MANAGERIAL ECONOMICS

MBA I semester
Unit 3 UTILITY ANALYSIS
INTRODUCTION:
Theory of Consumer Behavior
Our analysis of demand permits us to determine the underlying factors affecting the level of
consumer demand of a given commodity. An increase in the price of a commodity, we expect consumers
to react by decreasing the quantity they want to buy. Our discussion of elasticity of demand further
develop our understanding of demand by showing to us the extent of how consumers react to
adjustment in price.
In this chapter, we further explain the behavior of demand by analyzing consumer behavior. The
theory of consumer behavior describes how consumers buy different goods and services. Furthermore,
consumer behavior also explains how a consumer allocates its income in relation to the purchase of
different commodities and how price affects his or her decision. There are two theories that seek to
explain consumer behavior. These are the utility theory and the indifference preference theory.
Consumer Behavior-Assumptions
1. Rational Consumer
2. Budget Constraints
3. Consumer Preferences
The Utility Theory of Demand
The utility theory explains consumer behavior in relation to the satisfaction that a consumer
gets the moment he consumes a good. This theory was developed and introduced in 1870 by a British
Economist, William Stanley Jevons. When we speak of utility in economics, we refer to the satisfaction
or benefit that a consumer derives of his consumption. The utility theory of demand assumes that
satisfaction can be measured. The unit of measure of utility is called utils.
Meaning of Utility:
Utility refers to capacity of a commodity to satisfy a human want. Utility is the want satisfying power of
a commodity. It is a subjective entity and varies from person to person. It should be noted that utility is
not the same thing as usefulness. Even harmful things like Liquor and cigarette may be said to have
utility from the economic standpoint because people want them.
Utility is an important concept in economics and game theory, because it represents satisfaction
experienced by the consumer of a good. Not coincidentally, a good is something that satisfies human
wants and provides utility, for example, to a consumer making a purchase. It was recognized that one
cannot directly measure benefit, satisfaction or happiness from a good or service, so instead economists
have devised ways of representing and measuring utility in terms of economic choices that can be
counted. Economists have attempted to perfect highly abstract methods of comparing utilities by
observing and calculating economic choices. In the simplest sense, economists consider utility to be

revealed in people's willingness to pay different amounts for different goods (i.e. in prices; without
conflating the two concepts).
In simple terms, utility is defined as satisfaction or pleasure a consumer gets when he is
consuming a particular product or good.
Measurement of utility:
Utility can be measured in two ways
Total utility: it is the sum of the utility derived from different units of a commodity consumed by a
consumer.
Marginal Utility: It is the additional utility derived from consuming an additional unit of commodity.

MUn = TUn TU(n-1)

MU= Marginal Utility
TU= Total Utility

Approaches to Utility Analysis:

There are two approaches to analyze the utility from consumer point of view.
1. Cardinal Utility Analysis:
2. Ordinal Utility Analysis
Cardinal Utility analysis:
Alfred Marshall assumes cardinal measurement of utility. Cardinal measurement is a numerical
expression. Marshall believed that utility could be measured in numerical terms in its own units
called utils.
Consumer Equilibrium:
Where a consumer can get maximum benefits or utility by consuming a particular product is
known as consumer equilibrium.
How a consumer attains equilibrium position i.e. how he spends his income on different
commodities so as to derive maximum satisfaction is explained through two important laws.
1. Law of Diminishing Marginal Utility-LDMU (Marginalism)
2. Law of Equi-Marginal Utility-LEMU (Equi Marginalism)

Law of Diminishing Marginal Utility:

This theory is based on the satiability characteristic of human wants, that a single want
taken separately at a time can be fully satisfied
Definition of the Law/ statement of the Law: other things remaining the same , as the
quantity of commodity consumed or acquired by the consumer increases, the marginal utility of
the commodity tends to diminish