Hand-out - 2

PROGRAMME
:
FIRST YEAR FIRST SEMESTER
BACHELOR OF COMMERCE (SPECIAL) DEGREE
COURSE TITLE : ECONOMICS FOR ENTERPRISES
COURSE CODE : COM 11032
COURSE STATUS : COMPULSORY
HAND-OUT TITLE : THEORY OF MARGINAL UTILITY
LECTURER B.PRAHALATHAN, DEPARTMENT OF COMMERCE

Learning Objectives:
define total utility and marginal utility
understand law of diminishing marginal utility
describe relationship between total and marginal utility
demonstrate demand curve
define marginal utility of money
illustrate consumer equilibrium


Introduction
Two questions arise with regard to consumers behavior. The first one is: why does a consumer
demand a good or service. The second question: how should a consumer spend his limited
income on different goods and services so that the consumer may get maximum satisfaction or
that he may be in equilibrium? The traditional approach in this context is the Cardinal Utility
Approach. Marginal utility analysis (Cardinal Utility Approach) was developed by Alfred
Marshall to explain consumer demand. This approach is based on the fact that utility can be
measured in some units. The unit for measurement of utility is known as utils.

Concepts of Utility Analysis and Relationship

1. Initial Utility
2. Total Utility
3. Marginal Utility

Initial Utility
The utility derived from the first unit of a commodity is called initial utility. It is always positive.

Marginal Utility
The additional satisfaction gained by the consumption of one more unit of something. In other
words of Chapman, Marginal utility is the addition made to total utility by consuming one more
unit of the commodity.

MU
n
= TU
n
TU
n-1

Marginal utility can be
a. Positive Marginal Utility
b. Zero Marginal Utility
c. Negative Marginal Utility




2

Total Utility
The total satisfaction derived from the consumption of all the units of a commodity is called
TOTAL UTILITY. Consumption of n units of commodity, then the total utility (TU),

TU
n
= U
1
+ U
2
+ U
3
+ .. +U
n
OR TU
n
=MU
n


Relationship between Total Utility and Marginal Utility
a. When marginal utility is positive total utility increases
b. When marginal utility zero total utility is at maximum. It is also known as point of
maximum satisfaction
c. When marginal utility is negative total utility diminishes.

Law of Diminishing Marginal Utility
The law of diminishing marginal utility explains the relation between utility and quantity of a
commodity. It is a psychological fact that when a consumer gets more and more units of a
commodity, during a particular time, the utility from the successive units will diminish.

Assumptions
1. Utility is cardinal
2. The consumer is rational
3. Commodity is consumed are homogeneous
4. Constant marginal utility of money
5. The consumers income is limited and constant
6. The tastes and preferences of the consumer remain unchanged
7. Diminishing marginal utility

Consumers Equilibrium
Consumers equilibrium refers to a situation wherein a consumer gets maximum satisfaction out
of his limited income and he has no tendency to make any change in his existing expenditure
pattern.

Consumers Equilibrium A single commodity
When a consumer is purchasing a commodity, he will be in equilibrium position at a point where
marginal utility of a commodity is equal to its price.

The consumer is in equilibrium when the marginal utility of a good(x) is equal to its market price
(P
x
).

MU
x
= P
x
Supposing, if MUP, there can be two possibilities.

1. MU > P
2. MU < P

If MU > P, he will buy more, and marginal utility will come down to the level of price. On the
other hand, if MU < P, he will purchase less and the marginal utility goes up.


3

Law of Equi - Marginal Utility

The law of equi-marginal utility explains the behaviour of a consumer when he consumes more
than one commodity. Further, it explains how the consumer spends his limited income on
various commodities to get maximum satisfaction.

The law states that a consumer maximizes his total utility by distributing his entire income
optimally among the various goods consumed by him.

Assumptions

1. The consumer is rational so he wants to get maximum satisfaction
2. Cardinal measurement of utility is possible
3. Marginal utility of money remains constant
4. The income of the consumer is given and remain constant
5. Fashions, tastes and preferences remain constant
6. Prices of the commodities are given and remain constant
7. Consumption takes place at a given time period

Consumers Equilibrium a Several Commodities
When a consumer is consuming several commodities [suppose there are two goods X and Y]
with different prices simultaneously, he will be in equilibrium at the point where the utility
derived from the last rupee spent on each is equal.

m
y
y
x
x
MU
P
MU
P
MU


MU
x
: Marginal utility of commodity X
MU
y
: Marginal utility of commodity Y
P
x
: Price of X
P
y
: Price of Y
MU
m
: Marginal utility of money

y
y
x
x
P
MU
and
P
MU
are known as marginal utility of money expenditure. This explains the marginal
utility of one rupee spent on good X and the marginal utility of one rupee spent on good Y

The position of consumers equilibrium thus can be stated in following ways
1. The consumer is in equilibrium when the marginal utility of last rupee spent on each
commodity is equal
2. A consumer will be in equilibrium position where the ratios of marginal utilities of goods
to the ratios of corresponding prices for each pair of goods are equal.

When a consumer is at Equilibrium:
He maximizes his satisfaction
He spends his entire income
He attains optimum allocation of expenditure
He consumes optimum quantity of each good.

4

Derivation of the Demand Curve
If the marginal utility is measured in monetary units the demand curve for a good(X) is identical
to the positive segment of the Marginal utility curve.

x
x
m
P
MU
MU
x m x
MU MU x P

x x
MU P

Constancy of the Marginal Utility of Money
This is one of the important assumptions of the marginal utility analysis. This means, marginal
utility of money remains constant throughout when the individual is spending money.
Measurement of marginal utility of goods in terms of money is only possible if the marginal
utility of money itself remains constant. If the marginal utility of money varies, it is not possible
to correct measurement of the marginal utility of the good.

Marginal Utility of Money and Price change
When the price of a good falls the real income of the consumer rises the marginal utility of
money will fall. On the other hand, when the price of a good rises the real income of the
consumer falls the marginal utility of money will rise.

But Marshall ignored this and assumed that marginal utility of money did not change as a result
of price change. Due to this assumption

Marshall ignored the income effect of the price change
Marshall could not provide a satisfactory explanation of Giffen Paradox
Due to this assumption marginal utility curve becomes the demand curve of the good.

Demerits of Marginal Utility Analysis
1. Cardinal measurement is unrealistic
2. Assumption of constant marginal utility of money is not valid.
3. Cardinal utility analysis does not split up the price effect into substitution and income
effect.
4. Marshall could not explain Giffen Paradox.
5. Cardinal utility analysis assumes too much and explains little.


References:

1. H. L. Ahuja ; Principles of Microeconomics, 18th Edition; S.Chand Publishing
2. N. Gregory Mankiw; Principles of Microeconomics;