Utility Analysis in Economics

UTILITY ANALYSIS

What is utility: The quality of a good or service, which satisfies human wants, is called utility. The utility is the ability to satisfy human wants.

Example: If a person is thirsty and he drinks water to quench his thirst, it means that water has the quality to satisfy his thirst. This quality of water is called utility.

Characteristics / Features of Utility:

Utility is not equated with usefulness: A good that might have the capacity to satisfy a particular want but it might not be useful for a consumer, such as alcohol provides utility for the liquor but it is harmful. 

Utility is a psychological concept: It means that the satisfaction obtained from the consumption of a good or service, depends on the mental aspect of the person. 

Utility is always individual and relative: Utility differs from person to person. A different person will get different utility or satisfaction from the same commodity.  Even it varies in different situations and places too. For example—a person might get more utility in woolen clothes during the winter than in summer or at hills than at plains.

Utility has no moral or ethical significance: Utility refers to the want satisfying capacity of a good or service and it has no moral or ethical consideration.

Utility cannot be measured objectively:  Utility is a subjective concept and can not be measured objectively or in cardinal numbers.

Utility depends on the intensity of wants:  It depends on the intensity of wants. for example- if a consumer is thirsty, he has utility in water. As soon as his wants satisfied, he might not get the utility in the water.

Utility is different from pleasure:  A commodity that has utility, may not necessarily give any pleasure to the consumer. for example, medicine or injection provides utility for the patients but it does not give any pleasure.

Utility and satisfaction: Utility is the quality to satisfy human wants whereas satisfaction is the result of utility.

Measurement of Utility:

There are two approaches to measuring the utility.

1. Cardinal Utility

2. Ordinal Utility

Cardinal Utility: Classical economists, Bentham, Leon Walrus, Carl Menger, and new classical economist Dr. Alfred Marshall believed that the utility is a quantifiable entity that can be measured by assigning definite numbers such as 1, 2, 3, etc.

 According to Dr. Marshalls, it can be measured in terms of money. Util is the measuring scale to measure utility (One util equals a unit of money). For example, if the utility of apples is 10 utils and orange is 20 utils, so we can say that the utility of orange is double that of the apples.

This approach is useful to study combinations of two goods as it attempts to measure utility in cardinal numbers. It is also helpful to explain the Law of diminishing marginal utility, consumer surplus, and the law of demand.

Ordinal Utility: Modern economists most notably J.R. Hicks and Allen gave the concept of ordinal utility. According to them, we cannot measure utility in quantitative terms as it is a psychological concept. We can only express it in terms of less or more useful goods and according to it; we can assign a rank to them.

For example, we can tell that the orange is better than the apple but cannot measure the value of how much better is it. In such a case, orange can be given RANK-1 and apple RANK-2 by the consumer.

Ordinal Utility is normally used for surveys and questionnaires.

Types of Utility

1. Form Utility: It is created by changing the form or shape of the materials. Wood is used to make finished products like furniture, which adds significant value for the customer and increases the form of utility.

2. Place Utility: This utility is created by transporting goods from one place to another. When apples from Himachal Pradesh are transferred to South India, where the demand for apples is more, thus creates the place utility. 

3. Time Utility: When any commodity is stored for a certain period and it is sold when the demand is high, traders sell it at a higher rate and derive profits from the time utility. Storing, hoarding, and preserving selected goods over a period of time may create time utility. 

4. Service Utility: It is attained through specialized knowledge and skills. The services of doctors, teachers, lawyers, etc. are examples of service utility.

 

Kinds of Utility

Marginal Utility: It can be defined as the change in total utility resulting from one unit change in the consumption of a commodity per unit of time. According to Marshall, “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.”

In other words, change in the total utility resulting from the change in the quantity of the commodity consumed is called marginal utility.

Marginal Utility = Change in total utility/change in the number of units consumed

When a consumer consumes a particular good, from each next unit, he receives less utility than the previous one. When he gets the utility from the units of a good, it is positive, ultimately a situation comes when the utility becomes zero and if the use of the good is still continued, then the next unit will give disutility. In other words, we will derive negative utility.

Total Utility: Utility gained from all the units of the commodity is called total utility. Suppose, if a person is using 5 units of the commodity to satisfy his want, the sum of the utility gained from all 5 units of the good, is called total utility.

TU_x = ∑MU_x

Total utility is the total satisfaction received from consuming a given total quantity of a commodity, while the marginal utility is the satisfaction gained from consuming an additional quantity of that commodity.

Average Utility: It is the utility in which the total utility of consumption of a good is divided by the number of total units.

Average Utility =  Total Utility of the good / Total Units of the good

The Law of Diminishing Marginal Utility: It is also called Gossen's First Law. It is one of the fundamental laws of economics. It states that as quantity consumed of commodity increases, the utility derived from each successive unit decreases, consumption of all other commodities remaining the same.

For example, if a person starts eating bread one after another, the first bread gives more satisfaction to him as his intensity of want is more. By the time he starts eating the second one, he receives less utility in comparison to the first one. The satisfaction of the third one will be less than the previous one and so on. The additional satisfaction decreases with every successive bread until it drops down to zero. And if the consumer is forced to eat more, the utility may become negative.
Take a look at the table and diagram below.

Basic Assumptions of Marginal Utility Analysis

Cardinal Measurement of Utility: It is assumed that utility is a quantifiable entity and can be measured by assigning definite numbers such as 1, 2, 3, etc.

Utilities are independent: It is assumed that the utilities of different commodities are independent of one another. In other words, the utility derived from the consumption of one good is the function of that good alone and not of another.

Constant marginal utility of money: It is assumed that the marginal utility of a commodity varies with the quantity of the commodity purchased, but the marginal utility of the money remains constant. This assumption becomes necessary because we measure the marginal utility of a commodity in terms of money.

Reasonable Quantity: It is assumed that a reasonable quantity of each unit of a commodity is consumed. For example, if a thirsty person is given water in a spoon, then every additional spoon will give him more utility. For the application of this law, the commodity should be taken in suitable units.

Homogeneous: The quality of each unit of a commodity should be the same for the application of this law. 

Continuity: It is assumed that the consumption of a commodity is continuous. Only then, this law will be applicable. 

Rationality: Consumer should be rational in behavior so that he/she can maximize total satisfaction from the given income and prices of goods.

Limitations of this Law

• There should be no change in consumer’s tastes, income, and habits.
• This law does not apply to money as it is said that the more money he/she has, the more he/she wants.
• In the case of rare collection, this law will not be applicable. For example, If a man is fond of collecting ancient coins or stamps, the more he is able to collect, the greater satisfaction he will get.
• This law only applies to normal people. In case, the person behaves irrationally, the law will not hold good.
• This law is not applicable to durable goods such as refrigerators and furniture. This is because the consumption of these goods is not continuous in nature.
• This law is not applicable for complimentary goods
• In some cases, utility changes not because of a change in what we have but because of a change in other people's stock. Suppose if I have a rival collecting old coins and somehow he loses his collection, the utility of my collection automatically goes up. In the same manner, for me, the utility of my telephone increases as the number of telephone connections increases.

Importance of this law

• This law is helpful in deriving the law of demand, the law of substitution, and consumers' surplus.
• This law helps in formulating fiscal policy. High tax is imposed on the rich people and low taxes to the poor.
• This law helps the consumer to spend his money in such a way that he gets maximum satisfaction with a minimum income.
• The government implies this law to reduce the unequal distribution of wealth as the marginal utility of money, for the rich, is low and for the poor, it is comparatively, higher.
• It is also useful in price determination. The price of goods depends on utility so the seller must reduce the price if he wants to sell more quantity of goods.

The relation between Marginal Utility and Total Utility

Explanation: When a consumer goes on taking the units of a good, he meets with the less and less utility of successive unit. When his want is completely satisfied, he gets zero utility and even if he continues taking the additional unit, it turns in negative.

The total utility goes on increasing but at a diminishing rate. It’ll be maximum when the marginal utility is zero. It starts decreasing when marginal utility is negative.

Dr. Swati Gupta

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