2. Definitions of Managerial Economics:
1. “We define managerial economics as the integration of economic theory and methodology
with analytical tools for applications to decision making about the allocation of scarce
resource in public and private institution.” K. K. Seo & B.J. Winger
2. “Managerial economics is the application of economic theory and methodology to business
administration practice. More specifically, managerial economics is the use of the tools and
techniques of economic analysis to analyse and solve management problems.” J. L. Pappas &
E. F. Brigham
3. “Managerial economics is the application of economic theory and methodology to decision
making problems faced by public, private and not for profit institutions. In managerial
economics, one attempts to extract from economic theory (particularly micro-economics)
those concepts and techniques that enable the decision-maker to efficiently allocate the
resources of the organization.” J. R. McGuigan & R. C. Moyer
4. “It (managerial economics) is the study of why some businesses prosper and grow, why
some simply survive and why others fail at the market place and go under.” T. J. Coyne
5. “Managerial economics is concerned with the application of economic principles and
methodologies to the decision making process within the firm or organisation. It seeks to
establish rules and principles to facilitate the attainment of the desired economic goals of
management.” Evan J. Douglas
6. “Managerial economics is the study of allocation of the limited resources available to a
firm or other unit of management among the various possible activities of that unit.” W. R.
Henry & W. W. Haynes
Meaning of Managerial Economics:
Economics is concerned with the allocation of scarce resources, having alternative uses,
among competing goals (or unlimited ends). Managerial economics is slightly specific in its
approach. It studies the economic aspects of managerial decision making.
It provides the practicing manager with those tools and techniques which are useful in day-to-
day decision making. Like traditional economics, it is concerned with choice and allocation,
in a narrow sphere though, it examines how scarce resources are allocated within a firm.
3. Managerial economics is pragmatic. Its stress is on the real commercial world. It is concerned
with those analytical tools and techniques which are useful or are likely to be so as to
improve the decision making process within the firm.
Firms of different types and size arise in an economy because they have been able to organize
production more efficiently than other types of institutions could. Most production takes
place in business firms. In managerial economics the stress is on the process of resource
allocation and decision making within the firm which is thought to be the most efficient form
of organizing production.
The two terms ‘managerial’ economics and ‘business’ economics are often used
interchangeably. But the scope of the former is broader than that of the latter.
While the latter deals with the decision making in profit making organizations, the former
provides methods and a point of view that are also applicable in managing non-profit
organizations (like hospitals) and public corporations (like the Indian Airlines Corporation).
So, in a formal sense, managerial economics is the application of economic theory and
methodology to decision making problems faced by private, public and non-profit or-
ganizations. Various concepts of managerial economics can be applied to non-business or
non-profit institutions.
The implementation of cost reduction programmes, the selection of more productive alter-
natives, the enhancement of revenues and the adoption of other measures can help to
maximize the service and the social contribution of these institutions.
Governments should try to obtain the maximum benefit for tax payers in spending their
revenues; government agencies can measure their efficiency through cost-benefit analysis.
Hospitals often attempt to handle more patients and give better care at lower cost by applying
economic techniques. Even universities can gain much by practising what they teach about
managerial economics.
Scope of Marginal Economics:
Managerial Economics is a developing subject. The scope of managerial economics refers to
its area of study. Managerial economics has its roots in economic theory. The empirical
nature of managerial economics makes its scope wider. Managerial economics provides
management with strategic planning tools that can be used to get a clear perspective of the
way the business world works and what can be done to maintain profitability in an ever
changing environment.
4. Managerial economics refers to those aspects of economic theory and application which are
directly relevant to the practice of management and the decision making process within the
enterprise. Its scope does not extend to macro-economic theory and the economics of public
policy which will also be of interest to the manager. While considering the scope of
managerial economics we have to understand whether it is positive economics or normative
economics.
Positive versus Normative Economics:
Most of the managerial economists are of the opinion that managerial economics is
fundamentally normative and prescriptive in nature. It is concerned with what decisions
ought to be made.
The application of managerial economics is inseparable from consideration of values or
norms, for it is always concerned with the achievement of objectives or the optimization of
goals. In managerial economics, we are interested in what should happen rather than what
does happen. Instead of explaining what a firm is doing, we explain what it should do to
make its decision effective.
Positive Economics:
A positive science is concerned with ‘what is’. Robbins regards economics as a pure science
of what is, which is not concerned with moral or ethical questions. Economics is neutral
between ends. The economist has no right to pass judgment on the wisdom or folly of the
ends itself.
He is simply concerned with the problem of resources in relation to the ends desired. The
manufacture and sale of cigarettes and wine may be injurious to health and therefore morally
unjustifiable, but the economist has no right to pass judgment on these since both satisfy
human wants and involve economic activity.
Normative Economics:
Normative economics is concerned with describing what should be the things. It is, therefore,
also called prescriptive economics. What price for a product should be fixed, what wage
should be paid, how income should be distributed and so on, fall within the purview of
normative economics?
It should be noted that normative economics involves value judgments. Almost all the leading
managerial economists are of the opinion that managerial economics is fundamentally
normative and prescriptive in nature.
It refers mostly to what ought to be and cannot be neutral about the ends. The application of
managerial economics is inseparable from consideration of values, or norms for it is always
concerned with the achievement of objectives or the optimisation of goals.
5. In managerial economics, we are interested in what should happen rather than what does
happen. Instead of explaining what a firm is doing, we explain what it should do to make its
decision effective. Managerial economists are generally preoccupied with the optimum
allocation of scarce resources among competing ends with a view to obtaining the maximum
benefit according to predetermined criteria.
To achieve these objectives they do not assume ceteris paribus, but try to introduce policies.
The very important aspect of managerial economics is that it tries to find out the cause and
effect relationship by factual study and logical reasoning. The scope of managerial economics
is so wide that it embraces almost all the problems and areas of the manager and the firm.
Subject Matter of Marginal Economics:
(i) Demand Analysis and Forecasting:
A firm is an economic organisation which transforms inputs into output that is to be sold in a
market. Accurate estimation of demand, by analysing the forces acting on demand of the
product produced by the firm, forms the vital issue in taking effective decision at the firm
level.
A major part of managerial decision making depends on accurate estimates of demand. When
demand is estimated, the manager does not stop at the stage of assessing the current demand
but estimates future demand as well. This is what is meant by demand forecasting.
This forecast can also serve as a guide to management for maintaining or strengthening
market position and enlarging profit. Demand analysis helps in identifying the various factors
influencing the demand for a firm’s product and thus provides guidelines to manipulate
demand. The main topics covered are: Demand Determinants, Demand Distinctions and
Demand Forecasting.
(ii) Cost and Production Analysis:
Cost analysis is yet another function of managerial economics. In decision making, cost
estimates are very essential. The factors causing variation in costs must be recognised and
allowed for if management is to arrive at cost estimates which are significant for planning
purposes.
The determinants of estimating costs, the relationship between cost and output, the forecast of
cost and profit are very vital to a firm. An element of cost uncertainty exists because all the
factors determining costs are not always known or controllable. Managerial economics
touches these aspects of cost analysis as an effective knowledge and the application of which
is corner stone for the success of a firm.
6. Production analysis frequently proceeds in physical terms. Inputs play a vital role in the
economics of production. The factors of production otherwise called inputs, may be
combined in a particular way to yield the maximum output.
Alternatively, when the price of inputs shoots up, a firm is forced to work out a combination
of inputs so as to ensure that this combination becomes the least cost combination. The main
topics covered under cost and production analysis are production function, least cost
combination of factor inputs, factor productiveness, returns to scale, cost concepts and
classification, cost-output relationship and linear programming.
(iii) Inventory Management:
An inventory refers to a stock of raw materials which a firm keeps. Now the problem is how
much of the inventory is the ideal stock. If it is high, capital is unproductively tied up. If the
level of inventory is low, production will be affected.
Therefore, managerial economics will use such methods as Economic Order Quantity (EOQ)
approach, ABC analysis with a view to minimising the inventory cost. It also goes deeper
into such aspects as motives of holding inventory, cost of holding inventory, inventory
control, and main methods of inventory control and management.
(iv) Advertising:
To produce a commodity is one thing and to market it is another. Yet the message about the
product should reach the consumer before he thinks of buying it. Therefore, advertising forms
an integral part of decision making and forward planning. Expenditure on advertising and
related types of promotional activities is called selling costs by economists.
There are different methods for setting advertising budget: Percentage of Sales Approach, All
You can Afford Approach, Competitive Parity Approach, Objective and Task Approach and
Return on Investment Approach.
(v) Pricing Decision, Policies and Practices:
Pricing is very important area of managerial economics. The control functions of an
enterprise are not only productions but pricing as well. When pricing a commodity, the cost
of production has to be taken into account. Business decisions are greatly influenced by
pervading market structure and the structure of markets that has been evolved by the nature
of competition existing in the market.
Pricing is actually guided by consideration of cost plan pricing and the policies of public
enterprises. The knowledge of the pricing of a product under conditions of oligopoly is also
essential. The price system guides the manager to take valid and profitable decision.
(vi) Profit Management:
A business firm is an organisation designed to make profits. Profits are acid test of the
individual firm’s performance. In appraising a company, we must first understand how profit
7. arises. The concept of profit maximisation is very useful in selecting the alternatives in
making a decision at the firm level.
Profit forecasting is an essential function of any management. It relates to projection of future
earnings and involves the analysis of actual and expected behaviour of firms, the sales
volume, prices and competitor’s strategies, etc. The main aspects covered under this area are
the nature and measurement of profit, and profit policies of special significance to managerial
decision making.
Managerial economics tries to find out the cause and effect relationship by factual study and
logical reasoning. For example, the statement that profits are at a maximum when marginal
revenue is equal to marginal cost, a substantial part of economic analysis of this deductive
proposition attempts to reach specific conclusions about what should be done.
The logic of linear programming is deduction of mathematical form. In fine, managerial
economics is a branch of normative economics that draws from descriptive economics and
from well established deductive patterns of logic.
(vii) Capital Management:
Planning and control of capital expenditures is the basic executive function. The managerial
problem of planning and control of capital is examined from an economic stand point. The
capital budgeting process takes different forms in different industries.
It involves the equi-marginal principle. The objective is to assure the most profitable use of
funds, which means that funds must not be applied when the managerial returns are less than
in other uses. The main topics dealt with are: Cost of Capital, Rate of Return and Selection of
Projects.
Thus we see that a firm has uncertainties to rock on with. Therefore, we can conclude that the
subject matter of managerial economics consists of applying economic principles and
concepts towards adjusting with these uncertainties of the firm.
In recent years, there is a trend towards integration of managerial economics and Operation
Research. Hence, techniques such as linear Programming, Inventory Models, Waiting Line
Models, Bidding Models, Theory of Games, etc. have also come to be regarded as part of
managerial economics.
Relation to Other Branches of Knowledge:
A useful method of throwing light on the nature and scope of managerial economics is to
examine its relationship with other disciplines. To classify the scope of a field of study is to
discuss its relation to other subjects. If we take the subject in isolation, our study would not
8. be useful. Managerial economics has a close linkage with other disciplines and fields of
study.
The subject has gained by the interaction with economics, mathematics and statistics and has
drawn upon management theory and accounting concepts. The managerial economics
integrates concepts and methods from these disciplines and bringing them to bear on
managerial problems.
Managerial Economics and Economics:
Managerial Economics has been described as economics applied to decision making. It may
be studied as a special branch of economics, bridging the gap between pure economic theory
and managerial practice. Economics has two main branches—micro-economics and macro-
economics.
Micro-economics:
‘Micro’ means small. It studies the behaviour of the individual units and small groups of such
units. It is a study of particular firms, particular households, individual prices, wages,
incomes, individual industries and particular commodities. Thus micro-economics gives a
microscopic view of the economy.
The micro-economic analysis may be undertaken at three levels:
(i) The equalisation of individual consumers and produces;
(ii) The equalization of the single market;
(iii) The simultaneous equilibrium of all markets. The problems of scarcity and optimal or
ideal allocation of resources are the central problem in micro-economics.
The roots of managerial economics spring from micro-economic theory. In price theory,
demand concepts, elasticity of demand, marginal cost marginal revenue, the short and long
runs and theories of market structure are sources of the elements of micro-economics which
managerial economics draws upon. It also makes use of well known models in price theory
such as the model for monopoly price, the kinked demand theory and the model of price
discrimination.
Macro-economics:
‘Macro’ means large. It deals with the behaviour of the large aggregates in the economy. The
large aggregates are total saving, total consumption, total income, total employment, general
price level, wage level, cost structure, etc. Thus macro-economics is aggregative economics.
It examines the interrelations among the various aggregates, and causes of fluctuations in
them. Problems of determination of total income, total employment and general price level
are the central problems in macro-economics.
9. Macro-economies is also related to managerial economics. The environment, in which a
business operates, fluctuations in national income, changes in fiscal and monetary measures
and variations in the level of business activity have relevance to business decisions. The
understanding of the overall operation of the economic system is very useful to the
managerial economist in the formulation of his policies.
The chief contribution of macro-economics is in the area of forecasting. The post-Keynesian
aggregative theory has direct implications for forecasting general business conditions. Since
the prospects of an individual firm often depend greatly on business in general, for-casts of an
individual firm depend on general business forecasts, which make use of models derived
from theory. The most widely used model in modern forecasting is the gross national product
model.
Managerial Economics and Theory of Decision Making:
The theory of decision making is a relatively new subject that has a significance for
managerial economics. In the entire process of management and in each of the management
activities such as planning, organising, leading and controlling, decision making is always
essential. In fact, decision making is an integral part of today’s business management. A
manager faces a number of problems connected with his/her business such as production,
inventory, cost, marketing, pricing, investment and personnel.
Economist are interested in the efficient use of scarce resources hence they are naturally
interested in business decision problems and they apply economics in management of
business problems. Hence managerial economics is economics applied in decision making.
According to M.H. Spencer and L. Siegelman, “Managerial economics is the integration of
economic theory with business practice for the purpose of facilitating decision making up and
forward planning by management”. Managerial economics is a fundamental academic subject
which seeks to understand and to analyse the problems of business decision making.
The theory of decision making recognises the multiplicity of goals and the pervasiveness of
uncertainty in the real world of management. The theory of decision making replaces the
notion of a single optimum solution with the view that the objective is to find solution that
‘satisfies’ rather than maximise. It probes into an analysis of motivation of the relation of
rewards and aspiration levels, and of pattern of influence and authority.
Economic theory and theory of decision making appear to be in conflict, each based on
different set of assumptions. Much of the economic theory is based on the assumption of
single goal-maximisation of utility for the individual or maximisation of profit for the firm.
Managerial Economics and Operations Research:
Mathematicians, statisticians, engineers and others teamed up together and developed models
and analytical tools which have since grown into a specialised subject, known as operation
research. The basic purpose of the approach is to develop a scientific model of the system
which may be utilised for policy making.
10. Much of the development of techniques and concepts such as Linear Programming, Dynamic
Programming, Input-output Analysis, Inventory Theory, Information Theory, Probability
Theory, Queueing Theory, Game Theory, Decision Theory and Symbolic Logic.
Linear programming deals with those programming problems where the relationship among
the variables is linear. It is a useful tool for the managerial economist for reducing
transportation costs and allocating purchase amongst different supplies and site depots. It is
employed when the objective function is to maximise profit, output or efficiency.
Dynamic programming helps in solving certain types of sequential decision problems. A
sequential decision problem is one in which a sequence of decision must be made with each
decision affecting future decision. It has been applied in cases of maintenance and repair,
financial portfolio balancing, inventory and production control, equipment replacement and
directed marketing.
Input-output analysis is a technique for analysing inter-industry relation. Prof. W.W. Leontief
tries to establish inter industry relationships by dividing the economy into different sectors. In
this model, the final demand is treated as exogenously determined and the input-output
technique is used to find out the levels of activity in the various sectors of the economic
system. It can be used by firms for planning, co-ordination and mobilisation of resources.
Queueing is a particular application of the statistical decision theory. It is employed to get the
optimum solution. The theory may be applied to such problems as how to meet a given
demand most economically or how to minimise the waiting period or idle time. The theory of
games holds out the hope of solving certain problems concerning oligopolistic interminacy.
When we apply the game theory, we have to consider the following:
(i) The players are the two firms;
(ii) They play the game in the market place;
(iii) Their strategies are their price or output decision; and
(iv) The pay-offs or rewards are their profits. The numerical figures are what is called payoff
matrix. This matrix is the most important tool of game theory.
Managerial Economics and Statistics:
Statistics is important to managerial economics. It provides the basis for the empirical testing
of theory. Statistics is important in providing the individual firm with measures of the
appropriate functional relationship involved in decision making. Statistics is a very useful
science for business executives because a business runs on estimates and probabilities.
Statistics supplies many tools to managerial economics. Suppose forecasting has to be done.
For this purpose, trend projections are used. Similarly, multiple regression technique is used.
In managerial economics, measures of central tendency like the mean, median, mode, and
11. measures of dispersion, correlation, regression, least square, estimators are widely used. The
managerial economics is constantly faced with the choice between models ignoring
uncertainty and those that explicitly incorporate probability theory.
Statistical tools are widely used in the solution of managerial problems. For example,
sampling is very useful in data collection. Managerial economics makes use of correlation
and multiple regression in business problems involving some kind of cause and effect
relationship.
Managerial Economics and Accounting:
Managerial economics is closely related to accounting. It is concerned with recording the
financial operation of a business firm. A business is started with the main aim of earning
profit. Capital is invested it is employed for purchasing properties such as building, furniture,
etc and for meeting the current expenses of the business.
Goods are bought and sold for cash as well as credit. Cash is paid to credit sellers. It is
received from credit buyers. Expenses are met and incomes derived. This goes on the daily
routine work of the business. The buying of goods, sale of goods, payment of cash, receipt of
cash and similar dealings are called business transactions.
The business transactions are varied and multifarious. They are too numerous to be kept in
one’s memory. This has given rise to the necessity of recording business transaction in books.
They are written in a set of books in a systematic manner so as to facilitate proper study of
their results.
There are three classes of accounts:
(i) Personal account,
(ii) Property accounts, and
(iii) Nominal accounts.
Management accounting provides the accounting data for taking business decisions. The
accounting techniques are very essential for the success of the firm because profit
maximisation is the major objective of the firm.
Managerial Economics and Mathematics:
Mathematics is yet another important subject closely related to managerial economics. For
the derivation and exposition of economic analysis, we require a set of mathematical tools.
Mathematics has helped in the development of economic theories and now mathematical
economics has become a very important branch of the science of economics.
Mathematical approach to economic theories makes them more precise and logical. For the
estimation and prediction of economic factors for decision making and forward planning, the
12. mathematical method is very helpful. The important branches of mathematics generally used
by a managerial economist are geometry, algebra and calculus.
The mathematical concepts used by the managerial economists are the logarithms and
exponential, vectors and determinants, input-out tables. Operations research which is closely
related to managerial economics is mathematical in character
Law of demand
There is an inverse relationship between quantity demanded and its price. The people know
that when price of a commodity goes up its demand comes down. When there is decrease in
price the demand for a commodity goes up. There is inverse relation between price and
demand . The law refers to the direction in which quantity demanded changes due to change
in price.
A consumer may demand one dozen oranges at $5 per dozen . He may demand two dozens
when the price is $4 per dozen. A person generally buys more at a lower price. He buys less
at higher price. It is not the case with one person but all people liken to buy more due to fall
in price and vice versa. This is true for all commodities and under all conditions. The
economists call it as law of demand. In simple words the law of demand states that other
things being equal more will be demanded at lower price and lower will be demanded at
higher price.
Definition
1. Alfred Marshal says that the amount demanded increase with a fall in price,
diminishes with a rise in price.
2. C.E. Ferguson says that according to law of demand, the quantity demanded varies
inversely with price.
3. Paul A. Samuelson says that law of demand states that people will buy more at a
lower prices and buy less at higher prices, other things remaining the same.
Assumptions of the law
1. There is no change in income of consumers.
2. There is no change in the price of product.
3. There is no change in quality of product.
4. There is no substitute of the commodity.
5. The prices of related commodities remain the same.
6. There is no change in customs.
7. There is no change in taste and preference of consumers.
8. The size of population remains the same.
9. The climate and weather conditions are same.
10. The tax rates and other fiscal measures remain the same.
13. Explanation of the law
The relationship between price of a commodity and its demand depends upon many factors.
The most important factor is nature of commodity. The demand schedule shows response of
quantity demanded to change in price of that commodity. This is the table that shows prices
per unit of commodity ands amount demanded per period of time. The demand of one person
is called individual demand. The demand of many persons is known as market demand. The
experts are concerned with market demand schedule. The market demand schedule means
'quantities of given commodity which all consumers want to buy at all possible prices at a
given moment of time'. The demand schedules of all individuals can be added up to find out
market demand schedule.
Demand schedule
Price in dollars. Demand in Kg.
5 100
4 200
3 300
2 400
The table shows the demand of all the consumers in a market. When the price decreases there
is increase in demand for goods and vice versa. When price is $5 demand is 100 kilograms.
When the price is $4 demand is 200 kilograms. Thus the table shows the total amount
demanded by all consumers various price levels.
Diagram
14. There is same price in the market. All consumers purchase commodity according to their
needs. The market demand curve is the total amount demanded by all consumers at different
prices. The market demand curve slopes from left down to the right.
Why demand curve falls
Marginal utility decreases:
When a consumer buys more units of a commodity, the marginal utility of such commodity
continue to decline. The consumer can buy more units of commodity when its price falls and
vice versa. The demand curve falls because demand is more at lower price.
Price effect:
When there is increase in price of commodity, the consumers reduce the consumption of such
commodity. The result is that there is decrease in demand for that commodity. The consumers
consume mo0re or less of a commodity due to price effect. The demand curve slopes
downward.
Income effect
Real income of consumer rises due to fall in prices. The consumer can buy more quantity of
same commodity. When there is increase in price, real income of consumer falls. This is
income effect that the consumer can spend increased income on other commodities. The
demand curve slopes downward due to positive income effect.
15. Same price of substitutes
When the price of a commodity falls, the prices of substitutes remaining the same, consumer
can buy more of the commodity and vice versa. The demand curve slopes downward due to
substitution effect.
Demand of poor people
The income of people is not the same, The rich people have money to buy same commodity
at high prices. Large majority of people are poor, They buy more when price fall and vice
versa. The demand curve slopes due to poor people.
Different uses of goods
There are different uses of many goods. When prices of such goods increase these goods are
put into uses that are more important and their demand falls. The demand curve slopes
downward due to such goods.
Exceptions to the law
Inferior goods
The law of demand does not apply in case of inferior goods. When price of inferior
commodity decreases and its demand also decrease and amount so saved in spent on superior
commodity. The wheat and rice are superior food grains while maize is inferior food grain.
Demonstration effect
The law of demand does not apply in case of diamond and jewelry. There is more demand
when prices are high. There is less demand due to low prices. The rich people like to
demonstrate such items that only they have such commodities.
Ignorance of consumers
The consumer usually judge the quality of a commodity from its price. A low priced
commodity is considered as inferior and less quantity is purchased. A high priced commodity
is treated as superior and more quantity is purchased. The law of demand does not apply in
this case.
Less supply
The law of demand does not work when there is less supply of commodity. The people buy
more for stock purpose even at high price. They think that commodity will become short.
Depression
16. The law of demand does not work during period of depression. The prices of commodities are
low but there is increase in demand. it is due to low purchasing power of people.
Speculation
The law does not apply in case of speculation. The speculators start buying share just to raise
the price. Then they start selling large quantity of shares to avoid losses.
Out of fashion
The law of demand is not applicable in case of goods out of fashion. The decrease in prices
cannot raise the demand of such goods. The quantity purchased is less even though there is
falls in prices.
UTILITY ANALYSIS
Introduction:
A consumer demands a good or a service. He demands a good
because it gives himutility. Wants – satisfying capacityofagood is called utility.
Meaning of Utility:
The term utility in economics is used to denote that quality in a commodity or
service byvirtue of which our wants are satisfied. In other words, want –
satisfying power of a goodis called utility.
Definitions:
•According to Jevons, “Utility refers to abstract quality whereby an object
servesour purpose.
•In the words of Hibdon, “Utility is the quality of good to satisfy a want.”
•According to Mrs. Robinson, “Utility is the quality in commodities
that makesindividuals wants to buy them”.
Features:
1.Utility is Subjective: It deals with the mental satisfaction of a man. A
thing mayhave different utility to different persons. E.g. Liquor has utility for
drunkard but for person who is teetotaller, it has no utility.
17. 2.Utility is Relative: As a utility of a commodity never remains the same. It
varies withtime and place. E.g. Cooler has utility in summer not during winter
season.
3.Utility is not essentially Useful:
A commodity having utility need not be useful. E.g.Liquor and cigarette are not
useful, but if these things satisfy the want of addict thenthey have utility for
him.
4.Utility is independent of Morality:
It has nothing to do with morality. Use of opiumliquor may not be proper
from moral point of view, but as these intoxicants satisfywants of
the opium – eaters, drunkards, they have utility.
Concepts of Utility:
1)Initial Utility:
The utility derived from the first unit of commodity is called
initialutility. It is obtained from the consumption of the first unit of a
commodity. It isalways positive.2)
Total Utility: The aggregate of utility obtained from the consumption of
different units of a commodity, is called Totalutility.
3)Marginal Utility:
The change that takes place in the total utility by the consumptionof an additional unit of
commodity is called marginal utility.
Marginal utility can be:
a) Positive Marginal Utility:
If by consuming additional units of commodity, totalutility goes on increasing, then marginal
utility of these units will be positive.
b) Zero Marginal Utility:
If the consumption of additional unit of commoditycauses no change in the
total utility, it means the marginal utility of additional unitis zero.
c) Negative Marginal Utility:
I f t he c o ns ump t io n o f a n a d d it io na l unit o f a commodity causes fall
in total utility, it means the marginal utility is negative.
Relation between Total Utility and Marginal Utility:
Total utility is the summation of the marginal utilities of different units of a commodity.
Table:Q u a n t i t y T o t a l UtilityMarginalUtilityDescription00-
1 8 8
–
0 =
8 Initial Utility2 1
4 1 4 –
8 =
18. 6 3 1 8 1 8
–
1 4 =
4 4 2 0 2 0
–
1 8 =
2 Positive Utility5 2 0 2 0 –
2 0 = 0 Z e r
o U t i l i t y 6 1
8 1 8 – 2 0 = -
2 N e g a t i v e U t i l
i t y
Table shows that:a)As more and more units of commodity is consumed, the
marginal utility derivedfrom each successive unit goes on diminishing. But the total
utility increases up toa limit.2
MUnth = Tn – Tn-1 or MU = change TU/ change Q
MUnth = Marginal utility of nth unit.Tn = total utility of n units.Tn-1 = total utility of n-1
unitsChange TU = change in total utilityChange Q = change in the quantity of commodity
TU = MU
Total utility is summation of Marginal utility
b)Marginal utility of the first four units being positive, the total
utility goes
onincreasing. Thus as long as the marginal utility of the commodity re
mains positive, total utility goes on increasing.c)Marginal utility of the fifth unit is
zero. In this situation total utility (20) will bemaximum. This situation also represents
point of saturation.d)Marginal utility of the sixth unit is negative. As
a result of it, total utilit y of sixunits of the commodity falls from 20 to 18 units.
Total Utility Curve[A]YO XMarginal Utility Curve[B]YO X
3OY–Axis Utility, OX–Axis Quantity
Figure A
•
TU represents Total utility
•
It slopes upwards upto point F means TUis rising upto the consumption of 4 unit.
•
From point F to G TU is constant
•
Point G represents maximum total utility.
•
After point G, TU slopes downwards,meaning there by utility becomesnegative and
total utility begins to fall.
Figure B
•
MU represents Marginal Utility
•
It slopes downwards from left to right;MU of successive units goes ondiminishing.
•
Upto fourth unit of commodity, MU goeson diminishing but TU goes onincreasing.
•
19. At the fifth unit MU curve touches OX – axis, MU utility is zero and TU ismaximum.
•
After fifth unit MU curve intersects Ox –
Can utility be measured?
It can be attempted to measure by two methods:1.
Measurement in terms of Money:
In order to measure the utility in terms of money,it is estimated what amount of money a man
is willing to pay for a thing.2.
Measurement in terms of Units:
Prof. Fisher has used the term,
“Util”,
as a unit for the measurement of utility. In this method utility is expressed in Utils.
Criticism of the Measurement of Utility:
I t ha s b e e n c r it ic ize d b y P r o f. S a mue ls o n a s t he va lue o f mo ne y
k e e p s c ha nging. Therefore utility cannot be measured definitely in the terms of
money.
Law of Diminishing Marginal Utility:
Assumptions and Exceptions
The law of diminishing marginal utility was first propounded by 19th century
German economist H.H. Gossen which explains the behavior of the consumers and
the basic tendency of human nature. Hence, this law is also known as Gossen’s
First Law. This was further modified by Marshall.
According to Marshall,
The additional benefit a person derives from a given increase of his stock of
anything diminishes with the growth of the stock that he already has.
According to Paul A. Samuelson,
As the amount consumed of a good increases, the marginal utility of the good leads
to decrease.
As per the definitions, we can conclude that, if the consumer consumes goods
continuously, the utility obtained from every successive unit goes on diminishing.
If the consumer is consuming the goods continuously, firstly he reaches the point
of maximum satisfaction which is known as level of satiety. If he continues to
20. consume the goods again, the utility obtained from that particular goods goes in
negative aspect or he gets inutility.
Law Of Diminishing Marginal Utility Assumptions
1. The consumer who is consuming the goods should be logical and
knowledgeable to consume every unit of goods.
2. The goods which are to be consumed should be equal in size and shape.
3. Consumer should consume the goods without time gap.
4. The consumer’s income, preference, taste and fashion should not be changed
while consuming the goods.
5. To hold the law good, utility should be measured in countable units or
cardinal numbers. The utility obtained from those goods is measured in ‘utils’
unit.
6. As we know that money is the measuring rod of utility, being so, marginal
utility of money should remain constant during consumption of the goods.
Example to Demonstrate Law of Diminishing Marginal Utility
This law can be illustrated with the help of a table shown below:
The table shows that when a consumer consumes 1st unit of orange he derives the
marginal utility equal to 6utils. As the consumer consumes 2nd and 3rd units of
orange, the marginal utility is declined from 4utils to 2utils respectively.
When he consumes 4th unit of orange the marginal utility becomes zero, which is
called the point of satiety. Similarly, from the consumption of 5th and 6th units of
orange, the marginal utility becomes negative, i.e., he gets disutility instead of
utility from these units of consumption.
Thus, the table shows that a consumer consumes more and more units of a
commodity at a certain period of time, the marginal utility declines, becomes zero
and even negative.
21. This law can be further explained with the help of a diagram:
In the figure, X-axis represents units of orange and Y-axis represents utility. MU is
the marginal utility curve which slopes downward from left to right. It means that
as a consumer consumes more and more units of a commodity, the marginal utility
he derives from the additional unit of consumption goes on declining, becomes
zero(at point D) and even negative(at point E and F.)
22. Exceptions Where Law of Diminishing Marginal Utility Doesn’t Apply
Dissimilar units
This law is applicable for homogenous unit only, i.e. only if all units of a
commodity consumed are similar in length, breadth, shape and size. If there is a
change in such factors, the utility obtained from it can be increased. For example:
If the 2nd orange is much larger than the 1stone, it will yield more satisfaction than
the 1st.
Unreasonable quantity
The quantity of the commodity a consumer consumes should be reasonable. If the
units of consumption are too small, then every successive unit of consumption may
give higher utility to the consumer. For example: If a person is given water by a
spoon when he is very thirsty, each additional spoonful will give him more
satisfaction.
Not a suitable time period
There should not be very long gap between the consumption of different units of
the commodity. If there is time lag between the consumption of different units,
then this law may not hold good. For example: If a man has lunch at 10 a.m. and
dinner at 8 p.m. and eats nothing in between, the dinner will possibly yield even
more satisfaction than the lunch, i.e. his marginal utility will not diminish.
Rare collection
This law does not apply for rare collections such as old coins, stamps and so on
because the longer and larger the number he collects, the greater will be the utility.
Change in taste and fashion of the consumer
The law of diminishing marginal utility will be applicable only if the consumer is
not supposed to change taste and fashion of the commodity whatever he/she was
using previously.
Abnormal person
The law of diminishing marginal utility is applicable for normal person only.
Abnormal persons such as drunkards and druggist are not associated with the law.
Change in income of the consumer
To hold the law good, there should not be any change in the income of the
consumer. If the income of the consumer increases, he will consume more and
23. more units of a commodity which he prefers. As a result, utility can be increased
rather than decreased.
Habitual goods
The law will not be applicable for habitual goods such as consumption of
cigarettes, consumption of drugs, alcohol, etc.
Durable and valuable goods
The law is not applicable in case of durable goods as well as valuable goods such
as buildings, vehicles, gems, gold, etc.
Consumer Surplus
The doctrine of Consumer’s Surplus which occupies an important place in the Marshallian
System of Welfare Economic Analysis was originally stated by William Stanley Jevons and
French Engineer economist Arsens Jules Dupuit in 1844 in a Crude form.
Later on Dr. Alfred Marshall explained this concept in “The Pure Theory of Domestic
Values” as consumer’s rent.
In his ‘Principles of Economics’ he further elaborated this concept in logical details and
describe it as “Consumer’s Surplus”. He is called the Consumer’s Surplus.
Explanation of the Concept of Consumer Surplus:
In actual life, when we buy a commodity for consumption, we gain some utility by
consuming it, at the same time we lose some utility in terms of the price that we need to pay
for it. In the beginning, utility gained is usually higher than the utility lost.
This concept is used to explain the gap between total utility that a consumer gets from the
consumption of a certain commodity and the total money value which he actually pays for the
same.
For Example:
Suppose, a student goes to buy a book. He is willing to pay Rs. 20 for the book. But he gets
the book for Rs. 15. Thus, he has saved Rs. 5. This is called Consumer’s Surplus.
Potential Price – Actual Price = Consumer’s Surplus.
Definition of Consumer Surplus:
1. Regarding this Prof. Marshall has said that “The excess of price which he (consumer)
would be willing to pay rather than go without. The thing over that which he actually does
pay, is the economic measure of this surplus satisfaction. It may be called “Consumer’s
Surplus”.
24. 2. According to Penson – “The difference between what we would pay and what we have to
pay is called Consumer’s Surplus.”
3. According to Prof. J. K. Mehta – “Consumer’s Surplus obtained by a person from a
commodity is the difference between satisfaction which he derives from it and which he
foregoes in order to procure that commodity.”
4. As per Samuelson – “There is always a gap between total welfare and total economic
value. This gap is the nature of a surplus which consumer gets because he always receives
more than he pays.”
5. According to Taussig – “Consumer’s Surplus is the difference between the sum which
measures total exchange value”.
Assumptions of Consumer’s Surplus:
Prof. Marshall has discussed the concept of Consumer’s Surplus on the basis of the
following assumptions:
1. Marginal Utility of Money is Constant:
The marginal utility of money to the consumer remains constant. It is so when the money
spent on purchasing the commodity is only a small fraction of this total income.
2. No Close Substitutes Available:
The commodity in question has no close substitutes and if it does have any substitute, the
same may be regarded as an identical commodity and thus only one demand should may be
prepared.
3. Utility can be Measured:
The utility is capable of cardinal measurement through the measuring rod of money.
Moreover, the utility obtainable from one good is absolutely independent of the utility from
the other goods. No goods affect the utility that can be derived from the other goods.
4. Tastes and Incomes are Same:
That all people are of identical tastes, fashions and their incomes also are the same.
Explanation of the Law:
The above definition of Prof. Marshall can be explained with the help of practical
examples:
(i) Consumer’s Surplus when there is single purchase and
(ii) Consumer’s Surplus when there is multiple unit purchase.
(i) Consumer Surplus on Single Unit Purchase:
When a consumer purchases only one unit of a commodity even then the Consumer Surplus
arises. Let us suppose a student is willing to pay Rs. 30 for a particular book and when he
actually go to market and purchase it at Rs. 25. Thus Rs. 5 (30-25) is the Consumer’s
Surplus.
25. (ii) Consumer’s Surplus on a Multi-unit Commodity:
In our real life one purchases number of units of a particular commodity. The price that a
consumer pays for all the different units of commodity actually measures the utilities of the
marginal unit and he pays the same price for different commodities.
The excess of utilities he derives from different commodities and the actual price paid is
called as Consumer’s Surplus. Let us take an example of a person whose marginal utility,
price and Consumer’s Surplus schedule for bread is given in the following table:
The above table expresses the various amounts of utilities he derives from the consumption of
different units of bread. From the first bread alone he derives marginal utility of Rs. 10 but
the price which he pays is Rs. 2 and hence Rs. 8 is the Consumer’s Surplus.
Similarly, the Consumer’s Surplus from 2nd, 3rd, 4th and 5th units are 6, 4, 2 and zero
respectively. A rational consumer will consume only 5th commodity where the marginal
utility is equal to its price and thereby maximises his Consumer’s Surplus. If he will consume
the 6th unit he derive zero marginal utility where as he pays the price as Rs. 2. A rational
consumer will not consume that commodity.
Diagrammatic Representation of Consumer Surplus:
This can be shown by the following diagram:
In this diagram AB is a demand curve of a consumer OR is the market price. The price line is
parallel to X axis because of perfect competition. At point P the marginal curve AB intersect
the market price curve OR. Thus for OQ quantity the consumer derives utility as AOQP
where as he pays ROQP. Thus, triangular shaded area ARP is
Consumer’s Surplus.
Consumer’s Surplus = Total Utility-(Marginal Utility) x (Multiply x No. of Units purchased)
Criticism of the Concept of Consumer’s Surplus, Or Difficulties in the Measurement of
Consumer’s Surplus:
26. The concept of Consumer’s Surplus has been criticised on several grounds:
1. This Concept is Imaginary:
The concept is complete imaginary, illogical and illusory. You just imagine, what you are
prepared to pay and you proceed to deduct from that what you actually pay. It is all
hypothetical. One may say that one is prepared to pay anything. Hence it is unreal.
2. Measurement of this Concept is Difficult:
The critics of this concept allege that measurement of Consumer’s Surplus is difficult. It is
because utility is a subjective concept and will vary from person to person. Total utility is
impossible to measure because when we consume more units it is said that the marginal
utility of even earlier units start diminishing. Prof. Hicks and Allen have contended and
proved that utility being a subjective phenomenon, is determinate and immeasurable.
3. This Concept is not Applicable to Substitutes:
The concept may not apply in case of goods which have substitutes. Why should on imagine
how much will be willing to pay for a commodity. One finds it hard to think that the
substitute of a commodity has no significant effect on the surplus satisfaction he derives from
the commodity.
Decidedly, the consumer will feel more satisfied if two good substitutes as well as
complements are made available to him than in case he gets only one of the two at a time.
The consumer can properly appreciate the utility from a pen only when the same is
accompanied by ink.
4. The Marginal Utility of Money never Remains Constant:
It is improper to assume with Prof. Marshall that the marginal utility of money remains
constant and does not alter with increase or decrease in the money stock with the consumer.
Therefore, it is incorrect to believe the consistency of the marginal utility of money in real
life.
5. Exhaustion of Surplus Utility:
It is said that if a consumer knew that any such thing existed, he would go on buying more
and more till the surplus utility he enjoyed disappeared. This is not correct. A consumer does
not run after a surplus yielded by one commodity. He has to weigh the utilities of other
commodities too.
6. This Concept is not Applicable to Necessaries:
The idea of Consumer’s Surplus does not apply to the necessaries of life or conventional
necessaries. In such cases the surplus is immeasurable. What would not a man be prepared to
pay for a glass of water when he is dying of thirst?
7. The Complete List of Demand and Price not Available to Consumer:
Another ground on which the concept has been criticized is that the complete and reliable list
of demand and prices is never available to the consumer. The demand schedule according to
which he regulates and decides his purchases is not necessary to come true in practice. How
much the consumer would be willing to pay rather than go without the thing is something
hard to answer correctly.
Practical Importance of Consumer’s Surplus:
27. Economists are of this opinion that the actual measurement of Consumer’s Surplus is a
difficult task as utility being purely a psychological concept, yet the concept has a great
practical importance.
1. Distinction between Value-in-use and Value in Exchange:
Consumer’s Surplus points to the distinction between the use value and the exchange value of
a thing. Commodities like salt and match-box have a great value-in-use but much less value
in exchange. Being necessaries and cheap things they yield, however a large Consumer’s
Surplus. The Consumer’s Surplus depends on total utility, where as price depends on
marginal utility.
2. Comparison of Gains from the International Trade:
Consumer’s Surplus from international transactions enables us to compare the relative gains
from the international trade of the different countries. For example—We can import things
cheaply from abroad, but before importing, we were paying more for similar home produced
goods. The imports, therefore yield a surplus satisfaction. This is Consumer’s Surplus. The
larger this surplus, the more beneficial is the international trade.
3. Useful to Businessman and Monopolist:
It is of practical importance to the monopolist and businessman in fixing the price of his
commodity. If the commodity is such that the consumers are willing to pay more for it, they
will enjoy large surplus. In such a case the monopolist and businessman can raise the price
without affecting the sale. Thus, the monopolist and businessman is guided by the knowledge
of the Consumer’s Surplus in fixing the price of his product.
4. Comparing Advantages of Different Places:
Consumer’s Surplus proves useful when we compare the advantage of living in two different
places. A place where there are greater amenities available at cheaper rates will be better to
live in. In these places, the consumers enjoy large surplus of satisfaction. Consumer’s Surplus
thus indicates environmental and conjectural advantages i.e., the advantages of environment
and opportunities.
5. Importance in Public Finance:
The concept has a great practical importance to the Government in determining the
desirability of imposing tax on certain commodity. A tax imposed on a commodity tends to
raise its price and to reduce Consumer’s Surplus thereby, but it yields some revenue to the
government.
The Finance Minister is to compare the Loss of Consumer’s surplus to the increase in tax-
revenue. A tax is justified when the loss in Consumer’s Surplus becomes less than the
increase in tax revenue, otherwise it will be harmful.
6. Importance in Welfare Economics:
This concept is an important tool in welfare economics also.
This can be explained in the following manner:
(i) In his partial analysis, Marshall deals with the surplus of all the consumers in a market.
(ii) Next, the effects of price-quantity variations of commodities on the welfare of the
commodity are also being worked out with the aid of this concept.
28. (iii) Further, the gain which accrues to the community from a new product and the loss from
the total dis-appearance of a product from the market are some of the other problems which
are being explained with the idea of Consumer Surplus.
(iv) In the end, the effects of a tax and a subsidy on total welfare can be explained by it.
Explanation of Consumer’s Surplus by Prof. Hicks:
The concept of Consumer’s Surplus was rehabilitated by Prof. J. R. Hicks even without the
measurement of utility. In this connection Hicks has said that the best way of looking at
Consumer’s Surplus is to regard it as a means of expressing in terms of money income, the
gain which accrues to the consumer as a result of all in price.
Hicks in his “Indifference Curve Analysis” takes resources to the external behaviour of a man
whereby a man prefer one situation to another and with the help of this ordinal utility
function, finds out the Consumer’s Surplus.
For example:
Let us suppose that the consumer does not know the price of commodity X. He chooses to
have the combination A on IC1 i.e., OR of X commodity and OS amount of money. In other-
words he is prepared to pay for OR commodity of X commodity and OS amount of money. In
other words he is prepared to pay for OR commodity of X the TS amount of money.
Now let us suppose he knows the price of X which is indicated by TM budget line. The
consumer finds that he can get on to a higher indifference curve with the same income. The
consumer’s new equilibrium is represented by B the tendency between IC2 and TM. At this
point consumers combination is OR amount of X commodity + UO amount of money.
In other-words, the consumer has to spend only TU
amount of money as compared to TS which he is prepared to pay for the same amount of X
commodity. Thus, Consumer’s Surplus equivalent to SUBA. We can thus conclude that in
indifference curve analysis Consumer’s Surplus signifies a passage from a lower to a higher
indifference curve which environment makes possible for an economic subject.
