Theory of Consumption - Utility Analysis

The Theory of consumption

Assumptions: In the Theory of Consumption we try to analyze the behaviour of the consumer. We try to find out how a consumer tries to satisfy his economic wants. But before we try to analyze his behaviour, we make the following assumptions about the behaviour of the consumer.

1. A consumer has a fixed amount of income.

2. The end of the consumer is to get the maximum satisfaction out of his consumption.

3. The consumer will act rationally.

Techniques: Economists have introduced techniques for the analysis of the behaviour of the consumer.

1. Utility Analysis
2. Indifference Curve Analysis
3. Revealed Preference Analysis

1. Utility Analysis

Introduction: The Utility Analysis was introduced by Mr. Alfred Marshall in 1890, when he published his book "The Principles of Economics."

Meaning of Utility: The aim of man is to satisfy his economic wants. So he uses the goods and services. Thus anything that has the power to satisfy the economic wants of man is said to possess utility.

Measurement of Utility: There are two different opinions among the economists for the measurement of utility.

According to one group of economists it is possible to measure the utility by the amount of money that one spends for the commodity. These economists are known as the Cardinalists.

According to another group of economists it is not possible to measure the utility because utility is abstract. These economists are known as the Ordinalists.

Law of diminishing Utility: If we increase the consumption of a particular commodity, the total utility will increase up to a certain point at a diminishing rate, and the marginal utility will decrease. Marginal utility is the utility derived from the last unit of the commodity consumed.

On the basis of the above table, we can draw the following diagram to explain the Law.

For a hungry person the utility of the first apple is quite high. But after eating the first apple, he may feel even more hungry. So the second apple fetches even higher utility. Thus utility, derived from the second apple eaten, increases. Total utility here is the sum total of utility derived from the first as well as the second apple. After eating the third apple he may start feeling less hungry. So the third apple fetches lesser utility than the second. Thus, marginal utility, that is the utility derived from the last apple consumed, starts diminishing. The fourth apple fetches even less. This way marginal utility keeps on diminishing. Hence the Law of Diminishing Utility. However, the total utility keeps on increasing, though at a diminishing rate.

Consumer Equilibrium: Meaning: The aim of the consumer is to satisfy his economic wants. The position where the consumer gets the maximum satisfaction out of his total consumption is said to be the consumer's equilibrium position. At this position, the consumer is so satisfied that he is not willing to make any alterations in his pattern of consumption.

Law of Equimarginal Utility: In order to find out the consumer's equilibrium position Mr. Marshall has introduced the Law of Equimarginal Utility. It is also known as the Law of Substitution. It is also known as the Law of Maximum Satisfaction.

Assumptions of the law: In order to find out the consumer's equilibrium position with the help of the Law of Equimarginal Utility, we make the following assumptions.

1. The consumer has a fixed amount of income and he will spend the whole income on the commodities, which are available in the market.

2. There are only two commodities, namely X and Y, available in the market.

3. These two commodities are finely divisible.

4. The consumer acts rationally.

Statement of the law: According to the Law of Equimarginal Utility, the consumer will be at equilibrium when the marginal utility of money spent on one commodity is equal to the marginal utility of money spent on another commodity. In order to find out this, Mr. Marshall has introduced the following formula:

Marginal utility of X /Price of X = Marginal utility of Y/Price of Y

When these two are equal, the consumer is said to be in an equilibrium position.

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