MARGINALISM

COURSE: PRINCIPLES OF ECONOMICS

Rational People Think at the Margin.
A rational
decision-maker
takes action if and
only if the
marginal benefit of
the action exceeds
the marginal cost.
+
Life Example
Ex : If you buy a used car, and plan to
spend $10,000, but the car is only priced at
$6,000, would you still buy it if it needed
$5,000 in repairs?
Of course not because
1) you are a rational thinker and
2) you would end up spending more than you
planned to.
+ What does it mean to think at the margin?

It means to think about your next step forward.

The word "marginal" means "additional one unit"
The first glass of lemonade on a hot day quenches
your thirst, but the next glass, maybe not so much.
If you think at the margin, you are thinking about
what the next or additional action means for you.
Concept of margin or increment
Contd…

 Marginality: a unit increase in cost or revenue or

utility.
 Marginal cost: change in Total Cost due to a unit change in
output.
 Marginal revenue: change in Total Revenue due to a unit
change in sales.
 Marginal utility: change in Total Utility due to a unit change in
consumption.
 Incremental: applied when the changes are in bulk,
say 10% increase in sales.
Consumer Choice
 Given the prices of different commodities,
consumers decide on the quantities of
commodities according to their paying capacity,
and tastes and preferences.
 Commodities are desired because of their utility
 Utility is the satisfaction a consumer derives from
consumption of a commodity
 Cardinal Utility Analysis

 Marshall and Jevons opined that Utility is a cardinal

concept and is measurable (in utils) like any other physical
commodity
 Total Utility (TU)
 Sum total of utility levels out of each unit of a commodity consumed
within a given period of time
 Marginal Utility (MU)
 Change in total utility due to a unit change in the commodity
consumed within a given period of time.
dTU
 MU=TUn -TUn-1 or MU=
dQ
VIDEO

https://www.youtube.com/watch?v=2JEQB_fVke8
RELATIONSHIP B/W TOTAL
UTILITY & MARGINAL UTILITY

QUANTIT TOTAL UTILITY MARGINAL

Y UTILITY
1 10 10 INITIAL UTILITY
2 18 18-10=8
3 24 24-18=6 POSITIVE
4 28 28-24=4
5 30 30-28=2
6 30 30-30=0 ZERO
7 28 28-30=-2 NEGATIVE
Cardinal Utility Analysis
 Law of Diminishing Marginal Utility
 Marginal utility for successive units consumed goes on decreasing.
 When the good is consumed in standard quantity, continuously and in
multiple units and the good is not addictive in nature.
 The following diagrams show Total Utility (TU) and Marginal Utility
(MU) curves

TU of X MU of X

MU

TU

O O
Quantity of X Quantity of X
Definition
 The law of diminishing marginal utility
describes a familiar and fundamental
tendency of human behavior.
 “The law of diminishing marginal utility
states that, “as a consumer consumes
more and more units of a specific
commodity, utility from the successive
units goes on diminishing”.
Law based upon two facts:
The law of diminishing utility is based upon two facts.

 Firstly
The wants of a man are unlimited but single want can
be satisfied. As a man gets more and more units of a
commodity, the desire of his want for that good goes on
falling. A point is reached when the consumer no longer
wants any more units of that good,

 Secondly
Different goods are not perfect substitutes for each
other in the satisfaction of various particular wants.
 Explanation of the Law:

Suppose a person is thirsty and the price of water is zero. He takes one
glass of water which gives him great satisfaction. We can say the first
glass of water has great utility for him.

He then takes second glass of water. The utility of the second glass of
water is less than that of first glass of water. The utility declines
because the edge of his thirst has been blunted to a great extent.

If he drinks third glass of water, the utility of the third glass will be less
than that of second and so on. The utility goes on diminishing with the
consumption of every successive glass of water till it drops down to
zero.

It is the position of consumer’s equilibrium or maximum satisfaction.

If the consumer is forced further to take a glass of water, it leads to

disutility causing total utility-to decline. The marginal utility will become
negative. A rational consumer will stop taking water at the point at
which marginal utility becomes negative even if the good is free.
The following table will make the law of
diminishing marginal utility more clear.

Units Total Utility Marginal Utility

1st glass 20 20
2nd glass 32 12
3rd glass 40 8
4th glass 42 2
5th glass 42 0
6th glass 39 –3
From the above table,

It is clear that in a given span of time :-

 The first glass of water to a thirsty man gives 20

units of utility.
 When he takes second glass of water, the
marginal utility goes down to 12 units.
 When he consumes fifth glass of water, the
marginal utility drops down to zero and
 if the consumption of water is forced further from
this point, the utility changes into disutility (–3).
The graph will make the law of
diminishing marginal utility more clear.
In the above figure,
OX - shows units of a commodity consumed and OY - shows the marginal
utility derived from them.

The marginal utility of the first glass of water is called initial utility. It is equal
to 20 units.

The MU of the 5th glass of water is zero. This is point of satiety.

The MU of the 6th glass of water is negative –3. MU curve here lies below
the OX axis.

The utility curve MM falls from left down to the right showing that the
marginal utility of the successive units of of water is falling.

 When a good is scarce and so priced the consumer will increase the
consumption of a commodity up to the extent where his marginal utility for
the good equals the price which he has to pay, i.e. Mu = P.
Limitations of the law
 Case of intoxicants.

 Application to money.

 Rare collections.

 Utility is subjective
 Cardinal measurement of utility is not possible
 Every commodity is not an independent commodity
 Marginal utility cannot be estimated for all
commodities
 Doesn’t explain Giffen paradox
 Meaning
It is the second important law of the utility analysis.
This law was first propounded by Gossen. It is known as
“Gossen’s Second Law”

The law of equi-marginal utility is simply an extension of the

law of diminishing marginal utility to two or more than two
commodities.

The law of equi-marginal, is known, by various names. It is

named as the Law of Substitution, the Law of Maximum
Satisfaction, the Law of Indifference, the Proportionate Rule
 Meaning
This law points out how a consumer can get maximum satisfaction
out of given expenditure on different goods.

The law states that in order to get maximum satisfaction, a

consumer should spend his limited income on different
commodities in such a way that the last rupee spent on each
commodity yields him equal marginal utility :-

MUa MUb Muc

----- = ------ = -------
Pa Pb Pc

It may here be noted that when a consumer is in equilibrium there is no

way to increase utility by reallocating his given money income.
 Consumer has unlimited wants with limited income at
his disposal at any time
 The consumer is therefore, faced with a choice among
many commodities
 He therefore, consciously or unconsciously compares the
satisfaction which he obtains from the purchase of the
commodity and the price which he pays for it.
 As he buys more and more of that commodity, the utility
of the successive units begins to diminish.
 He stops further purchase of the commodity at a point
where MU =P
 If he pushes the purchase further from his point of
equilibrium, then the marginal utility of the commodity
will be less than that of price and the household will be a
loser.
 Explanation
 Suppose a person has Rs.5 with him which he wishes to
spend on two commodities, tea and cigarettes. The marginal
utility derived from both these commodities is as under:
Unit MU of Tea MU of Cigarette

1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
Rs. 5 TU =30 TU =39
 A rational consumer would like to get maximum satisfaction from Rs.
5.00. He can spend this money in three ways.
 (1) Rs. 5.00 may be spent on tea only
 (2) Rs. 5.00 may be utilized for the purchase of cigarettes only.
 (3) Some rupees may be spent on the purchase of tea and some on the
purchase of cigarettes.

 In order to make the best of the limited resources, he adjusts his

expenditure.
 (1) By spending Rs. 4.00 on tea and Rs. 1.00 on cigarettes, he gets 40
utility (10+8+6+4+12=40).
 (2) By spending Rs. 3.00 oa tea and Rs. 200 on cigarettes, he derives 46
Utility (10+8+6+12+10=46).
 (3) By spending Rs. 2.00 on tea and Rs. 3.00 on cigarettes, he gets 48
utility (10+8+12+10+8=48).
 (4) By spending Rs. 1.00 on tea and Rs. 4.00 on cigarettes, he gets 46
utility (10+12+10+8+6=46).
 The sensible consumer will spend Rs. 2.00 on tea and Rs.
3.00 on cigarettes and will get the maximum satisfaction.

 When he spends Rs. 2.00 on tea and Rs. 3.00 on cigarettes,

the marginal utility derived from both these commodities is
equal to 8.

 When the marginal utilities of the two commodities are

equalized, the total utility is then maximum i.e., 48 as is clear
from the schedule given above.

 The law of equi-marginal utility can be explained with the

help of a diagram.
 In the diagram, MU is the marginal utility curve for tea and KL of
cigarette. When a consumer spends OP amount (Rs.2) on tea and OC
(Rs.3) on cigarettes, the marginal utility derived from the consumption
of both the items (Tea and Cigarettes) is equal to 8 units (EP=NC).
 The consumer gets the maximum utility when he spends Rs. 2.00 on
tea and Rs. 3.00 on cigarettes and by no other alteration in the
expenditure.
 We now assume that the consumer spends Rs. 4.00 (OQ’) on
cigarettes. If CQ’ more amount is spent on cigarettes, the added utility
is equal to the area CQ’ N’N.
 On the other hand, the expenditure on tea falls from OP amount (Rs.2)
to OC’ amount (Rs. 1.00). There is a toss of utility equal to the area
C’PEE’.
 The loss in utility (tea) is greater than that of its gain in cigarettes. The
consumer is not deriving maximun satisfaction except the combination
of expenditure of Rs. 2.00 on tea and Rs. 3.00 on cigarettes.