Utility Analysis

Prof. Tanushree Agarwal

Utility analysis and related concepts
It is a measure of satisfaction an individual gets from the consumption of the commodities.

In other words, it is a measurement of usefulness that a consumer obtains from any good.

A utility is a measure of how much one enjoys a movie, favourite food, or other goods. It varies
with the amount of desire.

Characteristic of Utility:
● It is dependent upon human wants. ● It depends on knowledge.
● It is immeasurable. ● Utility depends upon use.
● Utility is subjective.
Measurement of Utility
Measurement of a utility helps in analyzing the demand behaviour of a customer. It is measured in
two ways:
Cardinal Approach Alfred Marshall
This approach believes that utility is measurable. One can express his or her satisfaction in
cardinal numbers i.e., the quantitative numbers such as 1, 2, 3, and so on.
It tells the preference of a customer in cardinal measurement. It is measured in utils.
Limitation of Cardinal Approach
● In the real world, one cannot always measure utility.
● One cannot add different types of satisfaction from different goods.
● For measuring it, it is assumed that utility of consumption of one good is independent of
that of another.
● It does not analyze the effect of a change in the price
Ordinal Approach Developed By Edgeworth
Preferred by JR Hicks and RJD Allen
In this approach, one believes that it is comparable. One can express his or her satisfaction in
ranking. One can compare commodities and give them certain ranks like first, second, tenth, etc.
It shows the order of preference. An ordinal approach is a qualitative approach to measuring a
utility.

Limitation of Ordinal Approach:

● It assumes that there are only two goods or two baskets of goods. It is not always true.
● Assigning a numerical value to a concept of utility is not easy.
● The consumer’s choice is expected to be either transitive or consistent. It is always not
possible.
Types of Utility
It is basically of three types:

Total Marginal Average

The sum of the total It is the additional satisfaction One can obtain it by dividing the total
satisfaction from the gained from each extra unit of utility of consumption by the number
consumption of specific consumption. It decreases with of total units. Suppose there are total n
goods or services. It each additional increase in the units, then
increases as more goods are consumption of a good.
consumed. Average Utility (A.U.) = T.U. /
Marginal Utility (M.U.) = Change Number of units = T.U. / n
Total Utility (T.U.) = U1 + in T.U. / Change in Total Quantity
U2 + … + U n = Δ TU/ Δ Q
Law of Diminishing Marginal Utility
“During the course of consumption, as more and more units of a commodity are used, every successive unit gives utility with a
diminishing rate, provided other things remaining the same; although, the total utility increases.”

We can briefly explain Marshall’s theory with the help of an example. Assume that a consumer consumes 6 apples one after another. The first
apple gives him 20 utils (units for measuring utility). When he consumes the second and third apple, the marginal utility of each additional
apple will be lesser. This is because with an increase in the consumption of apples, his desire to consume more apples falls.

Therefore, this example proves the point that every successive unit of a commodity used gives the utility with the diminishing rate.

We can explain this more clearly with the help of a schedule and diagram.

Schedule for Law of Diminishing Marginal Utility:

 Indifference curve
An indifference curve is a graphical representation of a combined products that gives similar kind of satisfaction to a
consumer thereby making them indifferent.Every point on the indifference curve shows that an individual or a
consumer is indifferent between the two products as it gives him the same kind of utility.

For instance,some combination of the two,

e.g.,

Point ‘A’: 14 hot dogs and 20 hamburgers

Point ‘B’: 10 hot dogs and 26 hamburgers

Point ‘C’: 9 hot dogs and 41 hamburgers

Either combination provides the same

utility.
Characteristics of Indifference Curves
1. Indifference curves slope downward to the right
Let us consider the logical inferences or conclusions if the indifference curve does not slope
downwards from left to right. If it not like that, it should be either parallel to X axis or
vertical or it should be an upward sloping curve as shown in the Figure 1.
Characteristics of Indifference Curves
2. Every indifference curve to the right represents a higher level of
satisfaction
Every indifference curve to the right of the preceding curve indicates higher level of
satisfaction and the curve to the left shows lesser satisfaction. This means that the
indifference curve at a higher level from the axes shows greater satisfaction than an
indifference curve at a lower level. This can be illustrated by having two indifference curves
as given in Figure 2.
Characteristics of Indifference Curves
3. Indifference curves cannot intersect each other
The indifference curves never cut each other as higher and lower curves show different levels
of satisfaction. Suppose two indifferent curves cut each other at point K as shown in Figure 3.
This means that points K and T which are on the same indifference curve IC2 show equal
satisfaction; similarly points K and S which are on the same indifference curve IC1 show
equal satisfaction.

K = T, K = S, therefore, S = T
Characteristics of Indifference Curves
4. Indifference curve will not touch the axis
If an indifference curve touches the Y axis at a point P as shown in the figure, it means that
the consumer is satisfied with OP units of y commodity and zero units of x commodity. This
is contrary to our assumption that the consumer wants both commodities although in a
smaller or larger quantities. Therefore the indifference curve will not touch either the X axis
or Y axis.
Characteristics of Indifference Curves
5. Indifference curves are convex to the origin
Indifference curves are always convex to the origin because of diminishing marginal rate of
substitution. As the consumer consumes more and more of one good, his marginal utility of
this good keeps on declining and he is willing to give up less of other good. Therefore,
indifference curves are convex to the origin.
In the Figure 5, the indifference curve is convex
to the origin. The consumer passes from point
A to B on the same curve to remain in the same
level of satisfaction. While moving from A to B
the consumer gives up YY1 or AC units of Y
commodity in order to obtain XX1 units of X
commodities, i.e., CB units of X.
Characteristics of Indifference Curves
6. Indifference Map
The Indifference Map refers to a set of Indifference Curves that reflects an understanding and gives an entire view of a consumer’s choices.
The below diagram shows an indifference map with three indifference curves.
MARGINAL RATE OF SUBSTITUTION
Marginal rate of substitution (MRS) refers to the rate at
which consumer is willing to give up amount of other good to
obtain one extra unit of the good in question without
affecting total satisfaction. So, the rate of substitution of one
commodity for another is called marginal rate of substitution.
It is expressed as MRSxy of good X for good Y.

Symbolically,

MRSxy = Loss of good Y/ Gain of good X

AC/CB is the slope of indifference curve, i.e. slope of indifference curve = MRSXY.

As the consumer gets more and more units of good X, marginal utility of good X goes on falling with every increase in units of
good X. Simultaneously, the consumer is left with lesser units of good Y. So, marginal utility of Y rises. Therefore, he is willing to
give up lesser quantity of good Y for obtaining additional units of good X. Hence MRS diminishes along an indifference curve
when we move from upwards to downward.
Budget Line
The budget line, also known as the budget constraint, exhibits all the combinations of two commodities that a customer can
manage to afford at the provided market prices and within the particular earning degree.

Assumptions of a Budget Line Equation of Budget line

The budget line is mostly based on the assumption and not
The equation of the budget line equation can be represented
reality. However, to get clear and precise results and summary,
as follows:
the economist considers the following points in terms of a
budget line: M = Px × Qx + Py × Qy
Two commodities: The economist assumes that the customers Where,
spend their income to purchase only two products.
Px is the price of product X.
Income of the customers: The income of the customer is
limited, and it is designated to buy only two products. Qx is the quantity of product X.

Market price: The cost of each commodity is known to the Py is the price of product Y.
customer.
Qy is the quantity of product Y.
Expense is similar to income: It is assumed that the customer
M is the consumer’s income.
spends and consumes the whole income.
Example of Budget Line
You have M= ₹500 to buy a food item . You have few options to allocate your income so that you receives maximum utility from a limited
salary.

Budget Schedule
Hot Dog (@ Hamburgers
Combination Rs. 100) (@ Rs. 50) Budget allocation

Hamburgers
A 0 10 100*0+50*10=500
B 1 8 100*1+50*8=500
C 2 6 100*2+50*6=500
D 3 4 100*3+50*4=500
E 4 2 100*4+50*2=500
F 5 0 100*5+50*0=500
Hot dogs

The slope of the budget line (opportunity cost) is equal to the price ratio of commodities HD and HM i.e. PHD/ PHM
Consumer Equilibrium
Consumer’s Equilibrium refers to a situation when he gets maximum
satisfaction and he feels no need to change his position, subject to his
income and market prices of two goods.
Condition of Consumer’s Equilibrium: According to
indifference curve approach, a consumer will be at
equilibrium when:

● Budget line is tangent to the indifference curve.

○ i.e. slope of budget line = slope of indifference
curve Or, MRSxy = Px/Py
● Indifference curve should be convex to the origin
● Income should be fully spent on consumption.