Introductory Economics

Introduction

Utility Analysis

• Law of diminishing marginal utility,
• law of equi- marginal utility

Law of Diminishing Marginal Utility:

• Law of Diminishing Marginal Utility states that, as the consumer consumes more and more units of a commodity, the marginal utility of the commodity falls.
• The law of diminishing marginal utility is a psychological law arrived at by introspection and by empirical evidence. For example, when a consumer drinks water on a hot afternoon; the first glass of water gives him more satisfaction as compared to the second (as the thirst has decreased after consuming one glass of water). The second glass of water gives more satisfaction as compared to the third and so on.
• This theory is propounded by professor Marshall. According to him the additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has. It means as the amount consumed of a commodity increases the utility derived by the consumer from the additional units i.e. MU goes on diminishing.
• According to law of diminishing marginal utility, marginal utility (MU) tends to fall as we consume more and more units of a good. Graphically MU is a downward sloping straight line. It reaches zero (touches X-axis) and then becomes negative. Marginal utility is the rate of change of total utility (TU) i.e. slope of the TU curve. When marginal utility is falling but is positive, total utility (TU) is increasing at a diminishing rate. It reaches the maximum point (saturation point) where MU is zero. It starts falling beyond this point as MU becomes negative.

Saturation Point
Saturation point is the point where TU is maximum and MU is zero. At this point the particular want is completely satisfied for the time being.

Assumption of Law of DMU:

• A consumer should be a rational consumer i.e. He should be willing to maximize his satisfaction.
• The good should be homogeneous i.e. it should be same in every aspect eg: colour, taste, size etc.
• The unit of the goods must be standard eg: A glass of water not a cup of water.
• There should be no change in the taste and ; preferences of the consumer during the process of consumption.
• Utility can be measured by absolute numbers.
• There must be continuity in consumption and; if break is needed it should be very short.

Reasons behind operation of Law:

• Intensity of desire: when more andamp; more units of a commodity are consumed, the consumer’s intensity of desire decreases the utility derived from additional unit also decreases.
• Priority to important use: - If there are many uses of the commodity the most urgent requirement will be fulfilled first followed by next important use andamp; so on. e.g : Electricity

Exceptions / Limitations to the law of DMU
Law of DMU is not applicable in the following cases:

• Hobbies
• Goods of display
• Intoxicants
• Money
• Good books poetry
• Rare goods etc.

IMPORTANCE OF THE LAW:

BASIS OF LAW OF DEMAND:

• When a person consumes more units of say oranges he gets less and less satisfaction from the additional units. He will not be prepared to buy the additional units of oranges unless they are offered at lower and lower prices.
• For the units which give him higher utility the consumer will be prepared to pay more ,and for the units which give him lesser utility the consumer would not like to pay as much,. Thus the law of demand is based on law of diminishing marginal utility.

VARIETY IN CONSUMPTION AND PRODUCTION:

• The changes in design, pattern and packing of commodities very often brought about by producers are in keeping with this law .We know that the use of same good makes us feel bored ,its utility diminishes. We want variety such as soaps, toothpastes, pens etc. Thus this law helps in bringing variety in consumption and production.

IMPORTANCE IN THEORY OF VALUE:

• The law helps to explain the phenomenon in value theory that the price of a commodity falls when its supply increases. It is because with the increase in the stock of commodity its marginal utility diminishes.

EXPLANOTION OF DIAMOND WATER PARADOX:

• Because of their relative scarcity, diamond possesses high marginal utility and so a high price. Since water is relatively abundant, it possesses low marginal utility and hence low price even though its total utility is high

IMPORTANCE TO FINANCE MINISTER:

• The principle of progressive taxation is also based on this law. As a person’s income increases, the rate of tax rises because the marginal utility of money to him falls with the rise in his income.

CONSUMER’S EQUILLIBRIUM

• Consumer’s equilibrium means the allocation of income by a consumer on goods and services in such a way that he gets maximum satisfaction
• It refers to a situation when a consumer gets maximum satisfaction out of his limited income and he has no tendency to make any change in his existing expenditure. In other words consumer’s equilibrium refers to a situation where the consumer gets maximum satisfaction out of his scarce resources.

Assumptions

• The consumer is rational, means he aims at the maximization of utility
• Consumer’s income is given and remains constant.
• Price of the commodity is given and remains constant.
• Utility can be measured in terms of cardinal numbers
• Law of DMU operates
• MU of money remains constant