Individuals are willing to trade based upon the respective marginal utilities of the goods that they have or desire (with these marginal utilities being distinct for each potential trader), and prices thus develop constrained by these marginal utilities.

 

This graph shows the marginal utility of diamonds and water as a function of the amount consumed. As a person consumes (buys) more and more diamonds or water each additional unit of diamonds or water results in a lower marginal utility. This is phenomenon is known as the law of diminishing marginal utility. In 1871, Austrian economist Carl Menger published Principles of Economics in which he took special pains to explain why individuals should be expected to rank possible uses and then to use marginal utility to decide amongst trade-offs.

The graph makes it clear that a person derives much more utility from the first units of water than the first units of diamonds (the first units of water keep the person from dehydrating and thus have a much higher marginal utility). However, at some point the person can consume no more water and so the marginal utility falls to zero. Similarly, at some point you can’t wear any more diamond necklaces and earrings so another one has very little value to you.

Total Utility

Sum total of satisfaction derived from consumption of all the units. It refers to the psychological satisfaction that consumer derived from consuming given amount of a commodity.

“Total Utility refers to total satisfaction from the amount of a commodity consumed” Lipsey

For example- if we eat 2 loaves of bread at breakfast, the total utility is total satisfaction obtained from consuming 2 loaves of bread.

Sum of Marginal Utility is known as the total utility.

Where TU- Total Utility and – a sum of the total utilities from different units of a commodity

Marginal Utility

It is the additional utility, consumer arising from the consumption of one more unit of a commodity.

“The Marginal Utility is the utility which results from a unit increase in consumption” Prof Boulding

Concept of Law of Diminishing Marginal Utility

Law of diminishing marginal utility is also known as the fundamental law of satisfaction or Psychological law. It states that as consumer consumes more and more units of the commodity.

“As the amount consumed from a commodity increase, the utility derived by the consumer from the additional unit i.e. Marginal utility goes on decreasing” Alfred Marshall

Assumptions

• All the units of a commodity are same in terms of size, quality, design etc.
• Unit of a good must be standard
• No change in taste
• No change in the price of substitute goods
• Continuity in consumption.

Units	Total Utility (TU)	Marginal Utility (MU)
1	10	10
2	18	8
3	24	6
4	28	4
5	30	2
6	30	0
7	28	-2

Relationship absorbed between TU and MU

• When Marginal Utility falls, Total Utility increases at a diminishing rate.
• When Total Utility is maximum, Marginal Utility is Zero
• When Total Utility is decreasing, Marginal Utility is negative

Derivation of the Demand Curve in Terms of Utility Analysis:

Dr. Alfred Marshal 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:

1. In the case of a single commodity and
2. In the case of two or more than two commodities. In the utility analysis of demand, the following assumptions are made:

Assumptions:

(i) Utility is cardinally measurable.

(ii) Utilities of different commodities are independent.

(iii) The marginal utility of money to the consumer remains constant.

(iv) Utility gained from the successive units of a commodity diminishes.

(1) Derivation of Demand Curve in the 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 the 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.

A rational consumer, before, while purchasing a commodity compares the price of the commodity which he has to pay with the utility of a commodity he receives from it. So long as the marginal utility of a commodity is higher than its price (MU_x > P_x), the consumer would demand more and more units of it till its marginal utility is equal to its price MU_x = P_x or the equilibrium condition is established.

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.

Diagram/Curve:

In fig. 2.4 (a) the MU_x is negatively slopped. 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 fig. 2.4 (b).

At X¹, quantity the marginal utility of a good is MU¹. This is equal to P¹ by definition. 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.

We conclude from above, that as the purchase of the units of commodity X are increased, its marginal utility diminishes. So at diminishing price, the quantity demanded of good X increases as is evident from fig. 2.4 (b). The rational supports the notion of down slopping demand curve that when price falls, other things remaining the same, the quantity demanded of a good increases and vice verse. (The negative section of the MU curve does not form part of the demand curve, since negative quantities do not make sense in economics).

(2) Derivation of the Demand Curve in the Case of Two or More than Two Commodities (Law of Equi-Marginal Utility):

The law of diminishing marginal utility can also be applied in case of two or more than two goods. 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.

MU^x / P^x = MU^y / P^y = ……….. MUⁿ / Pⁿ

 

Derivation of Demand Curve:

 

In the fig. 2.5 (a), (b) and (c) given the money income, the price of X commodity (P_x) and the price of Y commodity (P_y) and constant marginal utility of money (MU_m), the demand curve derived is illustrated. 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 correspondence to:

MU_x / P_x = MU_y / P_y = MU_m

At the OM level (constant).

Diagram/Curve:

 

Let us assume that money income and 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 MU_x / P_x curve to shift towards right. 

     MU_x / P_x = MU_y / P_y = MU_m

The consumer now allocates his income to OQ₂ quantity of X commodity and O_y quantity of Y commodity because the combinations correspondence to (constant) at OM level. 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.

The utility approach to consumer behaviour is grounded upon psychological principles, and is best explained in terms of utility. Conceptually, utility can be measured in cardinal units, or ordinal approach, as discussed, in which case the consumer is able to rank products in order of preference. Consumer equilibrium is reached when the marginal utility per say is the same for all products, or when the slope of the indifference curve and the slope of the budget line are the same. The consumer’s demand curve for a particular product is directly related to the marginal utility of that product. The downward sloping demand curve is due to the law of diminishing marginal utility. In general, the individual’s demand curve consists of two effects, the substitution effect and the income effect. The income effect may be positive or negative depending on the taste and preferences of the consumer. Changes in the consumer’s income will change the quantity demanded at a given price level. The quantity demanded of normal goods will move in the same direction as income, whereas the quantity demanded of inferior goods will move in the opposite direction to income. The attribute approach to consumer behaviour gives several valuable insights into consumer choice, which are not readily apparent using the product approach. This approach allows the entire range of substitutes available to the consumer to be depicted on the same graph. It is, therefore, able to explain why a consumer buys one brand of a product over another one. Furthermore, this approach can explain why a consumer will purchase combinations of substitute products.