Law of Equi-marginal Utility

INTRODUCTION

• The Law of equi-marginal Utility is another fundamental principle of Economics. This law is also known as the Law of substitution or the Law of Maximum Satisfaction.

INTRODUCTION

• We know that human wants are unlimited whereas the means to satisfy these wants are strictly limited. It, therefore’ becomes necessary to pick up the most urgent wants that can be satisfied with the money that a consumer has. Of the things that he decides to buy he must buy just the right quantity. Every prudent consumer will try to make the best use of the money at his disposal and derive the maximum satisfaction.

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INTRODUCTION

• We know that human wants are unlimited whereas the means to satisfy these wants are strictly limited. It, therefore’ becomes necessary to pick up the most urgent wants that can be satisfied with the money that a consumer has. Of the things that he decides to buy he must buy just the right quantity. Every prudent consumer will try to make the best use of the money at his disposal and derive the maximum satisfaction.

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INTRODUCTION

• In the real world, a consumer may purchase more then one commodity. Let us assume that a consumer purchases two goods X and Y. How does a consumer spend his fixed money income in purchasing two goods so as to maximize his total utility? The law of equi­-marginal utility tells us the way how a consumer maximizes his total utility.

Assumptions of Law of Equi-Marginal Utility

• Units of goods are homogenous.

• No time gap between the consumption of the different units.

• Tastes, fashion, preferences, and priorities remain unchanged.

• Consumer aims at maximum satisfaction.

• Consumer’s income is fixed and limited.

• The consumer acts rationally.

Explanation

• The equi-marginal principle is based on the law of diminishing marginal utility. The equi-marginal principle states that a consumer will be maximizing his total utility when he allocates his fixed money income in such a way that the utility derived from the last unit of money spent on each good is equal.

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Explanation

• Suppose a man purchases two goods X and Y whose prices are P_X and P_Y, respectively. As he purchases more of X, his MU_X declines while MU_Y rises. Only at the margin the last unit of money spent on X has the same utility as the last unit of money spent on Y and the person thereby maximizes his satisfaction.

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Explanation

• Only when this is true, the consumer will not be distributing his money in buying good X and Y, since by reallocating his expenditure he cannot increase his total utility.

This condition for a consumer to maximize utility

• MU_X/P_X = MU_Y/P_Y
• So long as MU_Y/P_Y is higher than MU_X/P_X, the consumer will go on substituting Y for X until the marginal utilities of both X and Y are equalized.
• A consumer thus gets maximum utility from his limited income when the marginal utility per rupee spent is equal for all goods.

Example

• This equi-marginal principle or the law of substitution can be explained in terms of an arithmetical example. In Table on next slide, we have shown marginal utility schedule of X and Y from the different units consumed. Let us also assume that prices of X and Y are Rs. 4 and Rs. 5, respectively.

• MU_X and MU_Y schedules show dimini­shing marginal utilities for both goods X and Y from the different units consumed. Dividing MU_X and MU_Y by their respective prices we obtain weighted marginal utility or marginal utility of money expenditure. This has been shown in next Table

• MU_X/P_X and MU_Y/P_Y are equal to 6 when 5 units of X and 3 units of Y are purchased. By purchasing these combinations of X and Y, the consumer spends his entire money income of Rs. 35 (= Rs. 4 x 5 + Rs. 5 x 3) and, thus, gets maximum satisfaction [10 + 9 + 8 + 7 + 6] + [11 + 10 + 6] = 67 units. Purchase of any other combination other than this involves lower volume of satisfaction.

Graphical Representation:

Limitations:

• The law of equi-marginal utility is based on the measurability of utility in cardinal numbers. But utility is a subjective concept and, hence, not quantifiable.
• This law assumes that the consumer acts rationally. No consumer, in fact, purchases commodity in accordance with this principle of substitution. In fact, purchases are often guided by habit, sentiment, prejudice, or custom.
• This law cannot be applied in the case of indivisible commodities like motor car, refrigerator, etc. Since these commodities are not divisible into smaller units, the law may seem to be inoperative.

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Practical Importance of the Law of Substitution:

• Basis of Consumption
• Basis of Production
• Helpful in Exchange
• Helpful in Distribution
• Public Finance
• Influences Prices

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