EQUI Marginal Concept-word Doc.

EQUI-MARGINAL CONCEPT

INTRODUCTORY TERMS: UTILITY:- In simple words, utility means satisfaction. MARGINAL UTILITY:- The increment to the utility caused by an additional unit of a commodity Eg. If we are consuming ice cream, the first unit of ice cream will give a certain level of satisfaction or utility. When we are having a second ice cream, we will get some additional satisfaction or utility, but not to the same extent (value) as in the initial case. This additional satisfaction or the increment to the utility is called the marginal utility. Therefore the “marginal” is a key term in economics and always means extra Definition: Marginal Utility is defined as the additional utility arising from consumption of an additional unit of commodity. Relationship between Total & Marginal Utility We can take a numerical example to illustrate various utilities. Let us consider the following table: Quantity of goods

Total utility [ U ]

consumed [ Q ] 0 1 2 3 4 5

Marginal utility [ MU ]

0 4 7 9 10 10

0 4 3 2 1 0

From the table, it is clear that total utility (U) increases with consumption (Q), but the fact is that it is increasing with a decreasing rate. It is also noticed that marginal utility declines with each additional unit consumption which points out to Diminishing Marginal Utility. The graphical representation of the above table is given below:

The law of diminishing marginal utility is implied by the marginal utility curve, sloping downward. The total utility curve looks like a dome, a concave nature which shows that total utility is increasing but with a decreasing rate for each additional unit of consumption. Note- The area under smooth MU curve is equal to the height of the total utility curve (U-curve) for the same no. of units as in the shaded portion. CONCEPT OF EQUI-MARGINAL PRINCIPLE – EQUAL MARGINAL UTILITIES PER DOLLAR FOR EVERY GOOD The marginal utility analysis enables one to have microscopic examination of each unit-by-unit changes on the cost o& revenue of the commodity. The marginal utility analysis can now be used to explain how a rational consumer will allocate a given amount of spendable income among different goods he has already decided to buy to achieve maximum utility. The law of equi-marginal utility is a rule to determine the optimum (best) allocation of a given amount of income among different goods. The law of equi-marginal utility states that “a consumer will derive the maximum utility from a given level of spendable income when the ratio of marginal utility to the price is the same for all goods.”

If the given amount of income is allocated between two goods, law of equimarginal utility requires MU1/P1 = MU2/P2. [ MU1 – additional utility derived from one extra unit of product no. 1 P1 – Price tag of product no. 1] Ie. By spending P1, consumer gets MU1 of utility. Then by spending Re 1, consumer gets MU1/P1 of utility. Thus MU1/P1 measures the worth of last one rupee spent on product no. 1. Equality of MU1/P1 & MU2/P2 means that utility of last Re 1 spent on each good should be equal. To get into the depth of concept, let us imagine that now the current division of income between two goods, MU1/P1 > MU2/P2. ie utility that can be obtained from one extra rupee spent on good no. 1 is more than the same derived from the last rupee spent on good no. 2. So, if Re 1 is reallocated from good 2 to good 1, increase in utility from purchase of good 1 will exceed the decrease in utility from reduction in purchase of good 2. Thus, it is clear that this type of reallocation increases total utility of the consumer. The reallocation should continue until MU1/P1 = MU2/P2 (optimum condition ). Once this condition is reached, no more increase in utility is possible from reallocation of expenditure from one good to another. A simple problem is worked out to illustrate the concept: A consumer spends his income on two goods where prices are Rs. 4 & Rs. 10. At current level of consumption of two goods, MU1 = 8 & MU2 = 30. Is the consumer behaving optimally? If not, what changes are recommended to achieve optimality ? Solution : MU1/P1 = 8/4 = 2

MU2/P2 = 30/10 = 3 So her MU2/P2 > MU1/P1 ( not equal, not in optimum case). 3 – 2 = Re 1; If she spends Re 1 less on good 1, loss of utility is 2 & that Re 1 on good 2 utility increases by 3. So total utility rises by 1 due to reallocation of expenditure from product 1 to 2. This reallocation should be continued till optimum condition MU1/P1 = MU2/P2 is attained. Thus equi-marginal principle states that input should be allocated in such a way that the value added by last unit is same in all cases. Also, Equi-marginal principle holds good only in cases where the law of Diminishing Return operates.