SSS 2

WEEK 2
ELEMENTARY TREATMENT OF UTILITY

Utility is the amount of satisfaction an individual or consumer derives from the consumption of a
commodity or service at a particular time. A commodity or service possess utility if the
commodity is able to satisfy the consumer at that particular time. Utility is a relative term
meaning that what gives satisfaction to an individual may not give satisfaction to another
person.
Utility theory in economics pertains to the value or worth of a certain good, service, or item. It
suggests that goods, services, and items can be ranked according to their usefulness. The
premise was initially theorized by Swiss mathematician, Daniel Bernoulli, in the 18th century.
Bernoulli founded the idea with regard to the differing values of things. With respect to theory,
the utility of an item tends to be closely correlated to its price. An item such as gold, which is
very useful and thus has great utility (combined with its scarcity), is very expensive. Total utility
is closely tied to the bare concept of utility. Total utility points to the aggregate amount of
usefulness and fruit there is to be gained from the use of a specific good, service, or other item.
Furthermore, the abstract measurement of utility is another key concept of the theory.
Although it's hard to calculate the exact utility of something, economists use abstract
measurements to capture the usefulness of things.

TYPES OF UTILITY The three types of Utility are listed below,

1. TIME UTILITY
2. FORM UTILITY
3. PLACE UTILITY

TIME UTILITY: This is the ability of a commodity or service to satisfy a consumer’s wants at a
particular time. This means that a commodity or service does not satisfy wants all the time. It
has to do with storage of goods until the time they are needed.

FORM UTILITY This is the transformation of a commodity from one form to another for the
commodity to satisfy consumer’s wants. The change during the product manufacturing process
increases its utility. For instance, flour does not satisfy want of consumers till it is changed to
bread, cake, chin-chin etc.

PLACE UTILITY Place Utility involves moving commodities from one location where utility is
less to another place where utility or demand is high. For instance, Cocoa is produced in West
Africa and transported to Europe where they satisfy industrial needs, Yam can be moved from
farm to market where they would be bought.
CONCEPT OF MARGINAL UTILITY, TOTAL UTILITY AND AVERAGE UTILITY, TOTAL
UTILITY
Total Utility is the total amount of satisfaction a consumer derives from the consumption of a
particular commodity at a point in time. The amount of satisfaction received from the
consumption of goods does not increase at an equal rate to the quantity of goods supplied. The
consumer has the saturation point in the consumption of a commodity at a given time. The
teacher further illustrates TU using a curve. The formula for calculating total utility is
TU = AU * Q.

MARGINAL UTILITY (MU) means the additional or extra satisfaction a consumer derives from
the consumption of an additional unit of an output. Marginal utility is the change in the total utility
as a result of consumption of an additional unit of a commodity. MU is illustrated in a diagram for
better understanding. The formula for calculation of MU is;
MU = change in total utility divided by change in quantity.

AVERAGE UTILITY Average utility (AU) is the amount of satisfaction a consumer derives from
the consumption of a unit of commodity. Average utility is obtained by dividing the total utility by
the number of commodities consumed. That is; AU= TU divided by Q
RELATIONSHIP BETWEEN TOTAL AND MARGINAL UTILITY

1.​ TU and MU increase up to a point after which, further increase in TU leads to a decrease in
MU.
2.​ MU is the difference between two consecutive TU.
3.​ When TU is decreasing, MU is negative.
4.​ The summation of all MU is equal to TU.

Both marginal utility and total utility are related

When a consumer increases consumption of a commodity, total utility rises to a maximum and
then declines. On the other hand, the marginal utility of any commodity decreases as more is
consumed. When total utility increases to a maximum point then marginal utility is zero.

As total utility continues to decrease, marginal utility becomes negative. The table shows the
relationship between both concepts.

At quantity seven, total utility is zero. When total utility decreases at 8th unit, MU is negative.The
fact that total utility increases at a decreasing rate is shown by the decreasing steps of marginal
utility curve
Quantity of Goods Total Utility Marginal Utility Average Utility
consumed

0 0 – 0

1 15 15 15

2 25 10 12.5

3 32 7 10.7

4 38 6 9.5

5 41 3 8.2

6 43 2 7.2

7 43 0 6.1

8 42 -1 5.3
The Law of Diminishing marginal utility

The law of diminishing marginal utility states that as a consumer consumes more and more of a
particular commodity, utility (satisfaction) will increase up to a certain point and start decreasing
as a result of continuous consumption of the same commodity. For instance, as a thirsty child
keeps drinking water, the satisfaction keeps increasing up to a point and starts decreasing as
more water is consumed. Illustration of law of diminishing marginal utility is given below

Q TU AU MU

1 10 10 -

2 18 9 8

3 24 8 6

4 28 7 4

5 30 6 2

6 31 5.2 1

7 31 4.4. 0

UTILITY MAXIMISATION

Utility maximization also known as equilibrium of the consumer is a point where a consumer
derives maximum satisfaction. A consumer derives maximum satisfaction when his marginal
utility is equal to the price of the commodity consumed. That is; MUx = Px; if the consumer
consumes only one commodity. if the consumer consumes more than one commodities, he
maximizes his utility thus:

MUa divided by Pa = MUb divided by Pb = MUc divided by Pc = MUn divided by Pn

​
Utility Maximization for one product​
For one product, a consumer maximizes utility when the marginal utility of that commodity
equals the price of the commodity. This is represented mathematically thus, MUx = Px

Utility maximization of many products​

In the case of many products the consumer will be at equilibrium where there is equality of the
ratio of the marginal utility of the individual commodity to theirs twice.

The utility maximization concept requires that the ratio of marginal utilities of the last units of the
commodities should be equal to the ratio of prices.​
(MUx)/Px = (MUy)/Py = MUz/Pz

Derivation of demand curve from utility theory

​
Derivation of demand is based on the law of diminishing marginal utility. Marginal utility is key
concept underlying demand.​
It slopes downward from left to right like the demand curve.​
A consumer’s demand for any product is a function of marginal utility. Marginal utility slopes that
are more of a commodity are consumed, the satisfaction derived declines.
Derivation of Demand curve from marginal utility curve

The derivation of the demand curve is based on the true statement of diminishing marginal
utility. The demand curve therefore has a close resemblance with that of the marginal utility
curve. This is as a result of the fact that an expectation of an increase in satisfaction from a
commodity and vice versa. This can be illustrated with a demand curve cum marginal utility
curve as illustrated on the board.

THE CONCEPT OF INDIFFERENCE CURVES

An indifference curve is the curve which shows the possible combination of two commodities
and each commodity yielding the same level of satisfaction to the consumer. The combinations
of two commodities give the consumer the same level of satisfaction such that the consumer is
indifferent as to which particular set of combinations he prefers. It does not matter to the
consumer which combination he gets. If he gets combination X instead of combination Y, he will
not feel any better off. It is worthy to note that indifference curves indicate higher and higher
levels of satisfaction and secondary, the indifference curves cannot intersect since two
indifference curves represent two different levels of satisfaction which can never be equal.
APPLICATION OF UTILITY THEORY IN REAL WORLD SITUATION
Utility can be applied in everyday decision making by individuals, business organisations and
the government. For example,Utility plays a big role in the decision-making process of an
individual in determining If a good or service will be very useful for an individual, they'd most
likely opt for it. Utility theory from a business's perspective describes the utility a business finds
in the use of a good, service, or production resource.
The applications of utility theory in economics and decision-making are very relevant to rational
consumers' endeavors. Higher utility leads to higher processes as more complex systems tend
to form around goods and services with significant utility. The process surrounding the buying
and selling of an apple is simple; whereas, the trading of financial assets such as option
contracts is far more complex. Moreover, in light of decision-making, the indifference curve
allows for product substitution. This is due to the way the indifference curve illustrates how the
use of one product decreases as the use of another increases. These two products are thus
interchangeable. Finally, utility models can help businesses decide on the best possible price for
a product or service. The more satisfaction and usefulness there is in a good or service, the
more suppliers can demand for it.

Limits of Utility Theory

The four main limitations of utility theory are, namely, how consumers aren't completely rational,
and the theory itself doesn't fully compensate for income, substitution, and price effect, as
shown below:

●​ Irrational Consumers - The factor of bounded rationality and the fact that people are not
entirely rational decision-makers makes it impossible to achieve maximum utility every
single time

●​ Income Effect - The theory doesn't consider how people's preferences change as their
income changes

●​ Substitution Effect - The utility of a good or service isn't intrinsically decreased just
because there's another alternative

●​ Price Effect - Consumers' demand for a good or service isn't exclusively dictated by
utility. The price of the good or service also plays an influential role

HOMEWORK
1.​ Define utility
2.​ With the aid of diagrams, explain in detail
i. Total utility
ii. Marginal utility
iii. Average utility
3.​ Discuss the various types of utility
4.​ Discuss the application of utility theory in real life situations