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UTILITY ANALYSIS Notes

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8 views5 pages

UTILITY ANALYSIS Notes

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sunitisingh2017
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UTILITY ANALYSIS

Meaning of Utility
The capacity of a commodity to satisfy human wants is called utility.
So utility’s meaning can be divided in 4 parts ass:
1. Capacity
2. Commodity / Service
3. Satisfaction
4. Human Wants
Also, Utility is a subjective , as each individual’s taste and preferences are different and
hence the utility derived from them is also different.
We generally assume simply that tastes are given and are relatively stable  different
people may have different tastes but an individual’s tastes are not constantly changing, ,

Households Maximize Utility


We assume that people continuously attempt to maximize their level of satisfaction, sense of
well being, or overall welfare from whatever resources they have
Households, like other decision makers, are viewed as rational
By rational we mean that, individuals try to act in the best interest and would not
deliberately make choices without thinking twice about it, that would reduce their present
level of satisfaction.
Measurement of Utility
 Utility is a cardinal approach (i.e it can be measured in numbers)
 The units used for measuring utility are called “Utils”.

Consumers make choices on the basis of two very important concepts of Total and Marginal
Utility.
Concept of Total Utility and Marginal Utility
1. Total Utility (TU)
Total utility is the total satisfaction a person derives from consumption of goods or
services.

Formula : Total Utility (TU) = Total satisfaction derived


2. Marginal Utility (MU)

 Marginal utility is the change in total utility resulting from a one-unit change
in consumption of a good
 It can also be said that MU is the additional utility derived from consumption
of one extra unit.
 For a given unit of time, marginal utility is the increase or decrease in total
utility that is proportionately caused by increase or decrease of one unit in
consumption of commodity

Formula :

Marginal Utility (MU) = Change in Total Utility / Change in quantity consumed

Law of Diminishing Marginal Utility (DMU)

Statement of law

 The more of a good an individual consumes per time period, other things constant,
the smaller the increase in total utility from additional consumption

 That is, the smaller marginal utility of each additional unit consumed

Quantity Total Marginal


Utility Utility
0 0 -
1 40 40
2 60 20
3 70 10
4 75 5
5 73 -2
Behaviour of Total Utility

1. Increases at a Decreasing Rate:


o As the consumer consumes more units, the total utility rises, but the rate of
increase slows down because each additional unit contributes less utility than
the previous one.
2. Reaches a Maximum:
o At a certain point, the total utility reaches its maximum when marginal utility
becomes zero (the consumer no longer derives additional satisfaction from
the extra unit).
3. Declines if Consumption Continues:
o If the consumer keeps consuming beyond the point of maximum total utility,
total utility may start to decrease (disutility), as the additional consumption
might lead to dissatisfaction.
Behaviour of Marginal Utility
1. Positive but Decreasing:
o Initially, each additional unit provides positive marginal utility, but it
diminishes with each extra unit consumed.
2. Becomes Zero:
o Marginal utility becomes zero when total utility is at its maximum (saturation
point). At this stage, the consumer is fully satisfied.
3. Negative:
o If consumption continues beyond the saturation point, marginal utility
becomes negative, causing total utility to decline.
Total Utility Curve: Initially slopes upward (increasing at a decreasing rate) and
peaks, then starts to decline.
Marginal Utility Curve: Downward sloping, intersects the x-axis (zero marginal
utility), and then dips below it (negative marginal utility

More Than One Good

 What if the consumer is choosing among more than one good?


 Goods will have different prices, so we need to account for this.
 Instead of comparing MU, we will need to incorporate these price differences by
dividing MU by price.
 This yields the MU per rupee spent on the good.

 How should the utility maximizing consumer reallocate their budget when:
MUA/PA > MUB/PB
 The marginal utility per rupee spent on A exceeds the marginal utility per rupee
spent on B.
Hence, the consumer should purchase more A and less B

 How should the utility maximizing consumer reallocate their budget when:
MUA/PA < MUB/PB
 The marginal utility per rupee spent on A is less than the marginal utility per rupee
spent on B.
Hence, the consumer should purchase less of A and more of B

The utility maximizing consumer should allocate his budget such that:
MUA/PA = MUB/PB

 Suppose the price of good A rises while that of good B remains the same.
MUA/PA < MUB/PB
 In this situation, the marginal-utility-per-rupee spent on good A is less than that of
good B.
The consumer should increase the quantity of good B and decrease the quantity of good A

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