BCom 1st Year Utility in Business Economics Notes Study Material
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BCom 1st Year Utility in Business Economics Notes Study Material
The term ‘utility’ was introduced into economics by the British philosopher, Jeremy Bentham (1748-1831). He defined utility in the following words:
“Nature has placed mankind under the governance of two sovereign masters, pain and pleasure… The principle of utility recognizes this subjection…By the principle of utility is meant that principle which approves or disapproves of every action whatsoever, according to the tendency which it appears to have to augment or diminish the happiness of the party whose interest is in question.”
The maximization of utility, according to Bentham, simply means avoidance of pain and securing pleasure or happiness. He proposed the organization of society on the principle of utility—“the greatest happiness of the greatest number.” This doctrine of Bentham is known as utilitarianism.
Extension of the utility concept to explain consumer behaviour was the next step in the development of the utility theory. This step was taken by W. S. Javons (1835-1882). To him economic theory was a “calculus of pleasure and pain”. The neo-classical concept of utility was derived from this pain and pleasure psychology of the nineteenth century.
It lay at the heart of the classical theory of demand based on the law of diminishing marginal utility. This law was propounded on the assumption of the quantitative measurement of utility. In the 1930s objection was raised against this concept of utility, known as cardinal utility. Subsequent theory of demand was recast in terms of the concept of non-measurable utility, known as ordinal utility.
Meaning of Utility
As used in economics, the term utility may be defined as the amount of satisfaction to be derived from consuming a commodity or service at a particular time. It is essentially a psychological concept.
According to Marshall, “Utility is taken to be co-relative to desire or want.” In a broad sense utility is synonymous with ‘welfare’, ‘economic welfare’, satisfaction, and occasionally, happiness. “Thus Utility is a general term economists use to denote the satisfaction, pleasure, or benefits received by consumers from their consumption of goods or services or from other activities, such as sleeping, jogging, or playing tennis.”- Utility measures the intensity of a person’s desire for an item.
There are two important points that should be noted about utility. First, the utility of a commodity has nothing to do with its usefulness. Consumption of a commodity may or may not be useful. Consuming milk is useful, taking wine may not be; but both yield satisfaction, that is, utility. Thus utility has no ethical connotation. If we want something, it possesses utility for us. Possession of utility has nothing to do whether the commodity is good or bad for us.
Second, it must be noted that utility is applicable to something at a particular time. A commodity does not possess a specific amount of utility. To a hungry person bread will have great utility, whereas to a man who has just dined it may have no utility.
So Marshall said that utility of a commodity is correlated to desire or want for it. Utility depends on the individual’s own subjective estimate of the amount of satisfaction to be obtained from something. Utility is no such thing as the intrinsic value of a commodity, “for the same commodity has at the same time different utilities for different people, and even for the same person the utility of a thing is not constant but differs at different times and in different circumstances.”
Cardinal and Ordinal Utility
Cardinal Utility: Utility is essentially a psychological concept which is incapable of direct measurement in absolute units like the measure of length or weight. Marshall too says that utility cannot be measured directly; it can be measured indirectly by observable effect by the sum of money a man is prepared to give up in order to obtain a commodity rather than go without it. Measurable utility is known as cardinal utility. Marshall made the measurement of utility operational by means of the concept of consumer’s surplus.
There are two measures of cardinal utility. The first meaning is that utility attached to the units of a good is capable of absolute measurement in terms of some units such as ‘utils’, a term used by Jevons in 1871. Util is comparable to the units used to measure height, weight and distance. In this case absolute numbers are placed on the utility level. Marshall measures utility in money terms. In other words, money becomes the measuring rod of utility.
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 unit. Thus it can be said that the utility of the first unit of bread is Rs.10 and that of the second unit Rs. 8.
It can also be said that the first unit of bread is equivalent to Rs. 10, while the first unit of mango has a utility of Rs. 15. From these examples, the consumer is able to say that the first unit of bread gives more satisfaction or larger utility worth Rs. 2. Similarly, the utility of the first unit of mango is higher than that of bread by Rs. 5.
According to the second meaning of measurement, utility is regarded as measurable only in principle, not in actual practice.
Cardinal measure of utility in terms of money is based on the following assumptions:
(i) Utilities are independent in the sense that utilities derived from different commodities are independent of one another. From this it follows that utilities of a good are additive. So by adding utilities derived from different units of a commodity total utility of these units is derived.
(ii) Marginal utility of money is constant. Since money is the measuring rod of utility, it is essential that this measuring-rod must be invariant like other standards of measure.
In general, few economists now believe that utility is measurable in cardinal terms. The assumption of constant utility of money is unrealistic. As income increases, marginal utility of money changes. Thus money cannot be used as a measuring-rod as its own utility changes. Utilities are not independent but inter-related.
Ordinal Utility: Early economists thought utility could be measured quantitatively like length or temperature. Under cardinal utility an individual’s utility is shown as a function of the quantity of a consumption good. Utilities derived from the different units of a commodity could be added up. Modern economists do not share these views.
They generally believe that comparing or summing the utilities of different people is meaningless. They have reformulated this concept in which they retain the concept of utility or satisfaction but make it non-measurable. Maximization of utility problem does not necessarily need its measurability. As Schumpeter puts it: “there are means of telling whether or not we are on the top of a hill without measuring the elevation of the place where we stand.”
Raising objection against measurability of utility Pareto asked, “show me a utility or satisfaction that is, say, three times as great as another.” But nobody questions “people’s ability to compare satisfactions expected from the possession of different sets of goods without measuring them, that is to say, people’s ability to array such sets in a unique scale of preferences. This is what we mean by ordinal utility.”
Ordinal utility is a concept of utility which is based on the idea of preference ordering or ranking instead of the Marshallian concept of measurable utility. It is assumed that a consumer is capable of comparing any two alternative combinations of goods and deciding whether he prefers one to the other, or is indifferent between them.
A consumer is capable of constructing a scale of preferences in his mind in which different combinations or baskets or bundles of goods are placed in such a order that the highest utility is ranked above the bundle with the next highest utility and so on, that is, in a decreasing order of preferences.
In a strong ordering of preferences there is no place for indifference, while in a weak ordering possibility of indifference is not ruled out. This ranking or ordering is ordinal as it is not possible to say by how much utility differs between the first and second ranked bundle and between the second and third ranked bundle and so on.
In mathematics, 1, 2, 3, 4, etc. are cardinal numbers. The number 2 is twice of the size of number 1, number 4 is four times the size of number 1, and so on. As against this, numbers 1st, 2nd, 3rd, 4th, etc. are ordinal numbers. Such numbers are ordered or ranked.
From the ranking alone, the size relation 01 the numbers cannot be known. The 3rd might be three times the size of the first or might not be. The ordinal numbers 1st, 2nd, 3rd and 4th could be 10; 20, 30 and 40 or they could be 10, 1,000, 10,000 and 1,00,000. From such numbers we can only know whether one number is higher or lower than the other, but cannot say by how much it is higher or lower. We can say whether we are at a higher level of satisfaction or at a lower level, but cannot say by much higher or lower.
Pareto developed the idea of ordinal utility in 1900. Further advance was made by W. E. Johnson (1913) and the Russian economist and statistician Eugen Slutsky (1915). The job was, however, completed by R. G. D. Allen and J. R. Hicks in 1934 and J. R. Hicks in his book Value and Capital in 1939.