4 – Consumer Behaviour (Utility Analysis)

Introduction

Consumers seek goods and services driven by the utility they provide, where utility is the capacity of a product to satisfy wants. In economic terms, utility represents the quality of a commodity or service that fulfils our desires, showcasing its want-satisfying power.

Meaning of Utility:

Utility, in economics, signifies the attribute of a commodity or service that satisfies our wants. Essentially, it is the want-satisfying power of a good or service.

Definitions:

According to Jevons, “Utility refers to abstract quality whereby an object serves
our purpose.

In the words of Hibdon, “Utility is the quality of good to satisfy a want.”

According to Mrs. Robinson, “Utility is the quality in commodities that makes
individuals wants to buy them”.

Features:

1. Utility is Subjective:

Utility is subjective and tied to an individual’s mental satisfaction. Different people may assign different utility values to the same thing. For example, liquor has utility for a drinker but not for a teetotaler.

2. Utility is Relative:

The utility of a commodity varies with time and place. For instance, a cooler has utility in summer but not during the winter season.

3. Utility is not essentially Useful:

A commodity with utility may not necessarily be useful. Liquor and cigarettes, for example, are not considered useful, but they have utility for those who desire them.

4. Utility is independent of Morality:

Utility is unrelated to morality. Items like opium and liquor may not be morally acceptable, but they still have utility for those who consume them.

Concepts of Utility:

– Initial Utility:

The utility derived from the first unit of a commodity, obtained through its consumption, is termed an initial utility. It is always positive.

-Total Utility:

Total utility represents the sum of the utility obtained from the consumption of different units of a commodity.

Tux = f (Qx)
Tux = total utility of x is a function (f) of quantity of commodity x

– Marginal Utility:

Marginal Utility refers to the change in total utility resulting from the consumption of an additional unit of a commodity. In simpler terms, it measures the additional satisfaction or benefit gained when one more unit of a product is consumed.

MUnth = Tn – Tn-1 or MU = change TU/ change Q
MUnth = Marginal utility of nth unit.
Tn = total utility of n units.
Tn-1 = total utility of n-1 units
Change TU = change in total utility
Change Q = change in the quantity of commodity

Marginal utility can be:

a) Positive Marginal Utility: This occurs when consuming additional units of a commodity leads to a continuous increase in total utility. In this case, the marginal utility of these units is positive.

b) Zero Marginal Utility: This happens when the consumption of an extra unit of a commodity results in no change in the total utility. This indicates that the marginal utility of the additional unit is zero.

c) Negative Marginal Utility: This occurs when the consumption of an extra unit of a commodity causes a decline in total utility. In such instances, the marginal utility is considered negative.

Relation between Total Utility and Marginal Utility:

Total utility is the cumulative sum of the marginal utilities derived from various units of a commodity. In essence, it represents the combined satisfaction or benefit gained from consuming each additional unit of the commodity.

TU = ΣMU
Total utility is the summation of Marginal utility

Quantity	Total Utility	Marginal Utility	Description
0	0	–	–
1	8	8	Initial Utility
2	14	14 – 8 = 6	Positive Utility
3	18	18 – 14 = 4	Positive Utility
4	20	20 – 18 = 2	Positive Utility
5	20	20 – 20 = 0	Zero Utility
6	18	18 – 20 = -2	Negative Utility

This table illustrates the Quantity, Total Utility, and Marginal Utility at each level of consumption, providing a clear depiction of the dynamics between total and marginal utility.

The table reveals several key observations:

a) Diminishing Marginal Utility and Increasing Total Utility:

As the consumption of commodity units rises, the marginal utility from each additional unit diminishes. However, the total utility increases up to a certain limit.
The relationship is mathematically expressed as The relationship is mathematically expressed as

MUnth=Tn−Tn−1

$M U = change Q / change TU$

where:

$M U n t h$ is the marginal utility of the nth unit,
$T n$ is the total utility of n units,
$T_{n - 1}$ is the total utility of n-1 units,
$Change TU$ is the change in total utility, and
$Change Q$ is the change in the quantity of the commodity

It can be summarized as:

TU=∑MU

signifying that total utility is the summation of marginal utility.

b) Positive Marginal Utility Leading to Total Utility Increase:

The marginal utility of the first four units is positive, resulting in a continuous increase in total utility. As long as the marginal utility remains positive, the total utility continues to rise.

c) Zero Marginal Utility and Saturation Point:

The marginal utility of the fifth unit is zero, marking a situation where total utility (20) reaches its maximum. This scenario represents a point of saturation.

d) Negative Marginal Utility and Total Utility Decline:

With the marginal utility of the sixth unit turning negative, the total utility for six units of the commodity decreases from 20 to 18 units.

Can utility be measured? It can be attempted through two methods:

1. Measurement in terms of Money:

By calculating the price a person is willing to pay for a specific item, one can estimate utility.

2. Measurement in terms of Units:

Professor Fisher introduced the term “Util” as a unit for measuring utility. In this method, utility is expressed in Utils.

Criticism of the Measurement of Utility:

Prof. Samuelson has criticized the measurement of utility, pointing out that the value of money is subject to change. Consequently, utility cannot be definitively measured in terms of money.

Laws of Utility Analysis:

There are two main laws that govern utility:

1. the Law of Diminishing Marginal Utility

2. the Law of Equi-Marginal Utility.

I. LAW OF DIMINISHING MARGINAL UTILITY

The Law of Diminishing Marginal Utility is fundamental to utility analysis, reflecting a common aspect of daily life. As you acquire more of a particular item, the additional satisfaction or benefit gained from each successive unit diminishes. This principle, known as the Law of Diminishing Marginal Utility, is a fundamental concept in economics.

Definitions:

According to Marshall, “The additional benefit which a person derives from a
given stock of a thing diminishes with every increase in the stock that he already
has.”
Chapman states, “The more we have of a thing, the less we want
additional increments of it or more we want not to have additional increments of
it.”
Samuelson explains, “As the amount consumed of goods increases, the
marginal utility of a good tends to decrease.”

The definitions highlight that as we consume additional units of a commodity at a given time, the marginal utility from each successive unit decreases relative to the preceding unit. This diminishing tendency of marginal utility is encapsulated in the Law of Diminishing Marginal Utility.

Assumptions:

1. Utility can be measured in the Cardinal number system.

2. The marginal Utility of money remains constant.

3. The marginal Utility of every commodity is independent.

4. Every unit of the commodity being used is of the same quality and size.

5. There is continuous consumption of the commodity.

6. A suitable quantity of a commodity is consumed.

7. There is no change in the income of the consumer.

8. There is no change in the price of the commodity and its substitutes.

9. There is no change in the tastes, character, fashion, and habits of the consumer.

These assumptions provide the framework for understanding and applying the Law of Diminishing Marginal Utility in the analysis of economic behaviour.

Explanation:

The Law of Diminishing Marginal Utility can be elucidated through the aid of the table and figure presented below:

No. of Candies	Marginal Utility
First	4
Second	3
Third	2
Fourth	1
Fifth	0
Sixth	-1

This table illustrates the diminishing marginal utility of candies:

The first candy yields 4 utils of marginal utility.
The second candy provides less marginal utility than the first, specifically 3 utils.
The marginal utility continues to decrease, with the third candy yielding 2 utils.
For the fourth candy, the marginal utility further diminishes to just 1 util, suggesting potential satisfaction of the want.
The fifth candy yields zero marginal utility, indicating no additional satisfaction.
If forced to consume the sixth candy, it may disrupt the system, resulting in negative utility, say, -1 util.

utility

In the Figure:

The X-axis represents the Quantity of Candies.
The Y-axis represents Marginal Utility (MU).
AB is the Marginal Utility Curve (MUC).
The curve slopes downward from left to right (negative slope), signifying that the first candy yields 4 utils, the second 3 utils, the third 2 utils, and the fourth 1 util of marginal utility.
The fifth candy yields zero marginal utility, and the AB curve touches the X-axis at point C, representing the fifth candy.
The sixth candy yields negative marginal utility, causing the AB curve to dip below the X-axis.

Exceptions:

The law of diminishing marginal utility does not hold under certain circumstances:

1. Curious and rare things:

The law doesn’t apply to rare or curious items like collectors of old coins or postage stamps. The marginal utility for these rare articles seems to increase as the collection grows.

2. Misers:

Misers, driven by an insatiable desire for wealth, seem exempt from the law as their pursuit of money appears boundless.

3. Good books or poems:

The law appears to be bypassed when engaging with good books, melodious songs, or beautiful poems repeatedly. The utility derived from such experiences tends to increase with each encounter.

4. Drunkards:

For individuals indulging in liquor and intoxicants, the law may not fully apply. As a drunkard consumes more, the desire for additional consumption tends to escalate.

5. Initial units:

When initial units of a commodity are used in less than appropriate quantities, the marginal utility of additional units increases.

In essence, Prof. Taussig rightly asserts that the law of diminishing marginal utility is so broadly applicable that it can be considered a universal law.

Causes of its application:

1. Commodities are imperfect substitutes:

The law applies because commodities are imperfect substitutes, meaning one commodity cannot always be used in place of another.

2. Satiability of particular wants:

Its application is driven by the fact that almost any particular want can be fully satisfied. Total utility increases at a diminishing rate until saturation is reached.

3. Alternative uses:

Each commodity has multiple alternative uses, and the law operates as consumers prioritize the most important uses based on marginal utility.

Importance of the law:

1. Basis of the law of consumption:

The law serves as the foundation for all laws of consumption, including the law of equi-marginal utility, law of demand, and the concept of consumer surplus.

2. Variety in production and consumption:

The law prompts variety in production and consumption as continuous consumption of one commodity yields diminishing marginal utility.

3. Difference between value in use and value in exchange:

The law explains the difference between goods having more value in use (commanding low prices) and those having more value in exchange (commanding high prices).

4. Price determination:

A commodity’s marginal utility has an impact on the demand for it, which determines its price. Consumers buy more when the price per unit falls.

5. Basis of progressive taxation:

The law contributes to the rationale behind progressive taxation, where the tax rate increases as income rises due to the diminishing marginal utility of money.

6. Advantage to the consumer:

Consumers can maximize satisfaction by adhering to the law—buying only as many units of a good as its marginal utility equals its price.

7. Basis of redistribution:

The law plays a crucial role in income redistribution, as the marginal utility of money diminishes for the rich compared to the poor. Redistribution to the poor enhances overall societal welfare.

Derivation of the Demand Curve Using the Law of Diminishing Marginal Utility:

The price a consumer is willing to pay for a commodity is equivalent to its marginal utility. By the law of diminishing marginal utility, as a consumer continues to purchase additional units of a commodity, its marginal utility diminishes. Consequently, a consumer will only increase their purchases of a commodity when its price decreases. If marginal utility is expressed in monetary terms, the positive segment of the marginal utility curve becomes the demand curve.

utility

When the marginal utility is plotted on the OY-axis, the resulting curve is the marginal utility curve. If the price is represented on the OX-axis, the resulting curve is referred to as the demand curve, as illustrated in the above figure. Figure A depicts the marginal utility curve, while Figure B represents the demand curve (DD), which has been derived from the marginal utility curve (MU).

Criticism:

1. Cardinal measurement of utility is not possible:

The assumption that marginal utility can be measured in cardinal numbers is flawed. Without cardinal measurement, the calculation of diminishing marginal utility becomes impractical.

2. The marginal utility of money is not constant:

The law considers money as the measure of utility, but the marginal utility of money itself is not constant, making it an unreliable measure.

3. Not every commodity is independent:

The law assumes the independence of commodities, implying that the marginal utility of one commodity does not affect the consumption of others. However, in reality, all commodities are interconnected, making precise estimation of marginal utility challenging.

4. Estimation limitations:

The marginal utility can only be estimated for divisible commodities, whereas many real-life commodities are not divisible.

5. Unrealistic assumptions:

The law relies on unrealistic assumptions, applicable only when the consumer’s tastes, habits, fashion, and income remain constant. In actual life, these factors are constantly changing.

II. LAW OF EQUI-MARGINAL UTILITY

The Law of Equi-Marginal Utility stands as the second crucial principle in utility analysis, outlining how a consumer can attain maximum satisfaction from a given expenditure on various goods. The French engineer Gossen introduced this idea in the 19th century, and Dr. Marshall later referred to it as the Law of Equi-Marginal Utility.

According to this law, for optimal satisfaction, a consumer should allocate their limited income across different commodities in such a manner that the marginal utility derived from the last rupee spent on each commodity is equal. Some also refer to it as the general principle for maximising consumer satisfaction, and in simpler terms, it is known as the Law of Maximum Satisfaction.

Definitions:
According to Dr. Marshall, “If a person has a thing which he can put to several
uses, he will distribute it among these uses in such a way that it has the same
marginal utility in all.”

According to Prof. Lipsey “The household maximizing utility will so allocate its
expenditure between commodities that the last penny spent on each is equal.”

According to Samuelson “A consumer gets maximum satisfaction when the ratio
of marginal utilities of all commodities and their price is equal.”

The equation expresses the Law of Equi-Marginal Utility, emphasizing the balance between marginal utilities (MU) and prices (P) for different commodities.

$M U_{1} = M U_{2/P2} = M U_{3/P3}$

This equation signifies that for optimal satisfaction, a consumer should allocate their resources in a way that the marginal utility derived from the last unit of spending on each commodity is equal, creating equilibrium among the prices of different goods.

If commodity prices are equal, the formula for achieving maximum consumer satisfaction is expressed as follows:

$M U_{1} = M U_{2} = M U_{3}$

Assumptions:

1. Cardinal measurement of utility is feasible.

2. The consumer is rational, aiming for maximum satisfaction from their income.

3. The consumer’s income remains constant.

4. Marginal utility of money remains constant.

5. Prices of commodities remain constant.

6. Commodities are divisible into small units.

7. Consumption occurs within a given period.

The law of diminishing marginal utility can be elucidated with the aid of a table and figure, as illustrated below:

Rupee Spent	MU of Oranges	MU of Milk
1st	12	10
2nd	10	8
3rd	8	6
4th	6	4
5th	4	2

utility

In the figure above:

OY axis represents Marginal Utility, and OX axis represents Units of Rupees.
The illustration shows that if the consumer’s income is Rs. 5, he will allocate Rs. 3 for oranges and Rs. 2 for milk. This allocation ensures that the third rupee spent on oranges and the second rupee spent on milk yield equal marginal utility, i.e., 8 utils.
The line connecting the figure signifies equal marginal utility derived from the last rupee spent on both goods.
By distributing income on oranges and milk in this manner, the consumer attains a total utility of 48 utils.
The consumer will receive the most utility overall from his Rs. 5 investment as a result of this distribution.
Allocating his income in this manner allows the consumer to achieve maximum satisfaction.

utility

If the consumer spends his income on oranges and milk in any other manner, then his total utility will be less than the maximum, as shown in the figure above.

OX axis represents Rupees, and OY axis represents Marginal Utility.
It is evident from the figure that by spending one rupee on oranges, the consumer gains 6 utils of marginal utility, as shown by ABCD area.
Similarly, by spending one rupee less on milk, the consumer loses 8 utils of marginal utility, as shown by EFGH area.

Importance of the Law:

1. Consumption: Every consumer aims to maximize satisfaction from limited resources by allocating the last unit of money in a way that yields maximum utility.

2. Production: Producers aim to maximize profit by allocating resources until the marginal productivity of each factor is equal.

3. Exchange: Involves replacing goods with lower utility with those offering higher utility. Individuals substitute goods to equalize marginal utility until optimal satisfaction is achieved.

4. Distribution: Refers to the fair distribution of national income among factors of production, ensuring each factor receives a share according to its marginal utility.

5. Public Finance: The law is relevant in public finance, guiding decisions on state revenue and expenditure to ensure equal marginal benefit for each type of expenditure.

6. Distribution of Income between Saving and Consumption: Advocates for an optimal allocation of income between consumption and saving, ensuring the marginal utility of the last unit spent on present consumption equals the last unit saved.

7. Optimum Distribution of Commodities: This term refers to the distribution that, if changed slightly, could reduce the overall utility that society enjoys. Achieving optimum distribution involves allocating goods among individuals so that each person’s marginal utility is equal.

8. Distribution of Assets: Helps individuals distribute assets like bank deposits, bonds, and stocks, ensuring the last unit of money invested in each form yields equal marginal utility.

Criticism of the Law:

1. Consumers are Not Fully Rational: Assumes consumers are fully rational, but some may buy goods that satisfy habits or customs rather than maximizing utility.

2. Consumer is Not Always Calculating: Assumes consumers constantly calculate utility while spending, which may not be the case in reality.

3. Shortage of Goods: The law assumes goods offering higher utility are always available, which may not be true in the market.

4. The Influence of Fashion, Customs, and Habits: Factors like fashion and habits frequently have an impact on actual expenditure, which causes consumers to purchase goods with lower utility.

5. Consumer Ignorance: Consumers may lack information about prices, substitutes, and various uses of goods, hindering them from spending optimally.

6. Indivisibility of Goods: Does not apply to goods that cannot be divided into small parts.

7. Constant Incomes and Prices: Assumes constant incomes and prices, limiting applicability in dynamic economic conditions.

8. Indefinite Budget Period: The law assumes a definite budget period, while in reality, goods may continue to yield utility over many periods.

9. Cardinal Measurement of Utility Not Possible: Utility cannot be precisely measured in cardinal numbers, making the application of the law dubious.

10. Change in Marginal Utility of Money: In real life, the marginal utility of money may increase or decrease, affecting the application of the law.

11. Complementary Goods: The law does not apply to complementary goods used in fixed proportions.

Criticism of Utility Analysis:

Economists like Edgeworth, Pareto, Hicks, Allen, and Samuelson criticise utility analysis for the following reasons:

1. Subjectivity of Utility: Utility is subjective, making objective analysis challenging.

2. Cardinal Measurement Challenges: Utility cannot be measured precisely in cardinal numbers, as it cannot be added or subtracted.

3. Interdependence of Commodities: The utility of a commodity depends on the utility of other commodities, challenging the assumption of independent commodities.

4. Conditions for Measuring Marginal Utility: Marginal utility can only be measured for divisible commodities.

5. Change in Marginal Utility of Money: The marginal utility of money may not remain constant, affecting the validity of utility analysis.

6. Too Many Unrealistic Assumptions: Many assumptions, like the cardinal number system and independent commodities, are unrealistic.

7. No Division of Price Effect: Utility analysis does not distinguish between income and substitution effects when prices change.

8. Consumer as a Calculator: Assumes consumers constantly calculate utility while spending, which may not reflect real consumer behaviour.

9. Utility Analysis in Planned Economies: Utility analysis may not explain changes in consumer demand in planned economies with long-term plans.

10. Giffen’s Paradox: Fails to explain phenomena like Giffen’s paradox, where the demand for some inferior goods increases with rising prices.

In conclusion, while utility analysis has faced criticism for its unrealistic assumptions, it remains significant in economic theory, paving the way for later developments like indifference analysis and revealed preference analysis.

Curriculum

Managerial Economics

4 – Consumer Behaviour (Utility Analysis)

Introduction

Meaning of Utility:

Definitions:

Features:

Concepts of Utility:

Laws of Utility Analysis:

I. LAW OF DIMINISHING MARGINAL UTILITY