Concept of Utility
- Utility means satisfaction a consumer gets from consuming goods or services.
- It measures the want-satisfying power of a commodity.
Approaches of Utility Analysis
Cardinal Utility Analysis
Utility can be measured numerically (in "utils").
Ordinal Utility Analysis
Utility can only be ranked, not measured.
Cardinal Utility Analysis
Assumptions:
- Rational consumer – aims for maximum satisfaction
- Cardinal measurement – utility can be measured in numbers
- Constant marginal utility of money
- Diminishing marginal utility
- Independent utilities – utility from one good doesn't affect another
Relationship between TU and MU
| Condition |
TU |
MU |
| Increasing satisfaction |
↑ |
+ |
| Maximum satisfaction |
Max & constant |
0 |
| Decreasing satisfaction |
↓ |
– |
[Graph showing TU and MU relationship: TU curve increasing at decreasing rate, MU curve downward sloping]
Law of Diminishing Marginal Utility
Definition: As more units are consumed, MU decreases.
[Downward sloping Marginal Utility curve]
Assumptions:
- Rational consumer
- Measurable utility
- Constant MU of money
- Homogeneous goods
- Continuous consumption
- Suitable unit size
- Unchanged taste/habit
Exceptions:
- Non-homogeneous goods
- Taste change
- Breaks in consumption
- Large units
- Luxury items
- Changing income
- Irrational behavior
Importance:
- Basis of economic laws
- Taxation
- Price determination
- Consumer spending
- Wealth distribution
Law of Substitution (Equi-Marginal Utility / Gossen's Second Law)
Definition: Consumer gets maximum satisfaction when:
MUx/Px = MUy/Py = MUm
Assumptions:
- Cardinal utility
- Rational consumer
- Constant income
- Constant MU of money and prices
- Divisible goods
- Fixed time
Limitations:
- Ignorance
- Indivisible goods
- Immeasurable utility
- Customs
- Unlimited income
- Uncertain choice
Importance:
- Used in consumption
- Production decisions
- Exchange theory
- Distribution theory
- Public finance
- Price fixing
Consumer Surplus
Definition: Extra benefit consumer gets when willing to pay more than actual price.
[Demand curve showing consumer surplus as area above price and below demand curve]
Consumer Surplus = Total Utility – Total Expenditure
Assumptions:
- Rational consumer
- Measurable utility
- Constant MU of money
- Expected price > actual price
- Homogeneous units
- Constant price
Criticisms:
- Imaginary concept
- Utility not measurable
- MU of money not constant
- Not for necessities
- Ignores complementary/substitute goods
Importance:
- Used in public finance
- Business pricing
- Trade benefits
- Value comparisons
Producer's Surplus
Definition: Extra benefit to producer when selling price exceeds cost.
[Supply curve showing producer surplus as area below price and above supply curve]
Producer Surplus = Amount Received – Cost of Seller