UTILITY

ANALYSIS

 In this chapter we will discuss:

Choice and Utility Theory
Law of Diminishing Marginal Utility
Equi-Marginal Utility
Substitution and Income Effect
Indifference Curve Analysis
Consumer Surplus

CHOICE AND UTILITY THEORY

It is important to understand the difference

between preference and choice. The

consumers may have preference when they
have a range of products to choose from.
Preferences depend upon the consumers
likes and dislikes but the final decision is
dependent on budget constraints.

Utility
Utility means the satisfaction obtained from the

consumption of products and services by consumers.

Utility is the satisfaction obtained from good or
service.
Utility is the benefit or satisfaction that a person gets
from the consumption of a good or service
The concept of utility is purely subjective
(psychological satisfaction)

Measurement of Utility
There are two approaches by which utility

can be measured:
Cardinal utility approach: Cardinal
approach is based on Marshallian school of
thought. It has come out with a unit called
util to measure the utility. Util reveals how
much of money a consumer is willing to pay
for a given unit of product.

Measurement of Utility
Ordinal utility approach: This approach is

based on the view that utility cannot be

measured at all; it can just be ranked in order
of preferences.
The preference of the customer is based on
the choice of products available.
Customer is consistent in ranking

Assumptions of Utility Theory

The utility theory is based on some

assumptions.
Consumers are rational
Consumers always prefer more quantity
Consumers are ready to make tradeoffs
Diminishing marginal rate of substitution

Marginal Utility Analysis .

(Cardinal)

Assumptions of Marginal utility Analysis

Cardinal measurement of utility
Utilities are independent
Constant marginal utility of money.

Total Utility and Marginal Utility

Total utility can be defined as the amount of utility

a person derives from the consumption of a

particular product in a given period.
Total utility is the amount of satisfaction obtained
from entire consumption of a product
Total utility is the total benefit that a person gets

from the consumption of a good or service. Total

utility generally increases as the quantity consumed
of a good increases.
Total utility = Sum of marginal utilities

Total Utility and Marginal Utility

Marginal utility can be defined as the increase in

total utility that results from a unit increase in

consumption.
Marginal Utility: The additional utility a person
receives from consuming an additional unit of a
good.
Marginal utility is the change in total utility
obtained by consuming one additional (marginal)
unit of a good or service.

Relationship between
Marginal .
Utility and Total
Quantity
Utility of a Product Total Utility Marginal
Consumed
0
1
2
3
4
5
6

Utility

0
5
8
10
10
9
7

0
5
3
2
0
-1
-2

Relationship between Marginal

.
Utility and Total
Derivation of Total Utility and Marginal Utility
Utility

Total Utility
200
150
100
50
0
1

10 11

($) M U
50
40
30
20
10
0
-10
-20

11

Q
0
1
2
3
4
5
6
7
8
9
10

($) TU
0
40
85
120
140
150
157
160
160
155
145

($) MU
40
45
35
20
10
7
3
0
-5
-10
145

Law of Diminishing Marginal .

.
Utility
Diminishing marginal utility: As more and

more of good is consumed by a consumer,

ceteris paribus, beyond a certain point the
utility of each additional unit starts to fall.
The amount of marginal utility decline as a
person consumes more and more of a good.
The additional benefit which a person derives
from a given increase of his stock diminishes
with every increase in the stock that he already
has.

Relationship between
Marginal .
Utility and Total
Derivation of Total Utility and Marginal Utility
Utility

Applications of diminishing
marginal utility

Explains value paradox: (The Wealth of

Nations Adam Smith introduced the

diamond-water paradox.)
Explains the derivation of Law of demand:
Explains the redistribution of income:

Equimarginal Utility
We assume that each consumer maximizes

his utility, which means that consumer chooses the

most preferred bundle of goods from what is
available

Equimarginal Principle
Equimarginal Principle: The fundamental

condition of maximum satisfaction / utility

is the equimarginal principle. It states that
the consumer having a fixed income and
facing given market prices of goods will
achieve maximum satisfaction when the
marginal utility of the last rupee spent on
each good is exactly the same as the
marginal utility of the last rupee spent on
any other good.

Equimarginal Utility
Law of equimarginal utility states that the

consumer will spend his money on different

products in such a way that the marginal
utility of each product is proportional to its
price.
A consumer continues buying a product till
its marginal utility is equal to its price.
MUx
MUy

MUE =
=
Px
Py

Equimarginal Utility
A consumer continues buying a product till its

marginal utility is equal to its price. Hence the

demand curve for a single product is MUx = Px, if it
is assumed that the price of the product is fixed.
If there is any change in the income level, there is
going to be a change in the marginal utility. The
consumer goes on consuming or purchasing till the
marginal utility of his income or money is equal to
both the products. Thus, equilibrium can be achieved
at MUx / Px = MUy / Py = MUm

Optimal Purchase Mix:

Ice Cream and Hamburger
Q
1
2
3
4
5
6
7
8

MUI
40
45
35
20
10
7
3
0

PI
10
10
10
10
10
10
10
10

MUI/PI MUH PH MUH/PH

4
45
6
7.5
4.5
30
6
5
3.5
20
6
3.3
2
15
6
2.5
1
10
6
1.7
0.7
6
6
1
0.3
3
6
0.5
0
0
6
0

Indifference Curve Analysis

An indifference curve is a curve that

measures the amount of different goods

consumed. Each point on one curve gives
exactly the same level of satisfaction for a
given consumer.
An indifference curve can be said that
indifference curve shows the combinations
of two products or services to which the
customer is indifferent at a particular level
of income.

Indifference Curve Analysis

Indifference curves:

An indifference curve is a line drawn in a twodimensional space showing different combinations

of two goods from which the consumer draws the
same amount of utility and therefore he/she is
indifferent about.

Indifference Curve
X1

U1
0

X2

Indifference Curves
Slope = Change in Y/Change in X
= MUx/MUy

U4
U3
U2
U1
O

Assumption of Indifference
Curve Analysis
Rationality
Utility is ordinal
Consistency &Transitivity
Convexity (Diminishing MRS)

Properties of Indifference curves

Indifference curves for two goods are

generally negatively sloped

Indifference curves are generally convex,
reflecting the principle of diminishing returns
Indifference curves never cross
Indifference curves that are farther from the
origin represent higher levels of utility
The slope of an indifference curve reflects the
degree of substitutability of two goods for one
another

Budget Line
A budget line is a line drawn in a

two-dimensional space representing

a certain level of income with
which the consumer can purchase
various combinations of two goods
at given prices.

Y
I/Py

Budget Line
Income = Px .Qx + Py. Qy
Slope = Px/Py

X
O

I/Px

Marginal Rate of Substitution

Marginal rate of substitution can be

defined as the rate at which a

customer is willing to substitute one
product for the other, maintaining the
same level of utility.

Marginal Rate of Substitution

Utility

Quantity of
goods X
Consumed

Quantity of
goods Y
Consumed

MRS of X to
Y

20

15

----

20

11

4:1

20

3:1

20

2:1

20

1:1

Marginal Rate of Substitution

Marginal Rate of Substitution

.
(Perfect Substitutes)
Slope of U curve

X
1

(MRS)
Constant &
downward sloping

X2

Marginal Rate of Substitution .

.
(Perfect Complements)
U curves kinked at

point representing
the "right" mix of
consumption

X
1

U2
U1

X2

Consumer Equilibrium

Consumer Equilibrium
Can reach point D,
but prefer A to D
Why?

X1
B

D
0

U1

U2

X2

U3

Consumer Equilibrium

X1
B

D
0

U1

U2

X2

U3

So, point A is
clearly is
optimal, given
budget, prices,
tastes &
preferences.

Income-Consumption Curve
Optimal consumption of
X1, X2 as I changes

X
1

A
U3
U1

I1

I2

I3

U2

X2

Ps, tastes &

preferences held
constant
If normal goods, then
as I increases, outlays
on X1, X2 increase as
well

Income-Consumption Curve
X
1

Income
Consumptio
n Curve

And, increase income

from I2 to I3
and get

A
U3
U1

I1
D1 D2
A

I2
D3

I3

U2

X2

P2
X2

Income-Consumption Curve
X
1

Income
Income
Consumptio
Consumptio
nn Curve
Curve

U2

U1

U0

I1

I2

I3

X2

P2
X2

=> As income
increases, we can
see Demand for
inferior good
decreasing, given
Ps

Consumer Surplus
The difference between what a consumer is

willing to pay for an addition unit of a good

and the market price that he actually pays is
referred to as consumer surplus.
Consumer surplus can be defined as the
difference between what they would like to
pay for a product and what they actually
pay.
The area between the demand curve and the
price line is the total consumer surplus.

Why Consumer Surplus

We pay same price for each good.
Law of Diminishing Marginal Utility

Consumer Surplus
Qty. Willing Actual Consumer Surplus =
to pay pay
1
2
3
4
5
6

7
6
5
4
3
2

2
2
2
2
2
2

Total willing to pay -

Actual pay
27 12 = 15

Consumer Surplus
P

Price
D
0

Qx

Applications of Consumer Surplus

Consumer surplus is useful for designing

government policies and implementing

welfare programs.
Consumer surplus helps the monopolist in
fixing the price of a commodity
Consumer surplus also advocates for
international trade.
Consumer surplus can also be used to
measure the health of an economy.

any ?

Consumer Surplus
Consumer Surplus = Prepared to pay

actual pay
Consumer Surplus = Total Utility
amount spent
Consumer Surplus = Total utility P* Qd

Consumer Surplus
Qty Willing Actual
to pay pay
1
2
3
4
5
6

7
6
5
4
3
2

2
2
2
2
2
2

Total willing to pay

- Actual pay =
Consumer Surplus
28 12 = 16

Applications of Consumer Surplus

Consumer surplus is useful for designing

government policies and implementing

welfare programs.
Consumer surplus helps the monopolist in
fixing the price of a commodity
Consumer surplus also advocates for
international trade.
Consumer surplus can also be used to
measure the health of an economy.

any ?

Income-Consumption Curve
X
1

Can show typical

Demand curve
shifts with normal
good

Income
Consumptio
n Curve

A
U3
U1

I1
D1
A

I2

I3

U2

X2

P2
X2

Income-Consumption Curve
X
1

Income
Consumptio
n Curve

So, increase I from

I1 to I2 and get

A
U3
U1

I1
D1 D2
A

I2

I3

U2

X2

P2
X2

Income-Consumption Curve
X
1

Income
Consumptio
n Curve

And, increase income

from I2 to I3
and get

A
U3
U1

I1
D1 D2
A

I2
D3

I3

U2

X2

P2
X2

Income-Consumption Curve
X
1

If inferior goods, then

U2
U1

U0

I1

I2

I3

X2

As income increases,
outlays on goods, say X2
here, actually decrease
Occurs typically over
some, not the entire,
range of consumption

Note shapes of
indifference curves

Income-Consumption Curve
X
1

E.g. : SPAM, Texas

wines, as
before...

U2
U1

U0

I1

I2

I3

X2

Income-Consumption Curve
X
1

Again, can show

typical Demand
curve shifts with
IncomeConsumption curve

U2

U1

U0

I1

I2

I3

X2

Income-Consumption Curve
X
1

Income
Income
Consumptio
Consumptio
nn Curve
Curve

U2

U1

U0

I1

I2

I3

X2

P2
X2

=> As income
increases, we can
see Demand for
inferior good
decreasing, given
Ps