7.1 Utility

Chapter 7.1 Utility

7.1.1 Definition and Calculation of Total Utility and Marginal Utility

Utility refers to the satisfaction or benefit derived from the consumption of goods or services. It is a foundational concept in consumer behavior and demand theory.

• Total Utility (TU): The total amount of satisfaction a consumer derives from consuming a given quantity of goods or services. As consumption increases, total utility generally rises but at a decreasing rate.

• Marginal Utility (MU): The additional satisfaction gained from consuming one extra unit of a good or service. It is calculated as:
  
  MU = Change in Total Utility ÷ Change in Quantity
  MU = ΔTU / ΔQ

• Average Utility (AU): AU = TU / Q, showing utility per unit consumed.

Utility is subjective and varies from person to person. It cannot be measured precisely but is often expressed in hypothetical “utils” for analysis purposes.

7.1.2 Law of Diminishing Marginal Utility

This law states that as a person consumes more units of a good, keeping the consumption of other goods constant, the marginal utility derived from each additional unit declines.

For example, the first chocolate bar may provide high satisfaction, but the second and third bars offer less additional satisfaction. Eventually, additional units might provide zero or even negative utility.

This principle explains why consumers are willing to pay less for each additional unit, forming the basis for a downward-sloping demand curve.

7.1.3 Equi-Marginal Principle

Also called the law of equi-marginal utility, this principle guides consumers on how to allocate their limited income among various goods to achieve maximum total utility.

According to this principle, utility is maximized when:

MU₁ / P₁ = MU₂ / P₂ = MU₃ / P₃ = … = MUₙ / Pₙ

Where:

• MU = marginal utility

• P = price of the good

Consumers compare the marginal utility per rupee spent across different goods and allocate their spending until the ratio is equalized. If MU₁ / P₁ > MU₂ / P₂, the consumer will spend more on good 1 and less on good 2 until equilibrium is achieved.

This principle assumes rational behavior and the ability to divide goods into smaller units, as well as a stable income and constant prices.

7.1.4 Derivation of an Individual Demand Curve

The individual demand curve can be derived from the law of diminishing marginal utility and the equi-marginal principle. As the price of a good falls, the marginal utility per rupee spent increases, making the good more attractive relative to other goods. This leads the consumer to buy more of that good.

This inverse relationship between price and quantity demanded gives rise to the downward-sloping demand curve.

The derivation involves adjusting the consumer’s combination of goods to re-establish MU/P equilibrium after a price change, resulting in a new optimal quantity. Plotting these quantities against respective prices forms the demand curve.

Also contributing to this effect:

• Substitution Effect: Consumers substitute cheaper goods for relatively more expensive ones.

• Income Effect: A lower price increases real income, allowing the purchase of more goods.

7.1.5 Limitations of Marginal Utility Theory and Its Assumptions of Rational Behaviour

Though the theory is foundational in microeconomics, it faces several criticisms:

1. Utility is Subjective and Not Measurable: The theory assumes utility can be measured cardinally, which is not realistic since utility varies between individuals and situations.

2. Assumption of Rational Behavior: Consumers are assumed to act rationally, always seeking to maximize utility. In reality, behavior is often influenced by habits, emotions, culture, and incomplete information.

3. Constant Marginal Utility of Money: The theory assumes that the utility of money remains constant, which is not the case, especially as people become wealthier or poorer.

4. Indivisibility of Goods: Some goods (e.g., cars, refrigerators) are indivisible, making it impossible to consume them in marginal units as the theory suggests.

5. Static Preferences: The theory assumes that tastes, preferences, and incomes remain constant during analysis, whereas in real life, these variables change frequently.

6. Ignores Externalities: The theory focuses solely on private utility and ignores social or environmental effects.

Despite these limitations, the theory provides a useful framework for understanding consumer behavior and the formation of demand curves.