BUSINESS ECONOMICS

PROJECT REPORT

LAW OF DIMINISHING
MARGINAL UTILITY
Submitted To- Submitted by-
Mr. Inderjeet Singh Jayant Singla
UILS B. Com LLB(H.)
Panjab University, Sem-1 (Sec E)
Chandigarh Roll No. 249/20

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 Acknowledgement
The success and final outcome of this project required a lot of guidance and
assistance from many people and I am extremely fortunate to have got this all
along the completion of my project. Whatever I have done is only due to such
guidance and I would never forget to thank them.
I take this opportunity to record deep sense of gratitude to my teacher,
Mr. Inderjeet Singh, University Institute of Legal Studies, Chandigarh for her
incontestably perfect unmatched guidance, encouragement, valuable
suggestions and efforts made during the preparation of this project and
during her lectures which enabled me to complete this project successfully on
the topic,

“Cardinal Utility Analysis: Law of Diminishing Marginal

Utility”
I owe my regards to the entire faculty of the Department of Legal Studies from
where I have learnt the basics and whose informal discussions, intellectual
support helped me in the entire duration of this work.

Jayant Singla
B. Com LLB (H.)
Semester- 1 (Sec-E)
Roll No.- 249/20

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 Contents
1. What is Utility? ……………………….………………Page 04
2. The Marginal Utility Analysis…………………...Page 05
3. Assumptions………….…………………………….....Page 07
4. Law of Diminishing Marginal Utility.………...Page 10
5. Significance…………..………………………………...Page 14
6. Limitations…...………………………………………...Page 15
7. Bibliography…………………………………………...Page 17

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 WHAT IS UTILITY?
The simple meaning of ‘utility’ is ‘usefulness’. In economics utility is the
capacity of a commodity to satisfy human wants.

Utility is the quality in goods to satisfy human wants. Thus, it is said that

“Wants satisfying power of goods or services is called

Utility.”

In this way utility is measured in terms of money and it is relative. There is

difference between utility and usefulness. A useful commodity may not here
utility of goods depend upon the intensity of wants.

A consumer buys or demands a particular commodity he derives some benefit

from its use. He feels that his given want is satisfied by the use or
consumption of the commodity purchased. Utility is the basis of consumer
demand. A consumer thinks about his demand for a commodity on the basis of
utility derived from the commodity.

Utility depends upon the intensity of want. When a want is unsatisfied or

more intense, there is a greater urge to demand a particular commodity which
satisfies a given want. In modern time utility has been called as ‘expected
satisfaction.’ Expected satisfaction may be less or equal to or more than the
real satisfaction.

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 THE MARGINAL
UTILITY ANALYSIS
The marginal utility theory, formulated by Alfred Marshall, a British
economist, seeks to explain how a consumer chooses to spend his income on
different goods and services so as to maximize his utility. Marginal utility
theory treats consumers as striving to maximize utility which is a quantitative
measure of the consumer's well-being or satisfaction. According to Marshall,
utility is the numerical score in terms of utils representing the satisfaction
that a consumer obtains from the consumption of a particular good. (Utils
refer to the hypothetical measuring unit of utility)
This theory is based on certain assumptions. But before stating the
assumptions, let us understand the meaning of the terms total utility and
marginal utility.
(a) Total utility: Assuming that utility is quantitatively measurable and
additive, total utility may be defined as the sum of utility derived from
different units of a commodity consumed by consumer. Total utility is
the sum of marginal utilities derived from the consumption of different
units i.e.
TU=MU1+MU2+......+MUn
Where MU1, MU2.......MUn etc. are marginal utilities of the successive units of a
commodity.
(b)Marginal utility: The marginal utility of a good or service is the change in
total utility generated by consuming one additional unit of that good or
service. In other words, it is the utility derived from the marginal or one
additional unit consumed or possessed by the individual.
Marginal utility = the addition made to the total utility by the addition of
consumption of one more unit of a commodity

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Symbolically,
MUn = TUN-TUN-1
Where,
Mun is the marginal utility of the nth unit,
TUn is the total utility of the nth unit, and
TUn-1 is the total utility of the (n-1)th unit.

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 Assumptions
Cardinal utility analysis of demand is based upon certain important
assumptions. Before explaining how cardinal utility analysis explains
consumer’s equilibrium in regard to the demand for a good, it is essential to
describe the basic assumptions on which the whole utility analysis rests. As
we shall see later, cardinal utility analysis has been criticized because of its
unrealistic assumptions.

The Cardinal Measurability of Utility:

The exponents of cardinal utility analysis regard utility to be a cardinal
concept. In other words, they hold that utility is a measurable and quantifiable
entity. According to them, a person can express utility or satisfaction he
derives from the goods in the quantitative cardinal terms. Thus, a person can
say that he derives utility equal to 10 units from the consumption of a unit of
good A, and 20 units from the consumption of a unit of good B.

Moreover, the cardinal measurement of utility implies that a person can

compare utilities derived from goods in respect of size, that is, how much one
level of utility is greater than another. A person can say that the utility he gets
from the consumption of one unit of good B is double the utility he obtains
from the consumption of one unit of good A.

According to Marshall, marginal utility is actually measurable in terms of

money. Money represents the general purchasing power and it can therefore
be regarded as a command over alternative utility-yielding goods. Marshall
argues that the amount of money which a person is prepared to pay for a unit
of a good rather than go without it is a measure of the utility he derives from
that good.

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Thus, according to him, money is the measuring rod of utility Some
economists belonging to the cardinalist school measure utility in imaginary
units called “utils” They assume that a consumer is capable of saying that one
apple provides him utility equal to 4 utils. Further, on this ground, he can say
that he gets twice as much utility from an apple as compared to an orange.

The Hypothesis of Independent Utilities:

The second important tenet of the cardinal utility analysis is the hypothesis of
independent utilities. On this hypothesis, the utility which a consumer derives
from a good is the function of the quantity of that good and of that good only. In
other words, the utility which a consumer obtains from a good does not depend
upon the quantity consumed of other goods; it depends upon the quantity
purchased of that good alone.

On this assumption, then the total utility which a person gets from the whole
collection of goods purchased by him is simply the total sum of the separate
utilities of the goods. Thus, the cardinalist school regards utility as ‘additive’,
that is, separate utilities of different goods can be added to obtain the total sum
of the utilities of all goods purchased.

Constancy of the Marginal Utility of Money:

Another important assumption of the cardinal utility analysis is the constancy
of the marginal utility of money. Thus, while the cardinal utility analysis
assumes that marginal utilities of commodities diminish as more of them are
purchased or consumed, but the marginal utility of money remains constant
throughout when the individual is spending money on a good and due to
which the amount of money with him varies. Daniel Bernoulli first of all
introduced this assumption but later Marshall adopted this in his famous book
“Principles of Economics’.

As stated above, Marshall measured marginal utilities in terms of money. But

measurement of marginal utility of goods in terms of money is only possible if
the marginal utility of money itself remains constant. It should be noted that
the assumption of constant marginal utility of money is very crucial to the

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Marshallian analysis, because otherwise Marshall could not measure the
marginal utilities of goods in terms of money. If money which is the unit of
measurement itself varies as one is measuring with it, it cannot then yield
correct measurement of the marginal utility of goods.

Introspective Method:
Another important assumption of the cardinal utility analysis is the use of
introspective method in judging the behaviour of marginal utility.
“Introspection is the ability of the observer to reconstruct events which go on
in the mind of another person with the help of self-observation. This form of
comprehension may be just guesswork or intuition or the result of long lasting
experience.”

Thus, the economists construct with the help of their own experience the
trend of feeling which goes on in other men’s mind. From his own response to
certain forces and by experience and observation one gains understanding of
the way other people’s minds would work in similar situations. To sum up, in
introspective method we attribute to another person what we know of our
own mind. That is, by looking into ourselves we see inside the heads of other
individuals.

So, the law of diminishing marginal utility is based upon introspection. We

know from our own mind that as we have more of a thing, the less utility we
derive from an additional unit of it. We conclude from it that other individuals’
mind will work in a similar fashion, that is, marginal utility to them of a good
will diminish as they have more units of it.

With the above basic premises, the founders of cardinal utility analysis have
developed two laws which occupy an important place in economic theory and
have several applications and uses.

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LAW OF DIMINISHING
MARGINAL UTILITY
An important tenet of cardinal utility analysis relates to the behaviour of
marginal utility. This familiar behaviour of marginal utility has been stated in
the Law of Diminishing Marginal Utility according to which marginal utility of
a good diminishes as an individual consumes more units of a good. In other
words, as a consumer takes more units of a good, the extra utility or
satisfaction that he derives from an extra unit of the good goes on falling.
It should be carefully noted that it is the marginal utility and not the total
utility that declines with the increase in the consumption of a good. The law of
diminishing marginal utility means that the total utility increases at a
decreasing rate.

Marshall who has been a famous exponent of the cardinal utility analysis
has stated the law of diminishing marginal utility as follows:

“The additional benefit which a person derives from a given increase of

his stock of a thing diminishes with every increase in the stock that he
already has.”

This law is based upon two important facts. First, while the total wants of a
man are virtually unlimited, each single want is satiable. Therefore, as an
individual consumes more and more units of a good, intensity of his want for
the good goes on falling and a point is reached where the individual no longer
wants any more units of the good. That is, when saturation point is reached,
marginal utility of a good becomes zero. Zero marginal utility of a good
implies that the individual has all that he wants of the good in question.

The second fact on which the law of diminishing marginal utility is based is
that the different goods are not perfect substitutes for each other in the

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satisfaction of various wants. When an individual consumes more and more
units of a good, the intensity of his particular want for the good diminishes but
if the units of that good could be devoted to the satisfaction of other wants and
yielded as much satisfaction as they did initially in the satisfaction of the first
want, marginal utility of the good would not have diminished.

It is obvious from above that the law of diminishing marginal utility describes
a familiar and fundamental tendency of human nature. This law has been
arrived at by introspection and by observing how consumers behave.

ILLUSTRATION
Consider Table below where we have presented the total and marginal
utilities derived by a person from cups of tea consumed per day. When one
cup of tea is taken per day the total utility derived by the person is 12 utils.
And because this is the first cup its marginal utility is also 12 utils with the
consumption of 2nd cup per day, the total utility rises to 22 utils but marginal
utility falls to 10. It will be seen from the table that as the consumption of tea
increases to six cups per day, marginal utility from the additional cup goes on
diminishing (i.e., the total utility goes on increasing at a diminishing rate).

However, when the cups of tea consumed per day increases to seven, then
instead of giving positive marginal utility, the seventh cup gives negative
marginal utility equal to – 2 utils. This is because too many cups of tea
consumed per day (say more than six for a particular individual) may cause
acidity and gas trouble. Thus, the extra cups of tea beyond six to the individual
in question gives him disutility rather than positive satisfaction.

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Figure below illustrates the total utility and the marginal utility curves. The
total utility curve drawn in the Figure is based upon three assumptions. First,
as the quantity consumed per period by a consumer increases his total utility
increases but at a decreasing rate. This implies that as the consumption per
period of a commodity by the consumer increases, marginal utility diminishes
as shown in the lower panel of Figure. Secondly, as will be observed from the
figure when the rate of consumption of a commodity per period increases to
Q4, the total utility of the consumer reaches its maximum level.

Therefore, the quantity Q4 of the commodity is called satiation quantity or

satiety point. Thirdly, the increase in the quantity consumed of the good per
period by the consumer beyond the satiation point has an adverse effect on
his total utility that is, his total utility declines if more than Q4 quantity of the
good is consumed.

This means beyond Q4 marginal utility of the commodity for the consumer
becomes negative ads will be seen from the lower panel of Figure beyond the
satiation point Q4 marginal utility curve MU goes below the X-axis indicating it
becomes negative beyond quantity Q4 per period of the commodity consumed.
It is important to understand how we have drawn the marginal utility curve.
As stated above marginal utility is the increase in total utility of the consumer
caused by the consumption of an additional unit of the commodity per period.
We can directly find out the marginal utility of the successive units of the
commodity consumed by measuring the additional utility which a consumer
obtains from successive units of the commodity and plotting them against
their respective quantities.

However, in terms of calculus, marginal utility of a commodity X is the slope of

the total utility function U = f(Qx). Thus, we can derive the marginal utility
curve by measuring the slope at various points of the total utility curve TU in
the upper panel of by drawing tangents at them. For instance, at the quantity
Q1 marginal utility (i.e., dU/ dQ = MU1) is found out by drawing tangent at
point A and measuring its slope which is then plotted against quantity in the
lower panel of Figure. In the lower panel we measure marginal utility of the
commodity on the Y-axis. Likewise, at quantity Q2 marginal utility of the

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commodity has been obtained by measuring slope of the total utility curve TU
at point B and plotting it in the lower panel against the quantity Q2.
It will be seen from the figure that at Q4 of the commodity consumed, the total
utility reaches at the maximum level T. Therefore, at quantity Q4 the slope of
the total utility curve is zero at this point. Beyond the quantity Q4 the total
utility declines and marginal utility becomes negative. Thus, quantity Q4 of the
commodity represents the satiation quantity.

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 SIGNIFICANCE
The significance of the diminishing marginal utility of a good for the
theory of demand is that it helps us to show that the quantity demanded
of a good increase as its price falls and vice versa. Thus, it is because of
the diminishing marginal utility that the demand curve slopes
downward.

But it is worth mentioning that marginal utility of money is generally

never zero or negative. Money represents purchasing power over all
other goods, that is, a man can satisfy all his material wants if he
possesses enough money. Since man’s total wants are practically
unlimited, therefore, the marginal utility of money to him never falls to
zero.

The marginal utility analysis has a good number of uses and applications
in both economic theory and policy. The concept of marginal utility is of
crucial significance in explaining determination of the prices of
commodities. The discovery of the concept of marginal utility has helped
us to explain the paradox of value which troubled Adam Smith in “The
Wealth of Nations.”

Adam Smith was greatly surprised to know why water which is so very
essential and useful to life has such a low price (indeed no price), while
diamonds which are quite unnecessary, have such a high price. He could
not resolve this water-diamond paradox.

According to the modern economists, the total utility of a commodity

does not determine the price of a commodity and it is the marginal utility
which is crucially important determinant of price. Now, the water is
available in abundant quantities so that its relative marginal utility is
very low or even zero. Therefore, its price is low or zero. On the other
hand, the diamonds are scarce and therefore their relative marginal
utility is quite high and this is the reason why their prices are high.

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 LIMITATIONS
In the consumption of most goods and services, and for most people, the
principle of diminishing marginal utility holds true. However, the law of
diminishing marginal utility has certain exceptions and is valid only under
certain conditions-
(1) The law of diminishing marginal utility is based on rigorous assumptions
such as cardinal measurability of utility, constancy of marginal utility of
money, continuous consumption, homogeneity of units consumed. The law
would operate only when these unrealistic assumptions are met.
(2) Utility is not in fact independent. The shape of the utility curve may be
affected by the presence or absence of articles which are substitutes or
complements. The utility obtained from tea may be seriously affected if no
sugar is available and the utility of bottled soft drinks will be affected by the
availability of fresh juice.
(3) The law is not universal. There are many instances where the marginal
utility does not fall or quite the opposite may increase with increase in
consumption or stock obtained. Such cases are considered as exceptions to
this law. For example, the law may not apply in the following situations:
• The law may not apply in the case of prestigious goods and articles like
gold, cash, diamonds etc. where a greater quantity may increase the
utility rather than diminish it.
• The law also may not hold well in the case of hobbies, rare collections
etc. where, with every addition to the collection, the marginal utility will
go on rising. Similarly, people who seek greater knowledge and
information will be more satisfied with every additional information
secured by them.
• The law may not be operating in cases such as creative art, painting,
music, poetry etc. as more of these would generate greater satisfaction.
• The law does not hold good in the case of habit forming commodities
like alcohol, cigarettes, and computer games etc. because those who are

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 habituated into these may experience increasing utility with every
additional intake.
• The law also fails in the case of people with miserly behaviour as
accumulation of every additional unit of money would give them greater
levels of satisfaction.
However, we should keep in mind that in all the above-mentioned cases, the
fundamental assumptions necessary for the law to operate are not met and as
such they are not exceptions in the real sense.

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 Bibliography
• Principles of Microeconomics - H.L. AHUJA (SIXTEENTH
REVISEDEDITION)

• https://www.scribd.com

• https://www.economicsdiscussions.net

• https://corporatefinanceinstitute.com/

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