Law of Diminishing Marginal Utilit

Law of Diminishing Marginal Utility

Definition of the Law:

"Other things remaining the same when a person takes successive units of a commodity, the marginal utility diminishes constantly".

The marginal utility of a commodity diminishes at the consumer gets larger quantities of it. Marginal utility is the change in the total utility resulting from one unit change in the consumption of a commodity per unit of time.

Assumptions:

Following are the assumptions of the law of diminishing marginal utility.

1. The utility is measurable and a person can express the utility derived from a commodity in qualitative terms such as 2 units, 4 units and 7 units etc.
2. A rational consumer aims at the maximization of his utility.
3. It is necessary that a standard unit of measurement is constant
4. A commodity is being taken continuously. Any gap between the consumption of a commodity should be suitable.
5. There should be proper units of a good consumed by the consumer.
6. It is assumed that various units of commodity homogeneous in characteristics.
7. The taste of the consumer remains same during the consumption o the successive units of commodity.
8. Income of the consumer remains constant during the operation of the law of diminishing marginal utility.
9. It is assumed that the commodity is divisible.
10. There should be not change in fashion. For example, if there is a fashion of lifted shirts, then the consumer may have no utility in open shirts.
11. It is assumed that the prices of the substitutes do not change. For example, the demand for CNG increases due to rise in the prices of petroleum and these price changes effect the utility of CNG.

Explanation With Schedule and Diagram:

We assume that a man is very thirsty. He takes the glasses of water successively. The marginal utility of the successive glasses of water decreases, ultimately, he reaches the point of satiety. After this point the marginal utility becomes negative, if he is forced further to take a glass of water. The behavior of the consumer is indicated in the following schedule:

Units of commodity	Marginal utility	Total utility
1st glass	10	10
2nd glass	8	18
3rd glass	6	24
4th glass	4	28
5th glass	2	30
6th glass	0	30
7th glass	-2	28

On taking the 1st glass of water, the consumer gets 10 units of utility, because he is very thirsty. When he takes 2nd glass of water, his marginal utility goes down to 8 units because his thirst has been partly satisfied. This process continues until the marginal utility drops down to zero which is the saturation point. By taking the seventh glass of water, the marginal utility becomes negative because the thirst of the consumer has already been fully satisfied.

The law of diminishing marginal utility can be explained by the following diagram drawn with the help of above schedule:

In the above figure, the marginal utility of different glasses of water is measured on the y-axis and the units (glasses of water) on X-axis. With the help of the schedule, the points A, B, C, D, E, F and G are derived by the different combinations of units of the commodity (glasses of water) and the marginal utility gained by different units of commodity. By joining these points, we get the marginal utility curve. The marginal utility curve has the downward negative slope. It intersects the X-axis at the point of 6th unit of the commodity. At this point "F" the marginal utility becomes zero. When the MU curve goes beyond this point, the MU becomes negative. So there is an inverse functional relationship between the units of a commodity and the marginal utility of that commodity.

Exceptions or Limitations:

The limitations or exceptions of the law of diminishing marginal utility are as follows:

1. The law does not hold well in the rare collections. For example, collection of ancient coins, stamps etc.
2. The law is not fully applicable to money. The marginal utility of money declines with richness but never falls to zero.
3. It does not apply to the knowledge, art and innovations.
4. The law is not applicable for precious goods.
5. Historical things are also included in exceptions to the law.
6. Law does not operate if consumer behaves in irrational manner. For example, drunkard is said to enjoy each successive peg more than the previous one.
7. Man is fond of beauty and decoration. He gets more satisfaction by getting the above merits of the commodities.
8. If a dress comes in fashion, its utility goes up. On the other hand its utility goes down if it goes out of fashion.
9. The utility increases due to demonstration. It is a natural element.

Importance of the Law of Diminishing Marginal Utility:

The importance or the role of the law of diminishing marginal utility is as follows:

1. By purchasing more of a commodity the marginal utility decreases. Due to this behaviour, the consumer cuts his expenditures to that commodity.
2. In the field of public finance, this law has a practical application, imposing a heavier burden on the rich people.
3. This law is the base of some other economic laws such as law of demand, elasticity of demand, consumer surplus and the law of substitution etc.
4. The value of commodity falls by increasing the supply of a commodity. It forms a basis of the theory of value. In this way prices are determined

Law of Equi Marginal Utility

The law of equi marginal utility was presented in 19th century by an Australian economists H. H. Gossen. It is also known as law of maximum satisfaction or law of substitution or Gossen's second law. A consumer has number of wants. He tries to spend limited income on different things in such a way that marginal utility of all things is equal. When he buys several things with given money income he equalizes marginal utilities of all such things. The law of equi marginal utility is an extension of the law of diminishing marginal utility. The consumer can get maximum utility by allocating income among commodities in such a way that last dollar spent on each item provides the same marginal utility.

Definition:
"A person can get maximum utility with his given income when it is spent on different commodities in such a way that the marginal utility of money spent on each item is equal".

It is clear that consumer can get maximum utility from the expenditure of his limited income. He should purchase such amount of each commodity that the last unit of money spend on each item provides same marginal utility.

Assumptions of the Law of Equi Marginal Utility:
There is no change in the prices of the goods.
The income of consumer is fixed.
The marginal utility of money is constant.
Consumer has perfect knowledge of utility obtained from goods.
Consumer is normal person so he tries to seek maximum satisfaction.
The utility is measurable in cardinal terms.
Consumer has many wants.
The goods have substitutes.
Explanation With Schedule and Diagram:
The law of substitution can be explained with the help of an example. Suppose consumer has six dollars that he wants to spend on apples and bananas in order to obtain maximum total utility. The following table shows marginal utility (MU) of spending additional dollars of income on apples and bananas:

Money (Units) MU of apples MU of bananas
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3
   
The above schedule shows that consumer can spend six dollars in different ways:

$1 on apples and $5 on bananas. The total utility he can get  is:
[(10) + (8+7+6+5+4)] = 40.
$2 on apples and $4 on bananas. The total utility he can get is:
[(10+9) + (8+7+6+5)] = 45.
$3 on apples and $3 on bananas. The total utility he can get is:
[(10+9+8) + (8+7+6)] = 48.
$4 on apples and $2 on bananas. This way the total utility is:
[(10+9+8+7) + (8+7)] = 49.
$5 on apples and $1 on bananas. The total utility he can get is:
[(10+9+8+7+6) + (8)] = 48.
Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4 on apples and $2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7 is also satisfied. Any other allocation of the last dollar shall give less total utility to the consumer.

The same information can be used for graphical presentation of this law:

Law of Equi Marginal Utility Diagram

The diagram shows that consumer has income of six dollars. He wants to spend this money on apples and bananas in such a way that there is maximum satisfaction to the consumer.

Limitations:
The law is not applicable in case of knowledge. Reading of books provides more satisfaction and knowledge to the scholar. Different books provide variety of knowledge and satisfaction.
The law is not applicable in case of indivisible goods. The consumer is unable to divide the goods to adjust units of utility derived from consumption of goods.
There is no measurement of utility. It is psychological concept. It is not possible to express it into quantitative form.
The law does not hold well in case fashion and customs. The people like to spend money on birthdays, marriages and deaths.
 The does not hold well in case of very low income. The maximization of utility is not possible due to low income.
The law is not applicable in case of durable goods. The calculation of marginal utility of durable goods is impossible.
The law fails when goods of choice are not available. The consumer is bound to use commodity, which provides low utility due to non availability of goods having high utility.
There are certain lazy consumers. They do not care for maximum utility. The law fails to operate in case of laziness of consumers. They go on consuming goods with comparing utility.
It does not work when there are frequent prices changes. The consumer is unable to calculate utility of different commodities. Changing price levels create confusion in the minds of consumers.
There may be unlimited resources. The does not work due to unlimited resources. There is no need to change the direction of expenditure from one item to another when there are gifts of nature.
Importance:
The law of equi marginal utility is helpful in the field of production. The producer has limited resources. He uses limited resources to purchase production factors. He tries to equalize marginal utility of all factors. He wishes to get maximum output and profit.
National income is distributed among factors of production according to this law. An entrepreneur can pay factors of production equal to marginal product measured in money terms. He will substitute one factor for another until marginal productivity of all factors is equal to prices of their services.
The law is used in the field of exchange. The people like to exchange a commodity having low utility with a commodity having high utility. There is maximum benefit from exchange of commodities. The law is helpful in exchange of wealth, trade, import and export.
The law is applicable in consumption. A rational consumer tries to get maximum satisfaction when he spends his limited resources on various things. He tries to equalize weighted marginal utility of all the things.
The law is applicable in public finance. The government can spend its revenue to get maximum social advantage. The marginal utility of each dollar spent in one sector must be equal to marginal utility derived from all other sectors.
The law is useful for workers in allocating the time between work and rest. They can compare the marginal utility of work and the marginal utility of rest. They can decide working hours and rest hours.
The law holds well in case of saving and spending. The consumer can make choice between present wants and future wants. He can feel that a dollar saved has greater utility than a dollar spent, he can save more and spend less. He will substitute saving and spending till marginal utility of a dollar spent and a dollar saved are equal.
The law is helpful in prices. Due to scarcity of commodity its prices go up. The law tells us to use substitute commodity, which is less scarce. The result is that the price of commodity comes down.

Law of supply

It is observed in markets that when more price of commodities are offered to sellers. They increase the quantity supplied of these commodities and when the level of prices decreases, the sellers decrease the quantity supplied. This behavior of seller is called law of supply.

Definition
"Other things remaining the same, if the price of a commodity increases its quantity supplied increases and if the price of a commodity decreases, quantity supplied also decreases".

There exists a direct and positive relationship between price and quantity supplied of a commodity. The functional relationship between quantity supplied and the price of a commodity can be expressed as:

Qs = f(P)

Where Qs = quantity supplied

P = price of commodity

Assumptions
The assumptions of the law of supply are as under:

No change in cost of production
It assumed that there is no change in cost of production because of the profit decreases with the increase in cost of production and it causes the decrease in supply. If price of a commodity decreases and cost of production also decreases, at the same time, the quantity supplied does not decrease and profit remains constant.

No change in technology
It is also assumed that technique of production does not change. If better methods of production are invented, profit increases at the previous price. The sellers increase supply and law of supply does not operate.

No change in climate
It is also assumed that there is no change in climatic situation. For example, at any place flood or earth quake occurred. The supply of goods decreases at that place at previously prevailing price.

No change in prices of substitutes
If the prices of substitutes of a commodity fall then the tendency of consumers diverts to substitutes therefore, the supply of a commodity falls without any change in price.

No change in natural resources
If the quantity of natural resources (minerals, gas, coal, oil etc) increases, the cost of production decreases. It causes to increase in quantity supplied.

No change in price of capital goods
The capital goods are raw material, machinery, tools etc. The cost of production increases due to increase in prices of capital goods. It can lead to decrease in quantity supplied.

No change in political situation
The amount of investment is affected by the change in political situation of a country. The production of goods decreases due to decrease in investment.

No change in tax policy
It is also assumed that the taxation policy of government does not change. The increase in taxes effects the investment and production and supply of goods decreases.

Explanation
The slope of the supply function i.e. ΔQ/ΔP is positive. Regarding the assumptions, the standard supply function is written as Qs = - c + d P

Where c and d are parameters while P and Qs are independent and dependent variables, respectively. The positive sign represents direct relationship between P and Qs.

The supply function is expressed with the help of following example: Qs = - 2 + 2 P

By assuming different values of P, we can calculate the different values of Qs as shown below.

Price (P) Quantity supplied Qs
0 -2
1 -0
2 2
3 4
4 6
5 8
As we assumed the different values of 'P' from zero to 5, then the calculated values of Qs increases from - 2 to 8.

law-of-supply-diagram

The quantity supplied is expressed on X-axis while price is measured on Y-axis. The law of supply can be illustrated through the supply schedule as shown in the above supply curve SS'. By plotting the various combinations of price and quantity supplied, we get different points S, M, N, Q, R and T. by joining these points, we get our desired supply curve SS', having positive slope as shown in the above figure.

Causes of positive slope of supply curve
Following are the causes of positive slope of supply curve.

Profit
When the price of a commodity increases, the seller increases the quantity supplied. The profit of seller increases and the aim of seller is to profit maximization.

Cost of production
The cost of production increases due to increase in quantity supplied. It is necessary to increases price to maintain or increase the level of profit. Therefore, there is a direct relationship between price and quantity supplied.

Future Expectations
If there is a tendency of increasing prices at present period, the sellers increase quantity supplied for the lust of profit. It may be expectations in future to decrease prices. Now they want to maximize their profit due to good present circumstances.

Law Of Demand

The law of demand states that all other things being equal, the quantity bought of a good or service is a function of price. As long as nothing else changes, people will buy less of something when its price rises. They'll buy more when its price falls.

The demand schedule tells you the exact quantity that will be purchased at any given price. A real-life example of how this works in the demand schedule for beef in 2014.


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The demand curve plots those numbers on a chart. The quantity is on the horizontal or x-axis, and the price is on the vertical or y-axis. 

If the amount bought changes a lot when the price does, then it's called elastic demand. An example of this is ice cream. You can easily get a different dessert if the price rises too high. 

If the quantity doesn't change much when the price does, that's called inelastic demand. An example of this is gasoline. You need to buy enough to get to work regardless of the price. 

This relationship holds true as long as "all other things remain equal." That part is so important that economists use a Latin term to describe it: ceteris paribus. The "all other things" that need to be equal under ceteris paribus are the other determinants of demand. These are the prices of related goods or services, income, tastes or preferences, and expectations. For aggregate demand, the number of buyers in the market is also a determinant. 

If the other determinants change, then consumers will buy more or less of the product even though the price remains the same. That's called a shift in the demand curve.

Law of Demand Explained

For example, airlines want to lower costs when oil prices rise to remain profitable. They also don't want to cut flights. Instead, they buy more fuel-efficient planes, fill all seats, and change operations to improve efficiency. As a result, they've raised seat-miles per gallon from 55 in 2005 to 60 in 2011. The law of demand would describe this as the quantity of fuel required by the airlines dropped as the price rose. 

Of course, all other things were not equal during this period. In fact, demand for jet fuel was further lessened because airlines' income also dropped at the same time. The 2008 global financial crisis meant that travelers cut back on their demand for air travel. The airlines' expectations about the price of jet fuel also changed. They realized it would probably continue to rise over the long term. The other two determinants of airline's demand for jet fuel stayed the same. They couldn't switch to another fuel, and their tastes or desire to use jet fuel didn't change.

Retailers use the law of demand every time they offer a sale. In the short-term, all other things are equal. Sales are very successful in driving demand. Shoppers respond immediately to the advertised price drop. It works especially well during massive holiday sales, such as Black Friday and Cyber Monday.

The Law of Demand and the Business Cycle

Politicians and central bankers understand the law of demand very well. The Federal Reserve's mandate is to prevent inflation while reducing unemployment. During the expansion phase of the business cycle, the Fed tries to reduce demand for all goods and services by raising the price of everything. It does this with contractionary monetary policy. It raised the fed funds rate, which increases interest rates on loans and mortgages. That has the same effect as raising prices, first on loans, then on everything bought with loans, and finally everything else.

Of course, when prices go up, so does inflation. That's not always a bad thing. The Fed has a 2 percent inflation target for the core inflation rate. The nation's central bank wants that level of mild inflation. It sets an expectation that prices will increase 2 percent a year. Demand increases because people know that things will only cost more next year. They may as well buy it now ceteris paribus.

During a recession or the contraction phase of the business cycle, policymakers have a worse problem. They've got to stimulate demand when workers are losing jobs and homes and have less income and wealth. Expansionary monetary policy lowers interest rates, thereby reducing the price of everything. If the recession is bad enough, it doesn't reduce the price enough to offset the lower income. 

In that case, fiscal policy is needed. The federal government starts spending to create public works jobs. It extends unemployment benefits and cuts taxes. As a result, the deficit increases because the government's tax revenue falls. Once confidence and demand are restored, the deficit should shrink as tax receipts increase.