1. Lecture 2
Utility Analysis of Demand

2. Theory of Demand
• Theory of demand explains
– Relation ship between commodity demanded and its
price
– Variations in demand
• There are different approaches known to the
economists relating to theory of demand
• The oldest among them is marginal utility
approach

3. Marginal Utility
• Marginal utility can be defined as
– The change in the total utility resulting from a
one-unit change in the consumption of a
commodity per unit of time
• Marginal Utility
– MU=Change in total utility
Change in quantity consumed

4. Basic Assumptions of Marginal Utility Analysis
• Cardinal Measurement of Utility
– Utility can be measured and the exact measurement can be given by assigning definite
numbers e.g. 1, 2, 3…etc.
– A person can express the satisfaction derived from the consumption of a commodity in
quantitative terms
• Utilities are independent
– Utilities derived from one commodity is independent of other
– The satisfaction derived from the consumption of one good is not affected by
consumption of another good
– Total utility is simply the sum total of the separate utilities of all the goods consumed by
the consumers
• Constant Marginal Utility of Money
– Marginal utility of money remains constant even though the money with the consumer
is decreased by successive purchases made by him
• Introspection
– From one’s own experience it is possible to draw inference about another person
– It means that mind of men work identically in similar situation

5. Law of Diminishing Marginal Utility
• Marshall states the law as:
– The additional benefit a person derives from a
given increase of his stock of a thing diminishes
with every increase in stock that he already has

6. Example
Units (Toasts) Total Utility Marginal Utility
(Units of (Units of
Satisfaction) Satisfaction)
1 20 20
2 38 18
3 53 15
4 64 11
5 70 6
6 70 0
7 62 -8
8 46 -16
Suppose a person starts eating pieces of bread one after another.
The additional satisfaction will go on decreasing with every successive toast till it
drops down to zero.

7. Graphical representation of example
25
20
15
10
1
5
Marginal Utility
0
0
-5 1 2 3 4 5 6 7 8
-10
-15
-20

8. DMU Curve

9. Limitations of the Law
• Suitable Units
– It is assumed that commodity is taken in suitable units. If not
suitable then MU may increase instead of falling.
– e.g spoon of water or glass of water.
• Suitable Time
– Commodity is taken within suitable time otherwise law will not
apply
– e.g taking a glass of water after an hour
• No change in Consumer’s Tastes
– No change of consumer’s taste otherwise law will not apply
• Normal Persons
– Law of MU applies to normal persons and not to abnormal
persons
• Constant Income
– It is essential that income of a person remains constant

10. Limitations of the Law
• Rare Collection
– This law does not hold in case of rare collections
– e.g in case of collection of ancient coins utility increases with having more coins
• Change in Other People’s Stock
– Changes in other people’s stock may increase MU.
– e.g utility of my telephone increases as the number of connection increases
• Other Possessions
– Utility also depends on other possessions we have
– e.g a carriage may be lying useless with us, but as soon as we are able to buy a
horse, its utility goes up
• Fashion
– The utility of my dress goes up when that dress comes in fashion
• Not applicable to money
– The law does not apply to money. More money one has, the more one wants

11. Importance of the Law
• Taxation
– This law forms the basis of theory and practice of taxation
– Progressive system of Taxation
• Richer the person, higher is the rate of tax as MU of money to him is less
• Price Determination
– The law explains why, with increase in its supply, the value of commodity must
fall
– It thus, forms basis of the theory of value
• Household expenditure
– This law governs our daily life. Larger purchase will mean lower MU.
– Therefore, we restrict ourselves to particular commodity
• Downward sloping Demand Curve
– This law tells us why demand curve slopes downwards
• Value-in-use and value-in-exchange
– This law explains the divergence between value-in-use and value-in-exchange
– E.g air has great utility (value in use) but little (value in exchange), because it
has no MU
• Socialism
– The socialist argue on the basis of this law
– The MU of the wealth, that rich might lose, to rich is not so great while to MU
to this amount is great

12. Law of Equi-Marginal Utility
• According to this law
– A consumer is in equilibrium when he distributes
his given money income among various goods in
such a way that marginal utility derived from the
past rupee spent on each good is the same

13. Assumptions
• The main assumptions of the law of equi-
marginal utility are as under:
– Independent utilities.
• The marginal utilities of different commodities are
independent of each other and diminishes with more and
more purchases.
– Constant marginal utility of money.
• The marginal utility of money remains constant to the
consumer as he spends more and more of it on the
purchases of goods.
– Utility is cardinally measurable.
– Every consumer is rational in the purchase of goods.
– Limited money income.
• A consumer has limited amount of money income to spend.

14. Explanation of the 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.
– Law of Substitution, the
– Law of Maximum Satisfaction,
– Law of Indifference,

15. Explanation
• Every consumer has unlimited wants. However, the income at his
disposal at any time is limited.
– The consumer is therefore, faced with a choice among many
commodities that he can and would like to pay
– 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 the
marginal utility of the commodity and its price are just equal.
• The consumer will maximize total utility from his given income
when the utility from the last rupee spent on each good is the
same.

16. Example
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:
Units of Money MU of Tea MU of Cigarettes
1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
Rs.5 Total Utility = 30 Total Utility = 39

17. Explanation of Example
• If the prudent consumer
– spends Rs. 5.00 on the purchase of tea, he gets 30 utility.
– If he spends Rs. 5.00 on the purchase of cigarettes, the
total utility derived is 39 which is higher than tea
• By spending Rs. 4.00 on tea and Rs. 1.00 on
cigarettes, he gets 40 utility (10+8+6+4+12=40)
• By spending Rs. 3.00 on tea and Rs. 2.00 on
cigarettes, he derives 46 Utility (10+8+6+12+10=46)
• By spending Rs. 2.00 on tea and Rs. 3.00 on
cigarettes, he gets 48 utility (10+8+12+10+8=48)
• By spending Rs. 1.00 on tea and Rs. 4.00 on
cigarettes, he gets 46 utility (10+12+10+8+6=46)

18. Diagram
• MU is the marginal utility curve for tea
• KL is marginal utility 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.

19. Limitations of the Law
• Effect of fashions and customs
– The law of equi-marginal utility may become inoperative if people forced by fashions
and customs spend money on the purchase of those commodities which they clearly
know yield less utility but they cannot transfer the unit of money from the less
advantageous uses to the more advantageous uses because they are forced by the
customs of the country
• Ignorance or Carelessness
– Sometimes people due to their ignorance of price or carelessness to weigh the utility of
the purchased commodity do not obtain the maximum advantage by equating the
marginal utility in all the uses
• Indivisible Units
– If the goods are not divisible to equalise MUs, then again the law may become
inoperative.
• Unlimited Resources
• This law does not have apply where there are unlimited resources
• Basic Assumptions
– This law rests upon some questionable assumptions
– E.g we assume that utility can be added and compared while MU of money remains
constant

20. Importance of the Law
• The application of the principle of substitution extends over almost every
field of economic enquiry.
– Every consumer consciously or unconsciously trying to get the maximum
satisfaction from his limited resources acts upon this principle of substitution.
Same is the case with the producer.
– In the field of exchange and in theory of distribution too, this law plays a vital
role. In short, despite its limitation, the law of maximum satisfaction is
meaningful general statement of how consumers behave
• It applies equally to the theory of production and theory of distribution.
– it is applied on the substitution of various factors of production to the point
where marginal return from all the factors are equal.
– The government can also use this analysis for evaluation of its different
economic prices
• The equal marginal rule also guides an individual in the spending of his
saving on different types of assets.
• The law of equal marginal utility also guides an individual in the allocation
of his time between work and leisure
• In short, despite limitations the law of substitution is applicable to all
problems of allocation of scarce resources

21. Consumer’s Equilibrium
• Suppose there are two goods 'x' and 'y' on which the consumer
has to spend his given income. The consumer’s behavior is based
on two factors:
– Marginal Utilities of goods 'x' and 'y‘
– The prices of goods 'x' and 'y‘
– The consumer is in equilibrium position when marginal utility of
money expenditure on each good is the same.
• The consumer is in equilibrium in respect of the purchases of
goods 'x' and 'y' when:
– MUx = MUy
• Where MU is Marginal Utility and P equals Price
Px Py
– If MUx / Px and MUy / Py are not equal and MUx / Px is greater
than
• MUy / Py, then the consumer will substitute good 'x' for good 'y'.
• As a result the marginal utility of good 'x' will fall.

22. Demand
• It is necessary to distinguish between demand and
desire or need
– e.g. a sickly child needs a tonic, a peon desires to have a TV
set
– Such needs and desires do not constitute demand
– Willing to pay and able to pay constitute demand
• Demand for any thing at a given price is the amount of
it which will be bought per unit of time at that price
– It simply means that how much a person will be willing to
buy of a commodity at a certain price in set of possible
prices during some specified period of time
– Demand is always per unit of time e.g. per day, per
week, per month etc.

23. Types of Demand
• Price Demand
– Price demand refers to the various quantities of a
commodity or service that a consumer would purchase at
a given time in a market at various hypothetical prices
• Income Demand
– The income demand refers to the various quantities of
goods and services purchased by the consumers at various
levels of income
• Cross Demand
– The cross demand means the quantities of a good or
service which will be purchased with reference to change
in price not of this good but of other inter-related goods
– These goods are either substitutes or complementary
goods

24. Demand Curve

25. Law of Demand
• A rise in price of a commodity or service is
followed by a reduction in demand a fall in price
is followed by an increase in demand, if
conditions of demand remain constant
– These conditions relate to the consumer’s tastes, his
income, prices of other goods, possibility of other
substitutes, unexpected price change etc.

26. Limitations of the Law
• Change in taste or fashion
– Fashion has gone out so less demand even with decrease in price
• Change in income
– Increase in income may have increased in demand though prices have gone up
• Change in other’s prices
– Decrease in coffee’s price may lead to decrease in demand of tea
• Discovery of substitutes
– E.g CNG Vs Petrol
• Anticipatory changes in prices
– Anticipation that prices will may rise leads to more demand even with increase
in price
• Mark of distinction
– Rich demands more with price increase because it can be considered as mark
of distinction

27. Derivation in of Demand Curve
• Consumer’s equilibrium
– Mux/Px=MUy/Py=MUn/Pn=MUm
• If price of ‘X’ falls
• The equation would be disturbed
• The equality can be restored by purchasing more of ‘X’
• This means that as price of goods falls, its demand
increases

28. Causes of Changes in Demand
• Changes in tastes, preference, fashion
• Climate or weather changes
• Changes in size of composition of population
• Changes in money supply
• Change in price of a commodity
• Change in level of distribution of income
• Change in savings
• Change in asset preferences
• Conditions of trade
• Exceptions or anticipations

29. Short comings of Utility Analysis
• Unsound Psychology
– Market demand is an objective phenomenon while utility theorist try to
explain it in terms of desire, motivation etc.
• Cardinal Measurement – Not possible
• Wrong Assumption of Independent Utilities
– Utilities are interdependent
– E.g increase in demand of pen would lead to increase in demand of paper
• Income effect and substitution effect not brought out
– Income increased due to fall in price
– Income increase due to fall in price of substitution
• Assumption of Constant Marginal Utility of Money is Wrong
• Applies to one-commodity world
• Assumes too much and explains too little

30. Thank You