Lecture 2

Lecture 2Utility Analysis of Demand

Theory of Demand• Theory of demand explains– Relation ship between commodity demanded and its

price– Variations in demand

• There are different approaches known to the economists relating to theory of demand

• The oldest among them is marginal utility approach

Marginal Utility

• Marginal utility can be defined as – The change in the total utility resulting from a

one-unit change in the consumption of a commodity per unit of time

• Marginal Utility – MU=Change in total utility

Change in quantity consumed

Basic Assumptions of Marginal Utility Analysis• Cardinal Measurement of Utility– Utility can be measured and the exact measurement can be given by assigning definite

numbers e.g. 1, 2, 3…etc.– A person can express the satisfaction derived from the consumption of a commodity in

quantitative terms

• Utilities are independent– Utilities derived from one commodity is independent of other– The satisfaction derived from the consumption of one good is not affected by consumption

of another good– Total utility is simply the sum total of the separate utilities of all the goods consumed by

the consumers

• Constant Marginal Utility of Money– Marginal utility of money remains constant even though the money with the consumer is

decreased by successive purchases made by him

• Introspection– From one’s own experience it is possible to draw inference about another person– It means that mind of men work identically in similar situation

Law of Diminishing Marginal Utility

• Marshall states the law as:

– The additional benefit a person derives from a

given increase of his stock of a thing diminishes

with every increase in stock that he already has

ExampleUnits (Toasts) Total Utility

(Units of Satisfaction)

Marginal Utility(Units of

Satisfaction)1 20 20

2 38 183 53 15

4 64 11

5 70 6

6 70 0

7 62 -8

8 46 -16

Suppose a person starts eating pieces of bread one after another.The additional satisfaction will go on decreasing with every successive toast till it drops down to zero.

Graphical representation of example

1 2 3 4 5 6 7 8

-20

-15

-10

-5

0

5

10

15

20

25

1Marginal Utility0

DMU Curve

Limitations of the Law• Suitable Units– It is assumed that commodity is taken in suitable units. If not

suitable then MU may increase instead of falling.– e.g spoon of water or glass of water.

• Suitable Time– Commodity is taken within suitable time otherwise law will not

apply– e.g taking a glass of water after an hour

• No change in Consumer’s Tastes– No change of consumer’s taste otherwise law will not apply

• Normal Persons– Law of MU applies to normal persons and not to abnormal

persons• Constant Income– It is essential that income of a person remains constant

Limitations of the Law• Rare Collection

– This law does not hold in case of rare collections– e.g in case of collection of ancient coins utility increases with having more coins

• Change in Other People’s Stock– Changes in other people’s stock may increase MU. – e.g utility of my telephone increases as the number of connection increases

• Other Possessions– Utility also depends on other possessions we have– e.g a carriage may be lying useless with us, but as soon as we are able to buy a horse,

its utility goes up

• Fashion– The utility of my dress goes up when that dress comes in fashion

• Not applicable to money– The law does not apply to money. More money one has, the more one wants

Importance of the Law• Taxation

– This law forms the basis of theory and practice of taxation– Progressive system of Taxation

• Richer the person, higher is the rate of tax as MU of money to him is less

• Price Determination– The law explains why, with increase in its supply, the value of commodity must fall– It thus, forms basis of the theory of value

• Household expenditure– This law governs our daily life. Larger purchase will mean lower MU.– Therefore, we restrict ourselves to particular commodity

• Downward sloping Demand Curve– This law tells us why demand curve slopes downwards

• Value-in-use and value-in-exchange– This law explains the divergence between value-in-use and value-in-exchange– E.g air has great utility (value in use) but little (value in exchange), because it has

no MU• Socialism

– The socialist argue on the basis of this law– The MU of the wealth, that rich might lose, to rich is not so great while to MU to

this amount is great

Law of Equi-Marginal Utility

• According to this law

– A consumer is in equilibrium when he distributes

his given money income among various goods in

such a way that marginal utility derived from the

past rupee spent on each good is the same

Assumptions• The main assumptions of the law of equi-

marginal utility are as under:– Independent utilities.

• The marginal utilities of different commodities are independent of each other and diminishes with more and more purchases.

– Constant marginal utility of money. • The marginal utility of money remains constant to the

consumer as he spends more and more of it on the purchases of goods.

– Utility is cardinally measurable.– Every consumer is rational in the purchase of goods.– Limited money income.

• A consumer has limited amount of money income to spend.

Explanation of the Law• The law of equi-marginal utility is simply an

extension of the law of diminishing marginal utility to two or more than two commodities.

• The law of equi-marginal, is known, by various names. – Law of Substitution, the– Law of Maximum Satisfaction,– Law of Indifference,

Explanation• Every consumer has unlimited wants. However, the income at his

disposal at any time is limited. – The consumer is therefore, faced with a choice among many commodities

that he can and would like to pay

– He therefore, consciously or unconsciously compares the satisfaction which he obtains from the purchase of the commodity and the price which he pays for it

– As he buys more and more of that commodity, the utility of the successive units begins to diminish

– He stops further purchase of the commodity at a point where the marginal utility of the commodity and its price are just equal.

• The consumer will maximize total utility from his given income when the utility from the last rupee spent on each good is the same.

ExampleSuppose a person has Rs.5 with him which he wishes to spend on two commodities, tea and cigarettes. The marginal utility derived from both these commodities is as under:

Units of Money MU of Tea MU of Cigarettes

1 10 12

2 8 10

3 6 8

4 4 6

5 2 3

Rs.5 Total Utility = 30 Total Utility = 39

Explanation of Example• If the prudent consumer – spends Rs. 5.00 on the purchase of tea, he gets 30 utility.– If he spends Rs. 5.00 on the purchase of cigarettes, the total utility

derived is 39 which is higher than tea

• By spending Rs. 4.00 on tea and Rs. 1.00 on cigarettes, he gets 40 utility (10+8+6+4+12=40)

• By spending Rs. 3.00 on tea and Rs. 2.00 on cigarettes, he derives 46 Utility (10+8+6+12+10=46)



Diagram

• MU is the marginal utility curve for tea

• KL is marginal utility of cigarette

• When a consumer spends OP amount (Rs.2) on tea and OC (Rs.3) on cigarettes, the marginal utility derived from the consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP=NC).

• The consumer gets the maximum utility when he spends Rs. 2.00 on tea and Rs. 3.00 on cigarettes and by no other alteration in the expenditure.

Limitations of the Law• Effect of fashions and customs– The law of equi-marginal utility may become inoperative if people forced by fashions and

customs spend money on the purchase of those commodities which they clearly know yield less utility but they cannot transfer the unit of money from the less advantageous uses to the more advantageous uses because they are forced by the customs of the country

• Ignorance or Carelessness– Sometimes people due to their ignorance of price or carelessness to weigh the utility of the

purchased commodity do not obtain the maximum advantage by equating the marginal utility in all the uses

• Indivisible Units– If the goods are not divisible to equalise MUs, then again the law may become inoperative.

• Unlimited Resources• This law does not have apply where there are unlimited resources

• Basic Assumptions– This law rests upon some questionable assumptions – E.g we assume that utility can be added and compared while MU of money remains constant

Importance of the Law• The application of the principle of substitution extends over almost every field of

economic enquiry.– Every consumer consciously or unconsciously trying to get the maximum satisfaction

from his limited resources acts upon this principle of substitution. Same is the case with the producer.

– In the field of exchange and in theory of distribution too, this law plays a vital role. In short, despite its limitation, the law of maximum satisfaction is meaningful general statement of how consumers behave

• It applies equally to the theory of production and theory of distribution. – it is applied on the substitution of various factors of production to the point where

marginal return from all the factors are equal. – The government can also use this analysis for evaluation of its different economic prices

• The equal marginal rule also guides an individual in the spending of his saving on different types of assets.

• The law of equal marginal utility also guides an individual in the allocation of his time between work and leisure

• In short, despite limitations the law of substitution is applicable to all problems of allocation of scarce resources

Consumer’s Equilibrium• Suppose there are two goods 'x' and 'y' on which the consumer has

to spend his given income. The consumer’s behavior is based on two factors:– Marginal Utilities of goods 'x' and 'y‘– The prices of goods 'x' and 'y‘– The consumer is in equilibrium position when marginal utility of

money expenditure on each good is the same.

• The consumer is in equilibrium in respect of the purchases of goods 'x' and 'y' when:– MUx = MUy

• Where MU is Marginal Utility and P equals PricePx Py

– If MUx / Px and MUy / Py are not equal and MUx / Px is greater than• MUy / Py, then the consumer will substitute good 'x' for good 'y'. • As a result the marginal utility of good 'x' will fall.

Demand• It is necessary to distinguish between demand and desire

or need– e.g. a sickly child needs a tonic, a peon desires to have a TV set– Such needs and desires do not constitute demand– Willing to pay and able to pay constitute demand

• Demand for any thing at a given price is the amount of it which will be bought per unit of time at that price– It simply means that how much a person will be willing to buy

of a commodity at a certain price in set of possible prices during some specified period of time

– Demand is always per unit of time e.g. per day, per week, per month etc.

Types of Demand• Price Demand– Price demand refers to the various quantities of a

commodity or service that a consumer would purchase at a given time in a market at various hypothetical prices

• Income Demand– The income demand refers to the various quantities of

goods and services purchased by the consumers at various levels of income

• Cross Demand– The cross demand means the quantities of a good or

service which will be purchased with reference to change in price not of this good but of other inter-related goods

– These goods are either substitutes or complementary goods

Demand Curve

Law of Demand

• A rise in price of a commodity or service is

followed by a reduction in demand a fall in price is

followed by an increase in demand, if conditions

of demand remain constant

– These conditions relate to the consumer’s tastes, his

income, prices of other goods, possibility of other

substitutes, unexpected price change etc.

Limitations of the Law• Change in taste or fashion

– Fashion has gone out so less demand even with decrease in price

• Change in income– Increase in income may have increased in demand though prices have gone up

• Change in other’s prices– Decrease in coffee’s price may lead to decrease in demand of tea

• Discovery of substitutes– E.g CNG Vs Petrol

• Anticipatory changes in prices– Anticipation that prices will may rise leads to more demand even with increase in price

• Mark of distinction – Rich demands more with price increase because it can be considered as mark of

distinction

Derivation in of Demand Curve• Consumer’s equilibrium

– Mux/Px=MUy/Py=MUn/Pn=MUm

• If price of ‘X’ falls

• The equation would be disturbed

• The equality can be restored by purchasing more of ‘X’

• This means that as price of goods falls, its demand increases

Causes of Changes in Demand• Changes in tastes, preference, fashion• Climate or weather changes• Changes in size of composition of population• Changes in money supply• Change in price of a commodity• Change in level of distribution of income• Change in savings• Change in asset preferences• Conditions of trade• Exceptions or anticipations

Short comings of Utility Analysis• Unsound Psychology

– Market demand is an objective phenomenon while utility theorist try to explain it in terms of desire, motivation etc.

• Cardinal Measurement – Not possible

• Wrong Assumption of Independent Utilities– Utilities are interdependent – E.g increase in demand of pen would lead to increase in demand of paper

• Income effect and substitution effect not brought out– Income increased due to fall in price– Income increase due to fall in price of substitution

• Assumption of Constant Marginal Utility of Money is Wrong

• Applies to one-commodity world

• Assumes too much and explains too little

Thank You

Lecture 2

Education

Transcript of Lecture 2