Business Economics Notes

Unit-1st Part-2
 Concept and Definition of Utility

 Daniel Bernoulli, who was a Swiss mathematician in the 18th century is widely regarded as the

founder of the concept of utility theory. Utility is the oldest method for analyzing the behavior of

consumer and usually know as Prof. Marshall’s demand principle.

Concept of Utility

The concept of utility in economics is derived from the word ‘usefulness’. Utility is the measure of want

satisfying power of any goods and services used or consumed by the consumer. Utility is nothing but the

satisfaction gained by the consumer by usage of the inherent properties, ability, characteristics,

usefulness, etc. of any commodity that can fulfill any particular want of human being at any point of time.

Every product has some unique traits which satisfies the specific needs of consumer and that is utility of

that product.
 …Continued
Definition

According to Prof. E. Waugh, “To the economist utility is the ability to satisfy human wants.”

According to Thomas, “Utility is that property of a commodity which is inside it, for the satisfaction of

human needs.”

It is the want satisfying power of the property that gives birth to utility. It is the psychological

phenomenon that depends on the mental makeup of the consumer. Utility is subjective phenomenon

and remains in the mind of the individual due to which utility is different for the different people even

for the same commodity. For example one person may be more satisfied by eating south Indian food

as compared to another person who does not like it all.

 Characteristics of Utility

 Psychological phenomenon: Utility can only be felt which totally depends on the mental attitude,
inner emotion and assessment ability of any consumer consuming a particular commodity. It is
totally invisible and is not having any physical entity.
 Relative concept: Utility of a same commodity differ at different points of time, people, place,
situation, taste, fashion etc. of consumer. For example, blanket is useful in winter and not in
summer.
 Utility differ from usefulness: In economics every commodity has utility whether it is useful or
harmful product but every product is not useful. For example milk, butter, fruits, vegetables etc.
are called useful commodities whereas liquor, cigarette etc. are harmful commodities.
 …Continued

 Utility differ from satisfaction: Utility means expected satisfaction rather than actual satisfaction. A
consumer anticipates the utility while purchasing a commodity whereas satisfaction is obtained by actual
consumption of the commodity.
 Ethically neutral concept: The utility in the commodity has no ethical consideration as it satisfies any
want whether moral or immoral, socially desirable or undesirable. For example knife has utility as a
household appliance, but it also has a utility to a killer for stabbing some body.
 Utility is multi-purpose: The same commodity can be used for various purposes and can be utilized by
many people at the same time. For example milk can be used for curd, sweets, tea, coffee, shake, kheer
etc., similarly electricity can be used to serve many purposes at a time for many people
 …Continued
 Utility is the basis of demand: The demand for the commodity totally depends upon the utility it has
for satisfying the wants of the consumer. For example medicine is demanded by the consumer only
when they are sick.
 Utility cannot be measured: Utility is an intangible concept which can only be felt in terms of
satisfaction but can’t be touched or counted in numbers as it is subjective in nature. So it cannot be
measured cardinally but can only be expressed ordinally. For example first chapatti will have very high
utility for a very hungry person than the second chapatti.
 Utility depends on the intensity of want: Unsatisfied wants gives more utility to the consumer from
the commodity. It tends to experience diminishing utility from the commodity with an increase in
consumption of that commodity. In other words, the more we consume, the less utility is obtained
and vice-versa .
 Utility is different from pleasure: Every commodity carries utility but its consumption may not
necessarily provide pleasure to the consumer, e.g., injection and medicine for a patient does not give
any pleasure to consumer but is a necessary element for the patient .
 Measurement of Utility

The measurement of utility has always been a controversial issue between Neo-classical
economists, such as Alfred Marshall, Leon Walrus, and Carl Meneger who believed that utility is
cardinal approach whereas modern economists, such as J.R. Hicks, Allen, Pareto consider utility as
an ordinal approach.
Measurement of
Utility

Neo-Classical Economists
Modern Economists
(Alfred Marshal, Leon Walrus,
( J.R. Hicks, Allen, Pareto)
Carl Meneger)
ORDINAL APPROACH
CARDINAL APPROACH
Qualitative Measurement
Quantitative Measurement
 Cardinal Utility Approach
Cardinal utility is the satisfaction obtained from consuming a product is expressed in terms of cardinal
numbers such as 1, 2, 3, and so on as it is a quantitative concept. As per this approach, utility can be
expressed just like weight, height, temperature, length etc. There is no standard unit for measuring
utility of a commodity. Marshall used an imaginary unit called ‘util’ to measure the utility. Util is not
regarded as a standard unit because it varies from person to person, place to place, and time to time.
One util is equal to one unit of money. The technique of marginal utility analysis is used for examining
the consumer behavior through this approach.
Limitations
 Authentic measurement of utility is not possible like kilogram, kilometer as utility is a psychological
phenomenon.
 It is based on unrealistic assumptions which is generally not applicable in the real world.
 Utility is a relative concept that differs from person to person.
 The value of money itself is not constant.
 Ordinal Utility Approach

Modern economists replaced the cardinal approach with the concept of ordinal utility for the
analysis of consumer behavior. An ordinal approach is a qualitative phenomenon for measuring a
utility of commodity which shows order of preference, ranking or comparison like first, second, tenth,
etc. by the consumer as per the satisfaction derived from the commodity.

The satisfaction of a consumer after consuming a commodity cannot be measured in numbers like
cardinal utility rather, they are arranged in order of preference as utility is a psychological and
subjective concept. According to this approach utility can be measured in relative terms such as less
than and greater than but not in exact numbers. The technique of indifference curve analysis is used
for examining the behavior of consumer through this approach.
 Difference between Cardinal & Ordinal Approach
Basis Cardinal Approach Ordinal Approach
Concept According to cardinal approach, utility According to ordinal approach, utility is a
is an objective phenomenon subjective phenomenon
Approach It is the classical approach It is the modern approach
Measurement As per this approach, utility is As per this approach. Utility cannot be
measured in terms of numbers such as measured in terms of numbers, rather it can
1,2,3,4 etc.(Quantitative only be preference, ranked or compared.
phenomenon) (Qualitative phenomenon)
Unit of Utility under this approach is Utility under this approach is measured in
Measurement measured in terms of utils ranks
Analysis of Utility under this approach is Utility under this approach is measured using
Utility measured using marginal utility indifference curve analysis.
analysis.
Realistic It is less realistic approach It is more realistic approach
 Kinds of Utility
 Marginal Utility : The utility added to the total utility by consumption of an additional commodity is
called marginal utility. It is the utility derived from the last unit of a commodity purchased or
consumed. Marginal utility is of three types: positive, zero and negative.

Formula: MU= TUn-TUn-1

(Marginal Utility=Total Utility of n units- Total Utility of n-1 units)

 Total Utility : The aggregate of marginal utility derived from the various units of commodity is
called total utility. It measures the total satisfaction obtained from the consumption of all the units of
commodity. Total utility is always positive, it can never be negative or zero.
 Concept and Definition
Law of Diminishing Marginal
Utility
The law of Diminishing Marginal Utility is universally applicable to all products and services. It was
initially proposed by a German economist, H.H. Gossen and therefore, it is also known as Gossen’s
First Law of Consumption. Later, the economist like Bentham, William Stanley Jevons and Marshall
depicted its scientific explanation. The law of diminishing marginal utility is made up of three words
– diminishing, marginal and utility. The most important characteristic of utility is that it decreases as
the consumer purchases more units of any standard commodity at a point of time. Marginal Utility
shows the rate of change in total utility as the unit of consumption increases. The tendency of
marginal utility is that it starts falling after the first unit of consumption. Both the word ‘marginal’
and ‘utility’ depicts diminishing nature and that is why the name of this law is Law of Diminishing
Marginal Utility. Marginal utility is also known as marginal benefit, and it also refers the maximum
amount a consumer is willing to pay for one more unit of a commodity.
 …Continued
According to this law, the marginal utility depends upon the quantity consumed. This law is based on the
fact that only a particular want can be satisfied at a particular time. The law states that as the consumer
consumes more and more units of the commodity at the same point of time, the utility from each
successive unit goes on decreasing but remains positive and reaches the point of satiety where the
marginal utility is zero, thereafter if the consumer continues to consume the marginal utility becomes
negative.

The slope of law of diminishing marginal utility is downward moving from left to right indicating as the
consumption of the good’s or service’s increases the marginal utility start falling from initial. The
consumption of the first unit is always higher than the last unit. Many other economic laws such as law of
equi-marginal utility, law of demand etc. depends on the concept of diminishing marginal utility.
 …Continued
According to Marshall, “The additional benefit which a person derives from given increase of a
stock of a thing diminishes, other things being equal, with every increase in the stock of that he
already has.”

According to Thomas, “The utility of additional supplies of a commodity diminishes with every
increase in the available stock of it. Moreover, total utility increase but at a diminishing rate until
eventually any further increments of the commodity may have disutility.”

So, diminishing marginal utility is specifically related to the decrease of satisfaction from the
additional consumption of goods. It is an important concept of economics for determining the
preference of consumer for consuming or purchasing any commodity at a point of time to maintain
maximum satisfaction out of the limited income of the consumer. This law guides the consumer that
where he should stop purchasing or consuming any commodity.
 Assumptions of the Law of Diminishing Marginal Utility
 All the units of commodity should be homogeneous.
 Units and size of commodity should be proper and accurate.
 There should not be any difference in time and place of consumption.
 There should not be any change in value of commodities during consumption period.
 There should not be any change in the mental status of the consumer.
 The income, fashion, interest and behaviour of consumer should be constant.
 The value of substitutes should also remain constant.
 The customer must have perfect knowledge of all the alternatives available in the market.
 The marginal utility of money remains constant.
 Tabular Representation
Law of Diminishing Marginal Utility

Unit of Oranges Marginal Utility Total Utility

1 70 70
2 60 130
3 40 170
4 20 190
5 10 200
6 0 (Point of Satiety) 200( Maximum Satisfaction)
7 -10 190
8 -20 170
 Graphical Representation
Law of Diminishing Marginal
Utility

The law of diminishing marginal utility can be explained with the help of an example in which
consumer is consuming more and more units of oranges which collectively impact MU and TU. As
per the above table and diagram, MU and TU is shown on the Y axis and unit of oranges on the X
axis.
 …Continued

Marginal utility from the very first unit of orange consumption falls from 70 to 60….till 10, but
remains positive till 5th unit of oranges, whereas total utility (maximum at 5th unit i.e. 200) is
increasing but at a diminishing rate. If the unit of consumption is increased to 6 th unit of orange,
then MU will be 0 and TU is constant i.e. 200 which is point of satiety where consumer is in
equilibrium position getting maximum satisfaction. Consumer should stop consuming any further
unit at this level. If consumer continues to consume, then MU will become negative and TU will
start falling from 7th unit onwards. The downward-sloping curve of marginal utility from left to
right indicates that with every successive units the MU is decreasing. This law is applicable only
when other things remain the same as pointed out by Prof. Alfred Marshall.
 Conclusion

The Law of Diminishing Marginal Utility plays significant role in the economy. It has
direct relation with the production and consumption goods and services. This law
states that as we consume more of the commodity the satisfaction will gradually fall
from it, that is why the customers always look for a change to satisfy their unlimited
wants from limited means to obtain maximum satisfaction. Law of diminishing
marginal utility also helps and suggests the producers to design and create products
as per the customers’ changing requirements.
 Exceptions of Law of Diminishing Marginal Utility
 Small Units: The law does not hold well when the units of consumption of the commodity are
very small in size or quantity. For example, if a hungry person is given small piece of chapatti
instead of one chapatti the law does not operate. But this exception is not correct as this law
states that the units of commodity should be of proper size.
 Intoxicant Commodities: The law is not applicable in case of alcoholic drinks (drunkard person)
where with every additional unit of liquor consumption, the MU increases. However, this violate
the assumption of mental makeup of the consumer.
 Hobbies for rare Commodity: The law is not operational in case of rare commodities such as
monuments, antiques, old coins, documents, stamps etc. collected by people as hobby, where
the MU will increase instead of a decline in it. However, this violates the assumption of
homogeneity and continuity.
 …Continued
 Miser: For a miser, every additional rupee will give more and more pleasure. So, when the
stock of money increases, MU of money tend to rise. However, the behaviour of miser is
irrational. It violates the assumption of rationality
 Power: This is an exception to the law of diminishing marginal utility because when a person
holds some power, the desire for power increases one after the other. Again it violates the
assumption of rationality.
 Money: Since money is a medium of exchange for goods and services so, MU of money
increases with an increase in its stock .That is why MU of money is more for poor people than
for rich individuals.
 …Continued

 Interesting Commodities: The utility of rhymes, poems, songs, books, cinema etc.
gradually increases with additional usage. So MU tends to increase rather than decreasing.
After a point it becomes monotonous and ultimately yields dis-utility

 Alternative use of Commodities: Many products have alternative uses. If a product is used
only for a single purpose, MU will fall but if it used for various purposes, MU will increase.
But this violates the assumption of single use of commodity at a time. For example milk is
used for drinking, sweet, curd, paneer, shake etc. 
Importance of Law of Diminishing Marginal Utility
 Basis of Economic Laws: The law of consumption is primarily based on the law of
diminishing marginal utility. Many other significant laws such as law of demand, law of
equi-marginal utility, and consumer’s surplus are based on it.

 Consumption and Production: The concept of MU forces consumer to continuously shift

their consumption of commodity in order to derive maximum satisfaction. It’s the
consumption pattern of the consumer that increases the demand for different goods
which results in increase in the quantity of production. Consumption and production goes
side by side due to operation of this law.
 …Continued

 Basis for Law of Demand: The law of demand is based on the concept of law of diminishing
marginal utility. Consumer is ready to buy more units of commodity at less price because the
utility derived from these commodities are less, but on the other hand consumer buy less
commodity at high price because the utility derived from it is more. In very simple words,
consumers are ready to pay high price for high utility and less price for low utility of commodity. 

 Base for Law of Equi-Marginal Utility: The law of equi-marginal utility has been developed with
the help of law of diminishing marginal utility to derive maximum satisfaction (i.e. maximum total
utility) out of limited income by replacing one commodity for another. The consumer keeps on
transferring their income from one combination to another combination until the marginal utility
of income from every combination becomes equal.
 …Continued
 Consumer Surplus: The theory of consumer surplus is also based on the concept of diminishing
marginal utility. The consumer buys consecutive units of the product till it attains the point where the
marginal utility of the product is equal to its price. The units of consumption preceding to the point
where MU is zero have more utility although the price is same for all the units. The excess utility such
obtained is termed as consumer’s surplus. 
 Significance in Taxation: The principle of progressive taxation is also centered on the law of
diminishing marginal utility. As the income of a person increases the rate of taxation also increases
because the marginal utility of money falls with the rise in the income of a person.
 Price determination of the commodities: This law answers to the query of price determination of the
commodity. The price of a commodity is determined by its supply. The article whose supply is more,
their utility and price are less in comparison to the commodity whose supply is less.
Limitations of the Law of Diminishing Marginal Utility
The law of diminishing marginal utility forms the basis for various other economic laws. It
guides and help consumers to decide their expenditure but still suffer from following
limitations:

 Unrealistic assumptions: The assumption on which law of diminishing marginal utility is based
are unrealistic. The biggest limitation of this law is that nothing can remain constant in ever
changing era of world.

 Durable Commodities: The concept of MU is generally not applicable in case of durable products
like refrigerators, AC, washing machines, vehicles etc. because the consumption of these
commodities is not continuous in nature and the material value in it doesn’t get exhausted
within a small span of time.

 Marginal utility of money is constant: Utility is measured in terms of money, the value of which
is not constant and certain, it keeps on changing as the price level is highly influenced by the
economic conditions in the country. MU of money initially increases but later on it do get reduce
with the passage of time.
 Concept and Definition
Law of Equi- Marginal
Utility
The law of equi-marginal utility is one of the most important
economic laws which is based on everyday human experiences. This law is
an extension of the ‘law of diminishing marginal utility’. The concept of
equi-marginal principle was first propounded by H.H. Gossen (1810-1858)
of Germany. Hence, it is also called Gossen's second Law. The law of equi-
marginal utility implies that a consumer will distribute his/her income on
number of commodities in such a manner that marginal utility derived
from the last unit of money spent on each good is equal. This law has
various names such as law of maximum satisfaction, law of consumption,
law of economy, law of substitution etc.
 …Continued

Explanation of the Law: The law of equi-marginal utility explains the

behavior of a consumer when he/she consumes more than one
commodity at a time as human wants are unlimited but the income
available to them to satisfy their wants is limited. This law tells us the way
how a consumer maximizes his total utility. It is based on the principle of
obtaining maximum satisfaction from limited income spend on various
commodities. So, we can conclude that equi-marginal utility reveals how
consumers spend their limited income on various combinations of
commodities in such a way that the marginal utility derived from the last
rupee spent on each commodity is equal and the total utility from the
entire consumption should be maximum.
 …Continued

Definition
 According to J.R.Hicks, “The utility will maximize when the marginal unit of
expenditure in each direction bring the same increments of utility.”
 According to Marshall, “If a person has a thing which he can put to several
uses he will distribute it among these uses in such a way that it has the same
utility in all, for if it had a greater marginal utility in one use than another he
would gain by taking some of it from second use and applying into the first.”
It is thus, clear that a 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 spent on each item provides same
marginal utility.
 Assumptions
Law of Equi-Marginal
Utility
Like any other law of economics, this law is also based on some
assumptions which are as follows:

 The price of the goods or services remain constant, which means there is
no change in its price.

 The income of the consumer is fixed.

 The marginal utility of money is constant.

 The utility in equi-marginal principle is measured in cardinal numbers.

 Tastes, fashion, preferences, interest and priorities of consumer remain

unchanged at a particular time duration.
 …Continued

 The behavior of the consumer is rational, who always think of economic

benefit before spending his limited income for maximum satisfaction.

 This law is an extension of law of diminishing marginal utility.

 Consumer spends his money in small amounts.

 Various substitutes for the goods are available in the market.

 Consumer have unlimited wants, so they spend their money in small

lots/amount.
Tabular and Graphical Representation
Law of Equi- Marginal Utility

This concept can be explained with the help of a tabular and

graphical representation. Assume, Krishna has only 10 rupees which
he wants to spend on two commodities: rice and pulses (more than
two commodities can be taken, but for convenience only two
commodities are undertaken for the study of this example). The
utility derived from spending one rupee each on both the items is
mention in the table:
 Tabular Representation
Law of Equi- Marginal Utility
Unit of Money (₹ ) Marginal Utility Marginal Utility
from Rice from Pulses
1 22 (1) 18 (3)
2 20 (2) 16 (5)
3 18 (4) 14 (7)
4 16 (6) 12 (9)
5 14 (8) 10
6 12 (10) 8
7 10 6
8 8 4
9 6 2
10 4 0
Numbers shown in the brackets (1), (2)…. so on is the unit of money spent
by the consumer on purchasing and consuming the commodity.
 …Continued

This table clearly shows how Krishna is spending his limited income on rice

and pulses to derive maximum satisfaction. He spent his first and second unit
of money on consuming rice because he gets 22 and 20 utils of utility which is
higher than 18 utils of pulses. He can spend his third unit of money on rice or
pulses because utility in both the cases are same as 18 units but he will
consume pulses at this level. Similarly, he will spend fourth rupee on rice, fifth
rupee on pulses, sixth rupee on rice, seventh rupee on pulses, eighth rupee on
rice, ninth rupee on pulses and tenth rupee on rice. The last unit of money (i.e.
ninth and tenth) spent on both the commodities gives same marginal utility
equal to 12.
 …Continued
In this manner, Krishna spent total 6 rupees on rice getting the utility equal to
102 (22+20+18+16+14+12) and 4 rupees on pulses getting the utility equal to
60 (18+16+14+12), so the total utility derived from both the commodities by
spending 10 rupees is 162 (102+60). If Krishna spent all the ten rupees in
consuming rice only, the utility will be equal to 130
(22+20+18+16+14+12+10+8+6+4) but if he will spend all ten rupees in
consuming pulses only, the utility will be equal to 90
(18+16+14+12+10+8+6+4+2+0). By the above calculation, it is proved that
consumer will get maximum satisfaction (total utility equals to 162) by
spending his money in consuming more than one commodity rather than
spending the entire money on consuming any one commodity at a time (Total
utility for rice will be 130 and for pulses only 90).
 Graphical Representation
Law of Equi- Marginal Utility

The diagram depicts the concept of equi-marginal utility where unit of money is
shown on X-axis and marginal utility of rice and pulses are shown on Y-axis. Two
downward sloping lines are drawn on the diagram representing the marginal
utility of rice and pulses, which diminishes as the consumer consume more of it.
Krishna will get the maximum satisfaction from his limited income by spending 6
units of money on rice and 4 units of money on pulses. He should stop consuming
any further units where the last unit of money spend on both the commodity
gives equal marginal utility.
 Modern Interpretation
Law of Equi- Marginal Utility
As per the earlier concept of equi-marginal utility, there is no consideration
about different prices of the commodity but in actual perspective, consumers
are always rational while considering the price of the commodity for
purchasing any goods. It is an extended form of the law in which price of
different commodities are also undertaken for taking any decision. Consumer
will spend his limited money on different commodities in such a way that ratio
between marginal utility of first commodity and its price is same as ratio in
second and third commodities’ marginal utility and their respective prices and
so on.
Consumer Equilibrium = = =
etc.
=
Due to the equal ratio in each case between the marginal utility of commodity
and its price, this law of equi marginal utility is called, Law of Proportionality by
modern economists
 Importance
Law of Equi- Marginal Utility
In the area of Consumption

In the area of Production

In the area of Distribution

In the area of Exchange

In the area of Public Finance

In the area of Price Determination

In the area of saving and Investment

In the area of International trade

 Criticisms
Law of Equi- Marginal Utility
The practicability of the assumption of this law is not possible in the real world as
nothing remains constant. Thus, the law has been criticized on the following points
based on assumption:
 Economic Irrationality: This law assumes that consumer are rational in their
behavior. They always consider price of the commodity at the time of purchase.
But in reality, consumer does not always calculate in economic terms and make
impulsive purchase decision.
 Durability of Products: The life of durable products is more than one year so it
becomes difficult to accurately measure its utility over the life time of the product.
Thus, the consumer not only considers the current year utility of the product but
also the utility to be derived in the coming future. As a result, it is very difficult to
equalize the marginal utility derived from various commodities.
 …Continued
 Indivisibility of Goods: This law is applicable on those commodities that can
be divided and consumed in small lots. But in actual life there are various
commodities such as car, refrigerator, washing machine, AC, house etc. which
can neither be divided into small parts for consumption purpose nor can they
be compared with the marginal utility of other commodities. For example,
marginal utility of washing machine cannot be compared with marginal utility
of bananas as washing machine is indivisible good.
 Change in the Price: The price of the commodity never remains constant it
keeps on fluctuating in the market. Therefore, there is change in its utility
also.
 Complementary Goods: This law is not applicable in case of complementary
goods for example car and petrol, pen and ink etc.
 …Continued
 Measurement of Utility: This law assume utility can be measured in terms of
numbers but it is not possible as utility is psychological phenomenon.

 Marginal utility of the Money changes: The law assume the purchasing power of
the money is constant. But in reality the marginal utility of money rises instead of
being constant.

 Habits, Custom and Fashion: This law consider the habit, custom and fashion of
the consumer remains constant but in reality it do get change with the trend in
the market.

 Consumer are rational: As per this law the consumer are rational in their
behavior, but sometime consumer do act irrational due to lack of perfect
knowledge and carelessness in their attitude.