Sundaram holds a Master's degree in Economics and has worked in marketing, search engine indexing, banking, and research analysis.
Advantages of Marginal Utility Analysis
Prof. Marshall writes that the application of the marginal utility concept extends over almost every field of economics such as production, distribution, consumption, public finance, and so on. Let us look at how the principle of marginal utility applies to all these fields.
In the case of a consumer, the goal is to attain maximum satisfaction. Similarly, the goal of any entrepreneur would be to get maximum profit. In order to achieve maximum profit, the producer has to increase output with the least cost. Towards this end, the producer employs all factors of production according to the following condition:
MPL/PL = MPc/Pc = MPX/PX or MPL/MPc = PL/Pc
MPL = marginal product of labor
MPc = marginal product of capital
MPX = marginal product of n (‘X’ refers to any other factor of production)
PL = price of labor
Pc = price of capital
PX = price of X
According to the principle of marginal utility, when a producer employs all factors of production as per the condition mentioned above, he or she is able to attain maximum output with the least cost.
In distribution, what we are looking at is how the rewards (wages) are distributed among various factors of production. From the demand curve from the marginal utility curve, we learned that the price of a commodity is equal to its marginal utility (click here for an explanation). Likewise, the reward is equal to the marginal product of a factor of production.
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As stated earlier, the aim of a consumer is to attain maximum satisfaction from his or her limited resources. Here, the consumer faces a unique problem of multiple choices. The question now is how the consumer is able to achieve maximum satisfaction with limited resources and multiple choices. In order to achieve maximum satisfaction, a rational consumer arranges expenditures in such a way that
MUx/Px = MUy/Py = MUz/Pz
When a consumer arranges expenditure in this way, they get maximum satisfaction.
Furthermore, the concept of marginal utility helps to distribute income between savings (future needs) and consumption (present needs) rationally. Marshall explains that a rational human being tries to distribute resources between consumption and savings in such a way that the marginal utility of the last dollar put on saving is equal to the marginal utility of the last dollar spent on consumption.
In public finance, the principle of marginal utility helps to attain maximum social welfare. Professors Hicks and Dalton attribute that in order to achieve maximum social welfare, the revenue should be distributed in such a way that the last unit of expenditure on various programs brings equal welfare.
We all are endowed with limited time, i.e., twenty-four hours a day. The concept of marginal utility helps to utilize the limited time optimally. According to Prof. Boulding, a person should spend his limited time on various works such as reading, playing, cooking, earning, and gardening in such a way that the marginal utility from all these works is equal.
- The Law of Diminishing Marginal Utility or Gossen's First Law
- The Law of Equi-Marginal Utility or Gossen's Second Law
Disadvantages of Marginal Utility Analysis
Though marginal utility analysis is helpful in various fields of economics, it has certain limitations as well. Some economists such as Prof. Hicks feel that the analysis may be useful to explore elementary economic behavior. However, the concept may be of no use when it comes to an advanced analysis of consumer behavior. The following are the important weaknesses of the marginal utility approach:
This is one of the most common criticisms against theories of social sciences. The theory of marginal utility is also subject to this criticism. According to critics, too many unrealistic assumptions haunt Marshall’s utility theory. Because of these unrealistic assumptions, the theory becomes too vague. Critics confront the following assumptions of the theory:
1. Constant marginal utility of money
The theory states that the marginal utility of money is constant. However, this is not the case in the real world. When money in your hand increases, the marginal utility derived from it decreases because of abundance. In the real world, you can see affluent people being extravagant in their expenditures. Hence, according to the critics, money, as assumed by the theory, cannot be a measuring rod, as its own utility changes.
2. Utility is measurable
Cardinal utility theory claims that utility is measurable in cardinal numbers (1, 2, 3,….). However, utility is a subjective phenomenon, which can be felt by a consumer psychologically and cannot be measured.
3. Complements and substitutes
The Marshallian utility theory ignores complements and substitutes of the commodity under consideration. The theory states that no complement or substitute of a commodity influences the utility derived from it. However, in real life, there are various complements and substitutes for a commodity. Hence, the utility derived from the commodity under consideration is subject to all those goods. For instance, the utility derived from a car depends upon fuel price also
The theory assumes that the consumer is rational. However, various factors such as advertisement and ignorance can influence the consumer’s decision.
Income Effect and Substitution Effect
Prof. Hicks vehemently criticized that the marginal utility theory failed to throw light on income and substitution effects. When there is a change in the price of a commodity, two effects, namely income and substitution, occur. However, this is not explained by the marginal utility theory. In the words of Hicks, “The distinction between direct and indirect effects of a price change is accordingly left by the cardinal theory as an empty box, which is crying out to be filled.”
Similarly, Marshall was unable to relate the concept of marginal utility to Giffen goods. Hence, Giffen paradox remained a paradox to Marshall as well. (Click here for an explanation of Giffen paradox)
© 2013 Sundaram Ponnusamy