Basic Assumptions of Marginal Utility Analysis

Gazu Lakhotia Basic Assumptions of Marginal Utility Analysis We shall first mention a few basic assumptions on which the marginal utility analysis is based. We shall see later how the marginal utility analysis has been criticized on the ground that the assumptions on which it is based are unrealistic or invalid. The following are the main assumptions: Basic Assumptions of Marginal Utility Analysis We shall first mention a few basic assumptions on which the marginal utility analysis is based. We shall see later how the marginal utility analysis has been criticized on the ground that the assumptions on which it is based are unrealistic or invalid. The following are the main assumptions: (i) Cardinal Measurement of Utility. Marginal utility analysis assumes in the first place that utility can be measured and the exact measurement can be given by assigning definite numbers such as 1, 2, 3, etc. That is, it is assumed that utility is a quantifiable entity. This means that a person can express the satisfaction derived from the consumption of a commodity in quantitative terms. He can say, for instance, that for him the first unit of the commodity has utility equal to 10, the second unit 8, and so on. In this way, it is possible for a consumer to compare the utilities of different goods. If for example, fruit has for him utility 20 and sweets 10, then he can say, that for him the utility of fruits is double that of sweets. Utility is usually measured in imaginary units. (ii) Utilities are Independent. Marginal utility analysis assumes that the utilities of different commodities are independent of one another. That is, the utility of one commodity does not in any way affect that of another. In other words, the satisfaction desired from the consumption of one good is the function of that good alone and is not affected by the consumption of another. It depends on the quantity consumed of one good and not of another. On this assumption, the total utility of all goods consumed by a consumer is simply the sum total of the separate utilities of all the goods consumed by a consumer. Thus, according to this assumption, the utilities of various goods are additive i.e. separate utilities of the various goods can be added to obtain the total sum of the utilities of all goods consumed. (iii) Constant Marginal Utility of Money. Another important assumption of the marginal utility analysis is that the marginal utility of money remains constant even though the quantity of money with the consumer is diminished by the successive purchases made by him. It is assumed that while marginal utility of a commodity varies with the quantity of the commodity purchased, the marginal utility of money remains throughout the same as the quantity of the good purchased varies. This assumption becomes necessary because the marginal utility of a commodity is measured in terms of money. It is considered desirable that the measure itself should not keep changing. When a person purchases more of a good, the amount of money with him must diminish and the marginal utility of money must increase.

But this variation in the marginal utility of money is ignored and it is assumed to remain constant throughout.

Practical Importance of the Law of Diminishing Marginal Utility

Gazu Lakhotia Practical importance of the law of Diminishing Marginal Utility The law of Diminishing Marginal Utility has enormous sensible importance. It is used in the discussion of various aspects of economic theory. For example, it is applied to the discussion of the theory of value. The law of Diminishing Marginal Utility furnishes the basis for the law of demand which together with the law of supply influence the determination of value Practical importance of the law of Diminishing Marginal Utility The law of Diminishing Marginal Utility has enormous sensible importance. It is used in the discussion of various aspects of economic theory. For example, it is applied to the discussion of the theory of value. The law of Diminishing Marginal Utility furnishes the basis for the law of demand which together with the law of supply influence the determination of value. In actual life, our attention is always focused on the marginal utility. We are always weighing the utility of buying a little more or a little less of a thing, and we think whether instead we could buy a little more or a little less of something else. It is through the margin that the law of substitution works, and we are able to arrange our expenditure in such a mariner as to derive the maximum satisfaction. The margin helps us in the utilization of scarce means for the satisfaction of our multiple wants. It determines which wants are to be satisfied and to what extent. As such its practical importance both to the general consumer and to the businessman can hardly be exaggerated. It is this law which tells us why demand curves slope downwards. As the consumer buys more of a thing, its marginal utility to thq consumer falls, Therefore, the consumer will be prepared to buy more quantity of the good only when the price of the good falls so as to be equal to the reduced marginal utility. Thus, the law of demand, owing to which the demand curve slopes downwards, is based upon the law of diminishing marginal utility of a good. As law of diminishing marginal utility applies to money too, this forms the basis of the theory and practice of taxation. It is a common knowledge that the value of money to a rich man is not so great as it is to a poor man. All governments have taken note of it and they have based their system of taxation on it. There is a system of progressive taxation in the case of incomes according to which higher incomes are taxed at higher rates. Thus the theory and practice of taxation is based upon the law of diminishing utility. The advocates of socialism also take their stand on the law of diminishing utility. They advocate economic equality because the sacrifice of the rich will not be as great as the benefit to the poor. This is so because the utility of money to the rich is less than to the poor. This law also explains the familiar "diamond-water paradox". Diamonds command high price because of their high marginal utility, which is due to scarcity. Water, on the other hand, is in abundant supply so that its marginal utility is low and hence it has low price. Thus, the law of

diminishing marginal utility explains why diamonds are high-priced as compared with water, even though the latter is indispensable for life

Criticism of the Law of Diminishing Marginal Utility

Gazu Lakhotia FOLLOW Criticism of the law of Diminishing Marginal utility Now let us consider the objections raised against this law and how far these objections are valid. According to the Law of Diminishing Marginal Utility, as we have more and more of a particular commodity, its marginal utility (i.e., additional utility from successive units) goes on falling. The main objections leveled against this law are as under: Criticism of the law of Diminishing Marginal utility Now let us consider the objections raised against this law and how far these objections are valid. According to the Law of Diminishing Marginal Utility, as we have more and more of a particular commodity, its marginal utility (i.e., additional utility from successive units) goes on falling. The main objections leveled against this law are as under: 1. Utility is Relative. The law of Diminishing Marginal Utility is based on the assumption of independence of utilities, i.e., the utility which a consumer derives from a commodity depends on the quantity of that commodity only. In this world, where quantity of one commodity bought depends not only on its own quantity and price but also on the quantities and prices of other commodities needed. It is hardly real to say that the desire to have still more of a particular commodity, as we have more and more of it, is simply the result of its own influence on satisfactions. In this view utility is relative and not independent as the law of Diminishing Marginal Utility assumes. 2. Utility is Immeasurable. One of the pivotal assumptions of the law of Diminishing Marginal Utility is that utility is measurable. In other words, it is assumed that it is possible to express the utility or satisfaction which a person derives from a good in quantitative terms. Accordingly, a person can say that he gets utility equal to 15 units from the consumption of the first unit of a commodity and 10 units from the second unit of it, and so on. But it has been contended by modern economists that utility relates to the state of mind of an individual. Thus it is a subjective concept and is incapable of being measured quantitatively. 3. Marginal Utility of Money Variable. Another pillar on which the law of Diminishing Marginal Utility stands is that the marginal utility of money is constant. Thus the law

assumes that while the marginal utilities of commodities diminish as more and more of them are consumed, the marginal utility of money remains constant throughout the process of consumption. But this is contrary to what happens actually. As more and more is spent on the purchase of a commodity, and less and less of money is left with the purchase, the marginal utility of money goes on increasing. Thus the init of measurement itself is variable. In this context it is fallacious to use money as the measuring rod of utility. 4. The law of Diminishing Marginal Utility is not universally applicable. The law does not apply to all types of commodities and persons. A drunkard gets more satisfaction on taking successive cups of wine. Greed increase with more money ( with some people). In short, the fundamental defect in the law of Diminishing Marginal Utility is that all its attention is focused on a single commodity. Actually a consumer is thinking of many other things that he could buy with the same sum of money. That is why it is more proper to express consumers demand in terms of his scale of preferences.

Main Shortcomings of Utility Analysis

Gazu Lakhotia Main Shortcomings of Utility Analysis The utility analysis refers to the theory of consumer demand propounded by Marshall. This theory is based on the cardinal measurement of utility and on certain utilitarian premises. The marginal utility analysis has developed two laws, viz., the law of diminishing marginal utility and the law of equi-marginal utility and with the help of these two laws of consumer behavior, it has derived the law of demand. But this analysis suffers from the following shortcomings: Main Shortcomings of Utility Analysis The utility analysis refers to the theory of consumer demand propounded by Marshall. This theory is based on the cardinal measurement of utility and on certain utilitarian premises. The marginal utility analysis has developed two laws, viz., the law of diminishing marginal utility and the law of equi-marginal utility and with the help of these two laws of consumer behavior, it has derived the law of demand. But this analysis suffers from the following shortcomings: (i) The utility analysis assumes that utility is cardinally measurable, i.e., it can be assigned definite numbers. But it is wrong to say that utility can be measured cardinally. Utility is subjective and as such it cannot lie measured. We can only say whether satisfaction is more or less. We cannot say exactly how much. That is, ordinal measurement is possible and not cardinal measurement. (ii) The utility analysis further assumes that utilities are independent. That is why it is said that utility of a commodity varies with its quantity and of that commodity alone. But the fact is that commodities are interlinked and the utility of one is influenced by that of another.

(iii) Besides, the utility analysis does not fully bring out the income effect and substitution effect of a change in price. It is unable to explain how much of the increased demand for a commodity is due to the income effect and how much to the substitution effect when price of the commodity has changed. As Hicks says, "The distinction between direct and indirect effects of a price change is accordingly left by the cardinal theory as an empty box, which is crying out to be filled." (iv) Also, the utility analysis assumes that the marginal utility of money remains constant as a consumer goes on spending the money on the purchase of a commodity. This is not correct, because as the amount of money goes on decreasing, its marginal utility must rise. (v) Finally, the utility analysis fails to explain the demand for certain commodities which are big and indivisible, e.g., a house, a car. In view of these shortcomings of the utility analysis, modern economists have adopted a new technique, called the indifference curve technique, to explain consumer demand.

Limitations of the Law of Equi-marginal Utility

Limitations of the Law of Equi-marginal utility Like other economic laws, the Law of Equimarginal Utility too is a mere statement of a tendency. The actual expenditure of individuals may not actually conform to this law. This may be due to the following limitations: 1. No Rational and Conscious Calculations- The Law of Equi-marginal Utility involves very careful calculations of the expected satisfaction and its comparison with the amount of money spent as well as with the satisfaction which may be derived by spending the same amount of money in some other direction. But how many of us are competent of making such fine calculations? How many of us have the patience and the ability to do it? Are we all so rational and calculating? Limitations of the Law of Equi-marginal utility Like other economic laws, the Law of Equi-marginal Utility too is a mere statement of a tendency. The actual expenditure of individuals may not actually conform to this law. This may be due to the following limitations: 1. No Rational and Conscious Calculations- The Law of Equi-marginal Utility involves very careful calculations of the expected satisfaction and its comparison with the amount of money spent as well as with the satisfaction which may be derived by spending the same amount of money in some other direction. But how many of us are competent of making such fine calculations? How many of us have the patience and the ability to do it? Are we all so rational and calculating? The fact is that most of our expenditure is governed by habit. There is not much of conscious calculation and careful weighing of the utilities. Only in the case of big expenditure, a prudent person goes through a certain amount of thinking. Here we may take it that this expenditure does roughly conform to the law of Maximum Satisfaction. The utmost that we can say is that all rational and prudent persons are expected to act upon this law consciously or unconsciously 2. Ignorance of Consumers- Ignorance of consumers imposes another limitation. The consumers may not be aware of other useful alternatives. Hence no substitution takes place and the law of substitution does not operate. 3. Customs and Fashions-People are sometimes slaves of custom or fashion and are incapable of rational consumption. Without being rational and calculating a consumer cannot substitute one thing for another. This is another limitation of the law. 4. Indivisibility of Goods- Another limitation arises from the fact that all goods are not divisible into small bits to enable consumers to equalize marginal utilities. In actual practice, therefore, the marginal utilities cannot be equalized. The law remains only on a theoretical plane.

5. No Fixed Accounting Period- There is no definite budget period in the case of individuals. Even if there is a fixed accounting period, the application of this principle is rendered difficult by the varying degrees of durability of the goods consumed. A durable goods is available for consumption in several succeeding accounting periods. It is not, therefore, easy to bring it into the account of income and expenditure of a particular accounting period to see if satisfaction has been maximized during that period. 6. Questionable Assumptions- In the theory of consumer's equilibrium, the basic criticism of the law of Equi-marginal utility is that it rests on some questionable assumptions. For example, we assume that utilities can be added and compared; that during successive purchases, the marginal utility of money to the consumer remains constant .The modem economists criticize both these assumptions. The indifference curve approach to the theory of consumer's equilibrium is based on this basic criticism of the Marshallian analysis. In spite of these points of criticism, the law of equi-marginal utility occupies a very important place in economic theory. Whether it is a case of consumer's equilibrium, producer's equilibrium, allocation of resources or distribution of the national income among the productive resources, this law has a determining influence according to Marshallian analysis.

Derivation of the Law of Demand from the Law of Equimarginal Utility

Gazu Lakhotia Derivation of the Law of Demand from the Law of Equimarginal Utility Price is one of the factors which bring about a change in demand. But in this case the change is called extension or contraction of demand. There are, however, several other factors which can bring about a change in demand independently of a change in price. In such cases, we shall say that the demand has really increased or decreased as distinguished from mere extension or contraction. T Derivation of the Law of Demand from the Law of Equimarginal Utility Price is one of the factors which bring about a change in demand. But in this case the change is called extension or contraction of demand. There are, however, several other factors which can bring about a change in demand independently of a change in price. In such cases, we shall say that the demand has really increased or decreased as distinguished from mere extension or contraction. These factors are: (i) Changes in Tastes and Fashions-Increase in the habit of tea drinking has decreased the demand for milk. The fashion among ladies to keep hair long or short brings about changes in demand for hair-pins, hair nets, etc. (ii) Climatic or Weather Changes- In winter there is a great demand for warm clothing and in summer there is a demand for electric fans and cold drinks. (iii) Change in Population- Influx of new people will create demand for the good they are in the habit of consuming. A change in the composition of the population will also affect demand, if, for instance, on account of a war a large number of young persons are dead, then this will mean a decrease in the number of marriages and a decrease in commodities required for marriages. (iv) Changes in the Amount of Money-When there is inflation, it causes a great increase in demand which leads to a rise in prices. (v) Changes in Real Income-When things become cheap, the people are able to buy more, and it is said that their real income has increased. Less money will be needed to purchase the same quantity of the good and the saving so made will find outlet in the purchase of some other commodities. Thus the demand schedule will have to be recast. (vi) Change in Wealth Distribution- When wealth is more evenly distributed, the goods demanded by the people who have acquired more wealth will increase and the demand of the people who have lost wealth will decrease. (vii) Goods with Inter-connected Values- For example, in the case of substitutes increase in the consumption of one will lead to a decrease in the demand for the other.

(viii) Conditions of Trade- Demand for everything are greater in a boom though the prices are rising. Opposite is the case during depression. (ix) Changes in Taxes, Subsidies and Bounties- When there is change in taxes, subsidies and bounties in respect of the commodity in question, its price will be affected, which in turn will alter the pattern of demand. (x) Changes in the Methods of Production and the Pattern of Alternative Uses-Changes in techniques and in the use of factors will affect the demand pattern for those factors (i.e., the derived demand), as in the case of capital equipment and labour or chemicals. (xi) Anticipated Political or Price Changes- Sometimes, rumours and general speculation about tax changes, war, etc., or of future shortages or abundance cause the present pattern of demand to change. (xii) Changes in the Degree of Competition among the Consumers of the Product- If there is a change in the degree of competition among consumers of die product due to any of the above mentioned factors, there will also occur a shift in the pattern of demand.