Utility Analysis

Topics: Utility, Economics, Preference Pages: 5 (1531 words) Published: December 2, 2010
UNIT II: UTILITY ANALYSISConcept of Utility * For effective decision-making, businessmen have to analyze and understand consumer behavior. Every rational human being endeavors to maximize his total utility by selecting the best from the given set of alternatives. * Utility refers to the satisfaction or pleasure that a consumer obtains by consuming the product or service; or want-satisfying ability of a good or service. * The concept of utility has been developed to explain the basic principles of consumer choice and behavior. Choice is different from preference. When we talk about preference, we only express our likes and dislikes. By contrast, a choice is something that we select from our preferred alternatives that suits our budget well. By utility, we mean the level of satisfaction obtained by consuming a good/ service preferred by a consumer. * Given the limited resources, a rational consumer allocates his money in such a way that the preferred combination of goods/services gives him the highest level of satisfaction. |

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approaches to Measurement of Utility There are two approaches, namely cardinalist approach and ordinalist approach, to estimate utility. According to the cardinalist approach, utility can be measured in subjective units, say 10 utils, 20 utils, 30 utils, etc. Conversely, ordinalists feel that utility cannot be measured, but can only be ranked in order of preference (e.g. 1st, 2nd, and 3rd, etc).                     Cardinalist Approach    Ordinalist Approach| Good                     Utility (in utils)              Rank order|    A                        14                              2nd       B                        03                              5th     C                        10                              3rd    D                        08                              4th    E                        17                              1st| * According to the cardinalist approach, we choose a good that gives us maximum utils. In the given example, we select good E as it gives us 17 utils (which is best among the 5 goods). * According to the ordinalist approach, we choose a good that ranks higher among the given set. In the above example, we select good E, as it ranks 1st in the order.Total Utility and Marginal Utility |

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* Total utility is the total satisfaction obtained by a consumer from the consumption of the goods and services. Marginal utility is the additional or extra satisfaction a consumer derives from the consumption of an additional unit of a good or service. * Total utility (TU) increases as long as marginal utility (MU) is positive. TU reaches maximum when MU is zero (0). When MU is negative, TU decreases. Units of Good X | Total Utility | Marginal Utility | |

0 | 0 | 0 |
1 | 10 | 10 |
2 | 18 | 8 |
3 | 24 | 6 |
4 | 28 | 4 |
5 | 28 | 0 |
6 | 26 | -2 |
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Total Utility and Marginal Utility: A Graphical Representation In the figure, total utility and marginal utility curves are drawn assuming that the law of diminishing marginal utility is operating. Thus, as the quantity consumed per period increases, the total utility initially increases at a decreasing rate, reaches maximum (known as satiation point) and then declines. Total utility is at maximum, when marginal utility is equal to zero and TU declines when MU of the good becomes negative. |  |

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Law of Diminishing Marginal Utility According to the law of diminishing marginal utility, the additional utility of any good tends to decline as successive units of a given product are consumed over a definite period of time.| |

The table shows the operation of law of diminishing marginal utility. If you eat one Cadbury chocolate, you get some satisfaction. If you eat a second Cadbury chocolate, you may get satisfaction, but lesser than that of the first one. If somebody offers you another Cadbury chocolate, you may be reluctant...