Economics · Chapter 3
Study notes aligned to the official NEB syllabus.
The person who purchases goods and services for their own consumption is known as a consumer. The study of the behaviour of an individual consumer or household is called consumer behaviour.
The power contained in goods and services to satisfy human wants is known as utility. The satisfaction that a consumer derives from the consumption of the goods and services they buy is called their utility.
There are two approaches to the theory of consumer behaviour:
i. Cardinal utility: Cardinal utility was propounded by Alfred Marshall. When the consumer consumes goods and services and gets utility in a numerical form such as 1, 2, 3, 4, 5 and so on, it is called cardinal utility. It is measured in an imaginary unit known as utils.
ii. Ordinal utility: The concept of ordinal utility was propounded by Edgeworth and Fisher in the early 20th century. Later it was popularized by Pareto. It assumes that utility from any goods and services cannot be measured in numbers, but that the satisfaction obtained can be ranked in the order of 1st, 2nd, 3rd and so on. The common assumption of both concepts is that the consumer is rational while consuming goods and services.
1. Total Utility (TU): The total satisfaction derived from various units of consumption of goods and services is known as total utility. It is the utility derived from the total units consumed. Total utility can also be defined as the sum of marginal utility that a consumer derives from the continuous consumption of a commodity. It is expressed in an imaginary unit, i.e. utils. Symbolically,
$$ \begin{aligned} TU &= \sum MU \ &= MU_1 + MU_2 + \dots + MU_n \end{aligned} $$
Where $TU$ = total utility, $\sum$ = sum and $MU$ = marginal utility.
2. Average Utility (AU): Average utility is the per unit utility of a commodity consumed by a consumer. It is the outcome of total utility divided by the units of commodity consumed at a particular point of time:
$$AU = \frac{TU}{Q}$$
Where $AU$ = average utility, $TU$ = total utility and $Q$ = quantity consumed.
3. Marginal Utility (MU): The additional utility derived from the consumption of an additional unit of a commodity is known as marginal utility. It is also defined as the ratio of the change in total utility to the change in the quantity of a commodity consumed:
$$MU = \frac{\Delta TU}{\Delta Q_x}$$
Where $\Delta$ = small change, $MU$ = marginal utility, $TU$ = total utility and $Q_x$ = quantity of commodity.
In other words,
$$MU = TU_n - TU_{n-1}$$
Total utility is the sum of marginal utility (MU), average utility (AU) is the per unit utility, and marginal utility is the additional utility derived by the consumer in the process of consumption. The derivation is presented in the following table.
Table 2.1: Derivation of TU, AU and MU
| Quantity consumed (Q) | Marginal Utility (MU) | Total Utility (TU) | Average Utility (AU) |
|---|---|---|---|
| 1 | 10 | 10 | 10 |
| 2 | 8 | 18 | 9 |
| 3 | 6 | 24 | 8 |
| 4 | 4 | 28 | 7 |
| 5 | 2 | 30 | 6 |
| 6 | 0 | 30 | 5 |
| 7 | -2 | 28 | 4 |
Diagram: Total utility rises and becomes maximum at the point where marginal utility is zero (6th unit), then falls; the marginal utility curve slopes downward, cuts the horizontal axis at the 6th unit and becomes negative, while average utility falls throughout (Fig. 2.1, see textbook).
In part A of the figure, total utility initially increases and becomes maximum at the top point, then falls along with the increase in quantity consumed. In part B, marginal utility becomes zero at the 6th unit of consumption (where total utility is maximum) and then becomes negative, while average utility falls along with the increase in quantity consumed.
The law of diminishing marginal utility was propounded by Herman Heinrich Gossen in 1854, so it is also known as the first law of Gossen. But the credit for making it popular goes to the neo-classical economist Alfred Marshall, who developed the law in a scientific way in his book 'Principles of Economics' in 1890. This law was developed on the consumer's psychology regarding the consumption of a commodity.
The law of diminishing marginal utility states that when a rational consumer consumes more and more units of a commodity, then marginal utility falls.
Assumptions:
Table 2.2: Law of Diminishing Marginal Utility
| Quantity Consumed | Marginal Utility |
|---|---|
| 1 | 10 |
| 2 | 8 |
| 3 | 6 |
| 4 | 1 |
| 5 | 2 |
| 6 | 0 |
| 7 | -2 |
(The marginal utility at the 4th unit is shown as 1 in the source. This interrupts the otherwise decreasing sequence, so it appears to be a slip in the source, but the value is left as printed.)
In the above table, when the consumer consumes the 1st unit the marginal utility is 10, and as he or she increases the units the marginal utility falls. At the 6th unit consumed, marginal utility becomes zero, which is called full satisfaction, and then it becomes negative.
Diagram: Marginal utility curve sloping downward from left to right, cutting the horizontal (quantity) axis at the 6th unit and then turning negative (Fig. 2.2, see textbook).
The person who purchases goods and services for their own consumption is known as a consumer. The study of the behaviour of an individual consumer or household is called consumer behaviour.
The power contained in goods and services to satisfy human wants is known as utility. The satisfaction that a consumer derives from the consumption of the goods and services they buy is called their utility.
There are two approaches to the theory of consumer behaviour:
i. Cardinal utility: Cardinal utility was propounded by Alfred Marshall. When the consumer consumes goods and services and gets utility in a numerical form such as 1, 2, 3, 4, 5 and so on, it is called cardinal utility. It is measured in an imaginary unit known as utils.
ii. Ordinal utility: The concept of ordinal utility was propounded by Edgeworth and Fisher in the early 20th century. Later it was popularized by Pareto. It assumes that utility from any goods and services cannot be measured in numbers, but that the satisfaction obtained can be ranked in the order of 1st, 2nd, 3rd and so on. The common assumption of both concepts is that the consumer is rational while consuming goods and services.
1. Total Utility (TU): The total satisfaction derived from various units of consumption of goods and services is known as total utility. It is the utility derived from the total units consumed. Total utility can also be defined as the sum of marginal utility that a consumer derives from the continuous consumption of a commodity. It is expressed in an imaginary unit, i.e. utils. Symbolically,
Where = total utility, = sum and = marginal utility.
2. Average Utility (AU): Average utility is the per unit utility of a commodity consumed by a consumer. It is the outcome of total utility divided by the units of commodity consumed at a particular point of time:
Where = average utility, = total utility and = quantity consumed.
3. Marginal Utility (MU): The additional utility derived from the consumption of an additional unit of a commodity is known as marginal utility. It is also defined as the ratio of the change in total utility to the change in the quantity of a commodity consumed:
Where = small change, = marginal utility, = total utility and = quantity of commodity.
In other words,
Total utility is the sum of marginal utility (MU), average utility (AU) is the per unit utility, and marginal utility is the additional utility derived by the consumer in the process of consumption. The derivation is presented in the following table.
Table 2.1: Derivation of TU, AU and MU
| Quantity consumed (Q) | Marginal Utility (MU) | Total Utility (TU) | Average Utility (AU) |
|---|---|---|---|
| 1 | 10 | 10 | 10 |
| 2 | 8 | 18 | 9 |
| 3 | 6 | 24 | 8 |
| 4 | 4 | 28 | 7 |
| 5 | 2 | 30 | 6 |
| 6 | 0 | 30 | 5 |
| 7 | -2 | 28 | 4 |
Diagram: Total utility rises and becomes maximum at the point where marginal utility is zero (6th unit), then falls; the marginal utility curve slopes downward, cuts the horizontal axis at the 6th unit and becomes negative, while average utility falls throughout (Fig. 2.1, see textbook).
In part A of the figure, total utility initially increases and becomes maximum at the top point, then falls along with the increase in quantity consumed. In part B, marginal utility becomes zero at the 6th unit of consumption (where total utility is maximum) and then becomes negative, while average utility falls along with the increase in quantity consumed.
The law of diminishing marginal utility was propounded by Herman Heinrich Gossen in 1854, so it is also known as the first law of Gossen. But the credit for making it popular goes to the neo-classical economist Alfred Marshall, who developed the law in a scientific way in his book 'Principles of Economics' in 1890. This law was developed on the consumer's psychology regarding the consumption of a commodity.
The law of diminishing marginal utility states that when a rational consumer consumes more and more units of a commodity, then marginal utility falls.
Assumptions:
Table 2.2: Law of Diminishing Marginal Utility
| Quantity Consumed | Marginal Utility |
|---|---|
| 1 | 10 |
| 2 | 8 |
| 3 | 6 |
| 4 | 1 |
| 5 | 2 |
| 6 | 0 |
| 7 | -2 |
(The marginal utility at the 4th unit is shown as 1 in the source. This interrupts the otherwise decreasing sequence, so it appears to be a slip in the source, but the value is left as printed.)
In the above table, when the consumer consumes the 1st unit the marginal utility is 10, and as he or she increases the units the marginal utility falls. At the 6th unit consumed, marginal utility becomes zero, which is called full satisfaction, and then it becomes negative.
Diagram: Marginal utility curve sloping downward from left to right, cutting the horizontal (quantity) axis at the 6th unit and then turning negative (Fig. 2.2, see textbook).