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Unit 2 : Theories Of ConsumptionQ1. Differentiate between cardinal and ordinal utiliy.Utility: Eminent economists such as Jevons,Walras ,Menger developed the utility analysis during19th century, but the real credit for its present development goes to Alfred Marshall and Pigou.Utility means the want ...

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Unit 2 : Theories Of Consumption Q1. Differentiate between cardinal and ordinal utiliy. Utility: Eminent economists such as Jevons,Walras ,Menger developed the utility analysis during19th century, but the real credit for its present development goes to Alfred Marshall and Pigou. Utility means the want satisfying power of a commodity or a service. The features of utility: 1.Utility should be differentiated from satisfaction. A consumer gets satisfaction only after consumption of a commodity, where as utilty is the want satisfying power of a commodity calculated before consumption. Utility refers to ‘Expected satisfaction’. Satisfaction denotes ‘realised satisfaction’. 2. Utility should not be confused with usefulness. A commodity may satisfy human want, but may not be useful; it may harm or even be injurious to one’s health. For example, liquor is not useful commodity, yet it satisfies the want of a drunkard. 3.Ethically neutral The concept of utility does not speak anything about morality it is ethically neutral. 4.Subjective Concept Utility is a subjective concept. A consumer knows it by introspection. It depends on his thinking. It varies from individual to individual at different times and at different places.

Measurement of utility Utility can bebroadly measured in 2 approaches. 1. Cardinal Approach This approach is also known as utility approach. Masrshall is the chief exponent of the cardinal utility approach. According to cardinal concept, it is possible to measure utility in terms of numbers like 1,2,3,4, etc. And express in terms of SI unit Utils that is ‘U’ Utility can be measured and compared with the utilities of two commodities. For example, an apple may yield a consumer utilty of 20 units where as an orange may yield him an utility of 10 utils. 2. Ordinal Approach Modern economists like J R Hicks and R.G.D. Allen and others have supported the ordinal approach. According to this approach, utlity cannot be measured but it can only be compared. Consumer is supposed to rank or order utility obtained from consumption of different commodities as I, II, III etc. The ordinal concept permits to say that the consumer prefers an apple to an orange, but it does not indicate how much. In other words, only the preference of a particular consumer for one type of good in comparison with another type of good is represented by utility. For example: If a student likes apple more than orange then, according to ordinal approach, the student will give 1st rank to apple and 2nd rank to orange.

Concepts Of Utility Initial Utility: Initial utility refers to the utility refers to the utility that is derived by consuming the first unit of a commodity. For example, having a first cup of tea to reduce fatigue is initial utility. Total utility: Total utility is the amount of utility or satisfaction that a consumer gains from consuming a given amount of goods or services over a period. For example, a person consumes 5 units of commodity andderives U1,U2,U3,U4,U5, then the total utility will be TU=U1+U2+U3+U4+U5 In other words Total utility is the summation of marginal utility. TUx = ∑MUx Where TU= Total Utility MU= Marginal Utility ∑= Summation X= commodity

Marginal Utility: It refers to the additional satisfaction that a consumer derives from consuming an additional unit of a commodity. It can be expressed with the help of the following formula: MU=∆TU∕∆Q Here ∆TU = Change in total utility

∆Q=Change in consuming an additional unit of good. Marginal Utility can also be expressed with the help of the following formula MUn=TUn-TUn-1 Where MU= Marginal Utility TU= Total Utility n=Number of goods For example , suppose a person gets 10 utils by consuming one unit of a commodity and 15 utils by consuming an additional unit of that commodity. The marginal utility of the second commodity is 5 utils. i.e., MU=15-10=5 Utils Conclusion: Thus these are the types of utility. Of these, Ordinal utility is superior than cardinal utility.

Q2. Explain Law of Diminishing marginal utility with thehelp of table and diagram. Law Of Diminishing Marginal Utility Introduction: A German economist Gossen was the first to explain this law. Therefore, this law is also known as Gossen’s first law. Prof. Alfred Marshall, the founder of neo-classical school, popularised it. Statement: According to this law, as consumer increases the consumption of any one commodity keeping constant consumption of all other commodities, the marginal utility of the variable commodity must eventually decline. Assumptions: 1. The units of consumption must be in standard units. 2. All units of consumption must be identical in all aspects like taste, quality, colour, size etc. 3. The units of the commodity must be continuously consumed without any time gap. 4. Consumer is rational. It means consumer should maximise utility. 5. The price of the commodity consumed and its substitutes must remain constant. 6. Utility can be measured in cardinal numbers like 1,2,3, etc. 7. Consumer should be an ordinary person. This law is not applicable to extraordinary persons. Explanation: The law of diminishing marginal utility can be explained with the help of an example.

Example: Suppose it is a very hot summer month. A student is very thirsty. Now when the student comes to home and drinks 1 full glass of water, then the student will get a height degree of satisfaction.(Utility). When the student drinks another full glass of water from the same glass, then his additional satisfaction (marginal utility) shall be a bit less. This is so because student’s thirst would not be as high as before. Similarly when the student wants to drink third glass of water then his expected satisfaction (marginal utility) would be even lesser since after consuming second glass of water his thirst would have diminished even further. The following theory and example can be explained with the help of the following table and diagram. Table:

In the above table, we can see that, When the student consumes first full glass of water he gets highest satisfaction that is 12 utils. However,when he without any time gap, consumes 2nd full glass of water his additional utility is reduced from 12 utils to 8 utils

As his thirst has decreased. Eventually, when the student keeps on consuming full glasses of water without any time a point shall come when he gets no additional satisfaction. This is shown when he consumes 5thglass of water where in his marginal utility is zero. However, when the student forces himself to drink water when he can’t any more...then additional glass odf water will have adverse effect on him.....This is reflected in negative marginal utility. Diagram

In the above diagram, On ox axis, we have units of water consumed On oy axis, we have utility TU represents Total Utility MU represents Marginal Utlity

In the above diagram we can see that, as the student keeps on consuming identical full glasses of water, His total utility keeps on increasing so long as marginal utility is positive. When marginal utility becomes zero, then we observe that the Total Utility reaches the highest point. When marginal utility becomes negative then the total utility shall start to decline. Here MU curve is the slope of TU curve Since MU=∆TU/∆Q The falling MU curve exhibits the Law Of Diminishing Marginal Utility. Exceptions/Limitations (mr k dip n) 1. The law is not applicable to rare collections. For example collection of ancient coins, stamps, antiques etc. 2. The law is not fully applicable to money. The marginal utility of money declines with richness but shall never be equal to zero. 3. It does not apply to knowledge, art and innovations. 4. The law is not applicable to precious goods like diamond ,gold etc. 5. The law does not operate if the consumer operates in irrational manner. 6. The utility increases in demonstration effect (a person imitating his well off neighbour). It is a natural element. 7. Man is fond of nature’s beauty and gets more satisfaction by enjoying it. Importance of the law: (memory aid: tee pds) 1. By purchasing more units of a commodity, the marginal utility declines. Due to this behaviour consumer cuts down his

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expenditure on the same. It helps to utilise the resources more efficiently. In the field of public finance, this law has practical application as the principal of taxation that is imposing heavier tax burden on rich people is based on this law. This law is basis for other economic laws such as law of demand, elasticity of demand, consumer surplus etc. The theory of value is based on this law. The value of a commodity falls with an increase in the supply of that commodity. This forms the basis for determining prices. Adam Smith has explained diamond water paradox with the help of this law. This law is also the basis for the socialist plea for an equitable distribution of wealth. Since the marginal utility of money is low for rich people and marginal utility of money is high from poor people , it makes economic sense to take from the rich people and give it to the poor people. Conclusion: Despite the limitations the law of diminishing marginal utility has a great deal of theoretical significance in cardinal utility analysis, Theory of price, theory of value etc as well as it has tremendous practical applications in the fields of public finance, socialistic model etc.

Q3. Explain Law of Equimarginal utility with the help of table and diagram. Law of Equmarginal utility Introduction: The law of equi marginal utility was presented in 19th century by an German economists H. H. Gossen. It is also known as Law of maximum satisfaction or Law of substitution or Gossen's second law or The proportionality Rule. .This Law was refined and popularised by Alfred Marshall. Definition: According to Alfred Marshall, If a person has a thing which he can put to several uses, he will distribute the thing among these uses in such a manner that it has equal utility in all. In other words, "A person can get maximum utility with his given income when it is spent on different commodities in such a way that the marginal utility of money spent on each item is equal". It is clear that consumer can get maximum utility from the expenditure of his limited income. He should purchase such amount of each commodity that the last unit of money spend on each item provides same marginal utility. .Assumptions : 1. 2. 3. 4. 5.

There is no change in the prices of the goods. The income of consumer is fixed. The marginal utility of money is constant. Consumer has perfect knowledge of utility obtained from goods. Consumer is normal person so he tries to seek maximum satisfaction. 6. The utility is measurable in cardinal terms.

7. Consumer has many wants. 8. The goods have substitutes. Explanation: A consumer has number of wants. He tries to spend limited income on different things in such a way that marginal utility of all things is equal. When he buys several things with given money income he equalizes marginal utilities of all such things. The law of equi marginal utility is an extension of the law of diminishing marginal utility. The consumer can get maximum utility by allocating income among commodities in such a way that last rupee spent on each item provides the same marginal utility. Every consumer has unlimited wants, however the money with him shall be limited. The consumer will allocate his income on various commodities in such a manner that he shall maximise his satisfaction. For this he will compare the marginal utility of each commodity he wants to buy as well as marginal utility of the commodity to their price. If he finds marginal utility of commodity A is higher than commodity B, then he will substitute commodity B with commodity A Since the consumer has to allocate his budget on food, clothing, shelter, recreation etc he shall allocate his budget in such a manner that the last rupee spent on each good and service shall give him the same marginal utility. The following theory can be explained with the help of the following schedule and diagram The law of substitution can be explained with the help of an example. Example:

Suppose consumer has 60 rupees that he wants to spend on apples and bananas in order to obtain maximum total utility. Price of apple is Rs 10 Price of banana in Rs 10 The following table shows marginal utility (MU) of spending additional rupees of income on apples and bananas: Number of units MU of Apple MU of Banana 1 100 80 2 90 70 3 80 60 4 70 50 5 60 40 6 50 30

The above schedule shows that consumer can spend six rupees in different ways: 1. ₹10 on apples and ₹50 on bananas. The total utility he can get is: [(100) + (80+70+60+50+40)] = 400. 2. ₹20 on apples and ₹40 on bananas. The total utility he can get is: [(100+90) + (80+70+60+50)] = 450. 3. ₹30 on apples and ₹30 on bananas. The total utility he can get is: [(100+90+80) + (80+70+60)] = 480. 4. ₹40 on apples and ₹20 on bananas. This way the total utility is: [(100+90+80+70) + (80+70)] = 490. 5. ₹50 on apples and ₹10 on bananas. The total utility he can get is: [(100+90+80+70+60) + (80)] = 480. Total total utility for consumer is 490 utils that is the highest obtainable with expenditure of rupees 40 on apples and rupees 20 on bananas.

Here the condition MU of apple/Price of apple = MU of banana i.e 7 = 7 is also satisfied. Any other allocation of the last dollar shall give less total utility to the consumer. Hence the condition of equilibrium for the consumer is the ratio of marginal utility to price of all the commodities must be equal. That is

Thus the consumer will be in equilibrium when he spends his limited income 60 rupees on apples and oranges in such a manner that his marginal utility derived from the last rupee spent on both the commodities us equal.....which in this context happens to be 7utils. We can also further explain that any other combination will definitely give him less satisfaction with the help of the following diagram.

Diagram:

Scale:On OX axis:1cm=1unit On OY axis:1cm =2units

In the above diagram on the OX axis we have commodities namely apple and banana. On the OY axis we have the marginal utility. In the diagram we observe that, the consumer is deriving maximum satisfaction when he is deriving equal marginal utility from the last rupee he spends on both the commodities. That is he gets 7 utils of equal satisfaction when he buys 4 units of apple and 2 units of orange.

Suppose, he decides to buy an additional unit of apple forgoing 1 unit of orange, then we can clearly see from the diagram that, his gain from an additional unit of apple is PP1P2P3. However, we can also observe that his loss from foregoing an orange is qq1q2q3. Thus, here we can clearly observe that his loss of forgoing an orange (qq1q2q3.) is clearly greater than buying another unit of apple(PP1P2P3.).

This can be checked for any other combination as well. Thus, the consumer will be in equilibrium when he allocates his budget in such a manner that the last rupee spent on each good and service shall give him the same marginal utility. Limitations: 1. The law is not applicable in case of knowledge. Reading of books provides more satisfaction and knowledge to the scholar. Different books provide variety of knowledge and satisfaction. 2. The law is not applicable in case of indivisible goods. The consumer is unable to divide the goods to adjust units of utility derived from consumption of goods. 3. There is no measurement of utility. It is psychological concept. It is not possible to express it into quantitative form. 4. The law does not hold well in case fashion and customs. The people like to spend money on birthdays, marriages and deaths. 5. The does not hold well in case of very low income. The maximization of utility is not possible due to low income. 6. The law is not applicable in case of durable goods. The calculation of marginal utility of durable goods is impossible. 7. The law fails when goods of choice are not available. The consumer is bound to use commodity, which provides low utility due to non availability of goods having high utility. 8. There are certain lazy consumers. They do not care for maximum utility. The law fails to operate in case of laziness of consumers. They go on consuming goods with comparing utility.

9. It does not work when there are frequent prices changes. The consumer is unable to calculate utility of different commodities. Changing price levels create confusion in the minds of consumers. 10. There may be unlimited resources. The does not work due to unlimited resources. There is no need to change the direction of expenditure from one item to another when there are gifts of nature. Importance: 1. The law of equi marginal utility is helpful in the field of production. The producer has limited resources. He uses limited resources to purchase production factors. He tries to equalize marginal utility of all factors. He wishes to get maximum output and profit. 2. National income is distributed among factors of production according to this law. An entrepreneur can pay factors of production equal to marginal product measured in money terms. He will substitute one factor for another until marginal productivity of all factors is equal to prices of their services. 3. The law is used in the field of exchange. The people like to exchange a commodity having low utility with a commodity having high utility. There is maximum benefit from exchange of commodities. The law is helpful in exchange of wealth, trade, import and export. 4. The law is applicable in consumption. A rational consumer tries to get maximum satisfaction when he spends his limited resources on various things. He tries to equalize weighted marginal utility of all the things. 5. The law is applicable in public finance. The government can spend its revenue to get maximum social advantage. The marginal utility of each dollar spent in one sector must be equal to marginal utility derived from all other sectors. 6. The law is useful for workers in allocating the time between work and rest. They can compare the marginal utility of work and the marginal utility of rest. They can decide working hours and rest hours. 7. The law holds well in case of saving and spending. The consumer can make choice between present wants and future wants. He can feel that a dollar saved has greater utility than a dollar spent, he can save more and spend less. He will substitute saving and spending till marginal utility of a dollar spent and a dollar saved are equal. 8. The law is helpful in prices. Due to scarcity of commodity its prices go up. The law tells us to use substitute commodity, which is less scarce. The result is that the price of commodity comes down.

Conclusion: Despite the limitations, the theory has a great deal of significance

Q4. Critically Theory of Consumer Surplus with the help of table and diagram. Introduction: The doctrine of Consumer’s Surplus which occupies an important place in the Marshallian System of Welfare Economic Analysis was originally stated by William Stanley Jevons and French Engineer economist Arsens Jules Dupuit in 1844 in a Crude form. Later on Dr. Alfred Marshall explained this concept in “The Pure Theory of Domestic Values” as consumer’s rent. Statement: Consumer surplus is defined as the difference between the consumers' willingness to pay for a commodity and the actual price paid by them, or the equilibrium price. Consumer surplus= Price willing to pay – Price actually paid Explanation of the Concept of Consumer Surplus: Definition: Regarding this Prof. Marshall has said that “The excess of price which he (consumer) would be willing to pay rather than go without. The thing over that which he actually does pay, is the economic measure of this surplus satisfaction. It may be called “Consumer’s Surplus”. According to Penson – “The difference between what we would pay and what we have to pay is called Consumer’s Surplus.” For Example: Suppose, a student goes to buy a book. He is willing to pay Rs. 20 for the book. But he gets the book for Rs...