Utility Analysis

What is utility?
Utility means want satisfying and can best be analyzed with the

behavior of consumers at the market place. Consumer Behavior refers to the study of consumer , while he is engaged with the process of consumption. It tells us how a consumer with his limited resources purchase different varieties of goods and services in the market and compare price and utilities of different alternatives. The highest possible satisfaction for him is possible when he reaches the equilibrium position. The process of reaching equilibrium position can be explained with the help of two approaches of Utility analysis. 1 Cardinal Utility analysis [Marshall] and 2.Ordinal Utility analysis- The Indifference Curve analysis
[J.R.Hicks].
The Utility Analysis is other wise called as cardinal
utility theory of consumer behavior and it is also known as traditional approach to the measurement of consumer behavior and is popularized by Alfred Marshall. Under this cardinal approach, the numerals like 1,2,3,4,5. are used to measure utility. On the other hand Indifference Curve analysis is other wise called as ordinal utility theory of consumer behavior and is called as modern approach to the measurement of consumer behavior and is associated with Prof. J.R. Hicks.
Utility Approach
Utility refers to want satisfying capacity of a
commodity. It is purely subjective in its character. In this approach a relationship is to be established between total utility and marginal utility. Total utility refers to the sum total of satisfaction which a consumer receives by consuming various units of the same commodity. The more units of a commodity that a consumer consumes, his total utility of that commodity is high. As he goes on consuming more and more units of a commodity, he eventually reaches the maximum point and if the consumption increases beyond this point, total utility also diminishes.
Marginal Utility
Marginal Utility refers to the utility of every additional
unit of a commodity consumed. It can be defined as a change in total utility resulting from a one unit change in the consumption of a commodity at a particular point of time. According to Stonier and Hague, A consumer will exchange money for units of a commodity A up to the point where last (marginal) unit of A which he buys has for him a marginal significance in terms of money just equal to its money price.
Marginal Utility Theory

Utility and consumer satisfaction
Total and marginal utility
diminishing marginal utility
The optimum level of consumption

consumer surplus
marginal consumer surplus
total consumer surplus

consumer surplus and the marginal utility curve
120 110
Tinas marginal utility from petrol
100 90
MU, P
Consumer surplus
b c MU
80 70 60 50 40 0 250 500 750 1000
Q (litres per annum)


consumer surplus

marginal consumer surplus total consumer surplus consumer surplus and the marginal utility curve
rational consumer behaviour


consumer surplus

marginal consumer surplus total consumer surplus
consumer surplus and the marginal utility curve

maximising consumer surplus: P = MU
rational consumer behaviour
Consumer surplus
MU, P
P1
MU
Q1
Consumer surplus
MU, P
P1
Total consumer expenditure

O Q1
MU
Consumer surplus
MU, P
Total consumer surplus
P1
Total consumer expenditure

O Q1
MU

Marginal utility and the demand curve
an individuals demand curve
Deriving an individual persons demand curve

MU, P
P1
Consumption at Q1 where P1 = MU
MU = D
Q1

MU, P
P1 P2
b
MU = D
Q1
Q2

MU, P
P1 P2 P3
b c
MU = D
Q1
Q2
Q3

an individuals demand curve the market demand curve

the shape of the demand curve


shifts in the demand curve


Limitations of the one-commodity version



marginal utility affected by consumption of other goods



marginal utility affected by consumption of other goods marginal utility of money not constant
Risk, Uncertainty and Insurance

Demand under conditions of risk and uncertainty
the problem of imperfect information
Attitudes towards risk and uncertainty

defining risk and uncertainty types of odds risk attitudes

risk neutral risk loving risk averse

Diminishing marginal utility of income and
attitudes towards risk taking

most people are risk averse diminishing marginal utility of incomes
Total utility of income

TU
Total utility
U1
5000
10 000
15 000
Income

TU
U2 Total utility
U1
5000
10 000
15 000
Income ()

U3 U2 Total utility b c
TU
U1
5000
10 000
15 000
Income ()

U3 U2 U4 Total utility U1 a b d c
TU
5000
8000 10 000
15 000
Income ()

Insurance: a way of removing risks
how insurers spread risks
the law of large numbers importance of the independence of risks
problems for insurers
adverse selection moral hazard
Laws of Utility Analysis

There are two laws namely : The Law of Diminishing Marginal Utility (DMU) and The Law of Equi-Marginal Utility The Law of DMU states that if a consumer consumes
more of a commodity the utility of additional unit consume diminishes. Where as the Law of Equi-Marginal utility states that the consumer would distribute his money income between the goods in such a way that the utility derived from the last rupee spent on each good is equal.
1. Law of Diminishing Marginal Utility

Dr. Marshall---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. Prof. Lipsey---For any individual consumer, the value that he attaches to successive units of a particular commodity will diminish steadily as his total consumption of that commodity will increase. Assumptions--Various units of a commodity are homogeneous There is no time gap between the consumption of different units. Every consumer wants to maximize utility. The tastes & preferences of the consumer remains the same during the period of consumption. Marginal utility of money remains the same.
The law can be explained -----Units 1 2 3 4 5 6 7 8 Total utility 20 37 51 62 68 68 64 50 Marginal utility 20 17 14 11 6 0 -4 -14
Imaginary graph of DMU curve
Limitations of DMU
Homogeneity
Suitable time No change in the tastes & preferences of the consumer
Normal persons
Constant income Thus the law of DMU is a statement of tendency. It
depends on so many conditions. If these conditions are not fulfilled, the law does not operate.
Exceptions to DMU
Alcoholics
Misers Money
Hobbies & Rare collections
Importance of DMU
Explains the very popular Water-Diamond paradox
Explains the reasons of downward sloping demand curve Explains the concept of consumers surplus Explains the role of Direct Taxation Its importance in the field of Marketing, especially in
Packaging the products----variety of packing.

But an improved version of explaining this consumer
equilibrium is through Law of maximum satisfaction.
The paradox of water and diamonds

The law of diminishing marginal utility is said to explain
the paradox of water and diamonds, most commonly associated with Adam Smith (though recognized by earlier thinkers). Human beings cannot even survive without water, whereas diamonds are mere ornamentation or engraving bits. Yet water had a very low price, and diamonds a very high price, by any normal measure. Marginalists explained that it is the marginal usefulness of any given quantity that determines its price, rather than the usefulness of a class or of a totality. For most people, water was sufficiently abundant that the loss or gain of a gallon would withdraw or add only some very minor use if any; whereas diamonds were in much more restricted supply, so that the lost or gained use would be much greater.
Law of maximum satisfaction

Also known as the law of substitution, proportionality
rule and equi- marginal utility. The consumer with a given outlay of money, has to spend on various goods & services. Otherwise : MU of commodity x = MU of commodity y Price of commodity x Price of commodity y
Assumptions of the law

Units

MU of commodity x MU of commodity y 1 20 24 2 18 21 3 16 18 4 14 15 5 12 9 6 10 3 Let the price of x be Rs. 4 per unit & the price of y be Rs. 3 per unit. The consumer is in the equilibrium at 5th unit, where as his MU of the 2 commodities is equal.
Assumptions of the law

Utility is measurable in terms of money. The income of the consumer remains constant and it is

limited. The consumer behaves rationally. The marginal utility of remains constant. The utility schedule of one commodity is independent of the utility schedule of the other commodities. The law of DMU operates. There is perfect competition in the market and the consumer has to accept the prevailing price.
Significance of the law

As Marshall says the applications of this principle extend over almost

every field of economic enquiry. Some of the applications---Helps in the determination of optimum budget for the consumer. Helps in the distribution of earnings between savings and consumption. The entrepreneur can apply this law to maximize his profits. The ideal distribution of resources is possible in such a way, that the marginal social utility in each case is the same. An individual can distribute his assets among alternative forms using this principle. It is also applicable in public finance particularly in taxation. It is more useful to a person who has limited time to be spent among alternative uses. He can distribute time in such a way that the marginal utility gained from those uses are equal.
Limitations of the law

Presence of rational thinking all the time
MU of money will not be constant.

Maximization of consumer satisfaction is subject to
availability of goods. Utility is a subjective concept and it cannot be measured. The equi-marginal principle can work only if goods are divisible but certain goods are not divisible. This restricts the free working of the law. Because of these limitations the law lacks practical use. Hence Prof. Hicks put aside this approach and advanced an alternative approach which is called as Ordinal approach i.e. Indifference Curve Approach.
Indifference Curve Analysis:

Indifference analysis is an alternative way of explaining consumer choice that does not require an explicit discussion of utility.
Indifferent: the consumer has no preference among the choices. Indifference curve: a curve showing all the combinations of two goods (or classes of goods) that the consumer is indifferent among.
43
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Indifference curve analysis

In I.D. curve analysis, the consumer compares the satisfaction
obtained from different combinations of goods. If the various combinations are marked A,B,C,D & E, the consumer can tell whether he prefers A to B, B to C and so on. Similarly he can indicate his preference or indifference between any other combinations. The concept of ordinal utility implies that the consumer cannot go beyond stating his preference or indifference. Thus I.D. curve analysis does not use cardinal numbers like 1,2,3,4.., but instead it uses ordinal numbers like 1st,2nd,3rd..etc. Thus this approach was evolved as an alternate approach to cardinal utility analysis. Moreover this analysis very clearly stats that the consumer can only compare his levels of satisfaction in terms of degrees and in terms of numbers as assumed by Marshall. It makes use of the concept of scale of preferences. Scale of preferences refers to the ordering of different goods and their combinations in a set order of preferences.
Scale of preferences--schedule
Combination of 2 goods
level of satisfaction
order of preference
1st 3rd
1. 5apples&15mangoes 2. 4apples&12mangoes 3. 3apples&9mangoes
highest >1st2nd >1st&2nd
The scale of preference differs from person to person and it is drawn on the basis of mental attitude of consumers towards the commodities.
I.D. Schedule
An I.D. schedule is a list of different combinations of 2

goods which will give equal level of satisfaction to the consumer. Combination apples mangoes MRS A 20 1 -B 16 2 4:1 C 13 3 3:1 D 11 4 2:1 E 10 5 1:1
As the various combinations of 2 goods gives the same level
of satisfaction to the consumer so the consumer is indifferent among these combinations. Further we can see that the number of apples is decreasing and that of mangoes is increasing because the consumer has to remain at the same level of satisfaction. MRS is the marginal rate of substitution can be defined as the rate at which an individual will exchange successive units of one commodity for the other. Symbolically, MRSxy= dx/dy------It decides the slope of the I.D.curve.
I.D.Curves
An I.D. curve can be defined as a graphic
representation of the various quantities of 2 goods that will yield equal satisfaction.
An I.D. map can be defined as a collection or group of
I.D.curves.
Assumptions
It assumes that consumer is interested in buying 2 goods only. It is assumed that the consumer will always prefer large amount
of goods to a smaller amount , provided that the amount of other goods at his disposal remain unchanged and his income is fixed over a period of time. The tastes of the consumer remain unchanged during the period of consumption. The consumer is rational and his choices are transitive. The principle of diminishing rate of substitution is assumed. i.e., if a consumer prefers more and more units of one commodity, he will forego fewer units of the other commodity. It is based on ordinal analysis.
Properties of I.D.curves
Always slope downwards
Convex to the origin Do not intersect each other
Higher I.D.curve represents higher level of satisfaction

Need not be parallel to one another Should not touch either the x or y axis In general I.D.curves are like bangles.
Graphing the Indifference Curve

Indifference curve a curve that shows combinations
of goods among which an individual is indifferent. The slope of the indifference curve is the ratio of marginal utilities of the two goods.
Indifference Curves: Shape

A common shape for an indifference curve is
downward sloping.
For the consumer to be indifferent to the bundle of
goods chosen, as less of one good is consumed, more of another must be consumed.
52
Indifference Curves: Shape

The indifference curves are not likely to be vertical,
horizontal, or upward sloping.

A vertical or horizontal indifference curve holds the quantity of one
of the goods constant, implying that the consumer is indifferent to getting more of one good without giving up any of the other good. An upward-sloping curve would mean that the consumer is indifferent between a combination of goods that provides less of everything and another that provides more of everything. Rational consumers usually prefer more to less.
53
Indifference Curves: Slope

The slope or steepness of indifference curves is
determined by consumer preferences.

It reflects the amount of one good that a consumer must give
up to get an additional unit of the other good while remaining equally satisfied. This relationship changes according to diminishing marginal utilitythe more a consumer has of a good, the less the consumer values an additional value of that good. This is shown by an indifference curve that bows in toward the origin.
54
Bowed-in Indifference Curve
55
Indifference Curves: No Crossing Allowed!

Indifference curves cannot cross.
If the curves crossed, it would mean that the same bundle
of goods would offer two different levels of satisfaction at the same time. If we allow that the consumer is indifferent to all points on both curves, then the consumer must not prefer more to less. There is no way to sort this out. The consumer could not do this and remain a rational consumer.
56
Indifference Curves Cannot Cross!
57
Indifference Map
An indifference map is a complete set of indifference curves.
It indicates the consumers preferences among all
combinations of goods and services. The farther from the origin the indifference curve is, the more the combinations of goods along that curve are preferred.
58
Indifference Map
59

The absolute value of the slope of an indifference curve
is called the marginal rate of substitution.

Marginal rate of substitution the rate at which
one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.

Indifference curves are downward sloping and bowed
inward.

Law of diminishing marginal rate of substitution
as you get more and more of a good, if some of that good is taken away, then the marginal addition of another good you need to keep you on your indifference curve gets less and less.
A Group of Indifference Curves
Why Indifference Curves Cannot Cross

If indifference curves crossed, it would violate the
prefer-more-to-less principle.
Indifference Curves and Budget Constraints

The best combination is the point where the
indifference curve and the budget line are tangent.
Price/Budget line
It shows all the possible combinations of 2 goods that
the consumer can buy at a given level of income and price of 2 goods. Two phases of price line can be observed--- Shift of the price line, where the total income of the consumer changes ( increase/decrease), keeping constant the prices of the 2 goods. Slope of the price line, where, the income of the consumer does not change but price of one of the 2 goods will change(increase/decrease).
Indifference Curves and Budget Constraints
Budget Constraint
The indifference map only reveals the ordering of consumer preferences among bundles of goods. It tells us what the consumer is willing to buy. It does not tell us what the consumer is able to buy. It does not tell us anything about the consumers buying power. The budget line shows all the combinations of goods that can be purchased with a given level of income.
70
Consumer Equilibrium
The indifference map in combination with the budget
line allows us to determine the one combination of goods and services that the consumer most wants and is able to purchase. This is the consumer equilibrium.
The demand curve for a good can be derived from
indifference curves and budget lines by changing the price of one of the goods (leaving everything else the same) and finding the equilibrium points.
71
Consumer Equilibrium
The consumer maximizes satisfaction by purchasing the combination of goods that is on the indifference curve farthest from the origin but attainable given the consumers budget.
72
Deriving a Demand Curve from the Indifference Curve

By varying the price of one of the goods while holding
the price of other constant, the points of tangency will change.
This gives alternative price/quantity combinations.
Deriving the Demand Curve

By changing the price of one of the goods and leaving everything else the same, we can derive the demand curve.
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Utility Analysis

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Utility Analysis

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What is utility?

The Utility Analysis is other wise called as cardinal

Marginal Utility Theory

The optimum level of consumption

marginal consumer surplus

total consumer surplus

Tinas marginal utility from petrol

80 70 60 50 40 0 250 500 750 1000

Q (litres per annum)

Marginal Utility Theory

The optimum level of consumption

rational consumer behaviour

Marginal Utility Theory

The optimum level of consumption

marginal consumer surplus total consumer surplus

consumer surplus and the marginal utility curve

rational consumer behaviour

Total consumer expenditure

Total consumer surplus

Total consumer expenditure

Marginal Utility Theory

Deriving an individual persons demand curve

Deriving an individual persons demand curve

Deriving an individual persons demand curve

Marginal Utility Theory

Marginal Utility Theory

the shape of the demand curve

Marginal Utility Theory

the shape of the demand curve

Marginal Utility Theory

the shape of the demand curve

Limitations of the one-commodity version

Marginal Utility Theory

the shape of the demand curve

Limitations of the one-commodity version

Marginal Utility Theory

the shape of the demand curve

Limitations of the one-commodity version

Risk, Uncertainty and Insurance

Attitudes towards risk and uncertainty

risk neutral risk loving risk averse

Risk, Uncertainty and Insurance

attitudes towards risk taking

Total utility of income

Total utility of income

Total utility of income

Total utility of income

Risk, Uncertainty and Insurance

the law of large numbers importance of the independence of risks

problems for insurers

adverse selection moral hazard

Laws of Utility Analysis

1. Law of Diminishing Marginal Utility

Imaginary graph of DMU curve

Hobbies & Rare collections

Packaging the products----variety of packing.

equilibrium is through Law of maximum satisfaction.

The paradox of water and diamonds

Law of maximum satisfaction

Assumptions of the law

Assumptions of the law

Significance of the law

Limitations of the law

MU of money will not be constant.