Utility Analysis

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Last updated: June 14, 2019

SConcept of Utility * For effective decision-making, businessmen have to analyze and understand consumer behavior. Every rational human being endeavors to maximize his total utility by selecting the best from the given set of alternatives. * Utility refers to the satisfaction or pleasure that a consumer obtains by consuming the product or service; or want-satisfying ability of a good or service.

* The concept of utility has been developed to explain the basic principles of consumer choice and behavior.Choice is different from preference. When we talk about preference, we only express our likes and dislikes. By contrast, a choice is something that we select from our preferred alternatives that suits our budget well. By utility, we mean the level of satisfaction obtained by consuming a good/ service preferred by a consumer. * Given the limited resources, a rational consumer allocates his money in such a way that the preferred combination of goods/services gives him the highest level of satisfaction.

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| | approaches to Measurement of Utility There are two approaches, namely cardinalist approach and ordinalist approach, to estimate utility. According to the cardinalist approach, utility can be measured in subjective units, say 10 utils, 20 utils, 30 utils, etc. Conversely, ordinalists feel that utility cannot be measured, but can only be ranked in order of preference (e. g.

1st, 2nd, and 3rd, etc).According to the cardinalist approach, we choose a good that gives us maximum utils. In the given example, we select good E as it gives us 17 utils (which is best among the 5 goods). According to the ordinalist approach, we choose a good that ranks higher among the given set. In the above example, we select good E, as it ranks 1st in the order. Total Utility and Marginal Utility | | * Total utility is the total satisfaction obtained by a consumer from the consumption of the goods and services. Marginal utility is the additional or extra satisfaction a consumer derives from the consumption of an additional unit of a good or service. * Total utility (TU) increases as long as marginal utility (MU) is positive.

TU reaches maximum when MU is zero (0).When MU is negative, TU decreases. Units of Good X | Total Utility | Marginal Utility | | 0 | 0 | 0 | 1 | 10 | 10 | 2 | 18 | 8 | 3 | 24 | 6 | 4 | 28 | 4 | 5 | 28 | 0 | 6 | 26 | -2 | | | | Total Utility and Marginal Utility: A Graphical Representation In the figure, total utility and marginal utility curves are drawn assuming that the law of diminishing marginal utility is operating. Thus, as the quantity consumed per period increases, the total utility initially increases at a decreasing rate, reaches maximum (known as satiation point) and then declines.Total utility is at maximum, when marginal utility is equal to zero and TU declines when MU of the good becomes negative.

|  | | Law of Diminishing Marginal Utility According to the law of diminishing marginal utility, the additional utility of any good tends to decline as successive units of a given product are consumed over a definite period of time. | | The table shows the operation of law of diminishing marginal utility. If you eat one Cadbury chocolate, you get some satisfaction. If you eat a second Cadbury chocolate, you may get satisfaction, but lesser than that of the first one.If somebody offers you another Cadbury chocolate, you may be reluctant to accept it. This shows that the marginal utility (i. e. the additional utility a consumer derives from consuming an additional unit of a good) gradually diminishes.

This also indicates that by consuming more of a good, total satisfaction increases, but at a diminishing rate and after reaching a point, it declines. The Law of diminishing marginal utility (chocolates) | Unit of chocolates | Marginal utility, utils | Total utility, utils | First Second Third Fourth Fifth | 10 6 2 0 -5 | 10 16 18 18 13 | | |Law of Equi-Marginal Utility  or Utility-Maximizing Rule According to the maximum utility rule, in order to maximize total utility the consumer should allocate his income such that the last rupee spent on each product purchased gives the same amount of extra (marginal) utility. Symbolically, this relationship is given by MUa/Pa = MUb/Pb = MUn/Pn Where, MUa, MUb and MUn are marginal utilities of product a, b and c respectively, and Pa, Pb and Pc are prices of product a, b and c respectively.

Let us assume that a consumer has to allocate his income on two products – ‘a’ and ‘b’ such that he can maximize his utility.When MUa/Pa > MUb/Pb, the consumer will consume product ‘a’. He continues to consume more of product ‘a’ as long as MUa/Pa = MUb/Pb. Similarly, if MUa/Pa < MUb/Pb the consumer consumes product ‘b’ and he continues to consume product ‘b’ until MUa/Pa = MUb/Pb. Thus, the utility maximization equation is given by MUa/Pa = MUb/Pb. Illustration 1:Let us consider that a consumer has to allocate his income, say Rs. 10 between two products – A and B. Prices of products A and B are Rs.

1 and Rs. 2 per unit respectively.First unit of A gives him 10 utils and first unit of B gives him 24 units. Thus, marginal utility per rupee of first units of A and B are 10 and 12 respectively. A rational consumer consumes product B because it gives him more satisfaction than product A for the same rupee.

The consumer is now left with Rs. 8. Now, he has to chose between first unit of A and second unit of B. For each rupee spent on first unit of A or second unit of B, he will get the same amount of extra satisfaction, i. e. 10 units.

Therefore, he can choose either A or B. As he has Rs. , he will buy both A and B. Now, his remaining income reduces to Rs.

5 and he has to choose between the second unit of A and third unit of B. The consumer will buy third unit of product B as it gives him more additional satisfaction.Finally, the consumer consumes second unit of A and fourth unit of B with his remaining income, as each rupee spent on them give the same level of satisfaction. When the consumer allocates his total income in accordance with this rule, he finds no incentive to alter his expenditure pattern. Unit of product | Product A: Price = Rs.

| Product B: Price = Rs. 2 | | (a) Marginal Utility, Utils | (b) Marginal Utility per rupee (MU/price) | (a) Marginal Utility, Utils | (b) Marginal Utility per rupee (MU/price) | First Second Third Fourth Fifth Sixth | 10 8 7 6 5 4 | 10 8 7 6 5 4 | 24 20 18 16 12 6 | 12 10 9 8 6 3 | | | Illustration II: Suppose a man goes to the market with Rs. 400 in his pocket, which he wants to spend on oranges, caps and milk, and further. Suppose that the utility he expects to derive from each unit of Rs. 25 spent on these commodities is follows.Unit of Rs 25 spent| Utility derived from the each unit of Rs. 25| | Oranges| Caps| Milk| 1St| 10| 13| 11| 2nd| 8| 12| 9| 3rd| 7| 10| 6| 4th| 5| 8| 5| 5th| 4| 6| 4| 6th| 3| 4| 2| 7th| 2| 3| 1| The purchaser will spend the first 25 on the object, which will give him the greatest satisfaction. In this case such an article is cap, the utility of its first unit is 13, which is maximum.

Guided by the same motive, he will spend the second Rs. 25 on caps. He will spend the third Rs. 25 on milk and the forth-on oranges.

In this way he will go spending money.The following table indicates the order in which he will spend the Rs. 400 he has got with him.

Units of Rs. 25| Object of expenditure | Utility derived| Units of Rs. 25| Object of expenditure | Utility derived| 1St | Cap| 13| 9th| Orange| 7| 2nd| Cap| 12| 10th| Cap| 6| 3rd| Milk| 11| 11th| Milk| 6| 4rth | Orange| 10| 12th| Orange| 5| 5th| Cap| 10| 13th| Milk| 5| 6th| Milk| 9| 14th| Orange| 4| 7th| Orange| 8| 15th| Cap| 4| 8th| Cap| 8| 16th | Milk| 4| Total Utility derived from 16 units of Rs 25 =| 117| Total utility derived from Rs. 400 out off 117The above table shows that he will spend Rs. 25 each 5 on oranges, 6 on caps, and 5 on milk, and will in total derive 117 units of utility.

This is the maximum satisfaction that he can obtain out of his expenditure. If he does not follow this scheme of expenditure, he will not be able to derive maximum total utility. Therefore, if we want to derive maximum satisfaction out of our expenditure, we should spend our money in such a way as to derive, more or less, the same satisfaction from the last unit of money spends on each head. This is the law of Equi-Marginal Utility.


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