MCom I Semester Law Equi Marginal Utility Law Substitution Study Material Notes

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MCom I Semester Law Equi Marginal Utility Law Substitution Study Material Notes

MCom I Semester Law Equi Marginal Utility Law Substitution Study Material Notes: Explanation of Law Another Name os Law modern interpretation of Law Assumptions of Law Exceptions to The law Importance of The Law Relationship Between The Law of Equi Marginal Utility and The Law of Diminishing Marginal

Law Equi Marginal Utility
Law Equi Marginal Utility

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LAW OF EQUI-MARGINAL OR LAW OF SUBSTITUTION

EXPLANATION OF LAW

Law of equi-marginal utility is another fundamental law of consumption. This law states that every consumer wants to achieve maximum satisfaction. Wants of every consumer are unlimited and his resources to satisfy these wants are limited, that too with alternative uses. Every rational person allocates his limited resources in such a way that he may get maximum satisfaction. This law has been defined as under:

1 If a person has a thing, which can be put to several uses, he will distribute it among those uses in such a way that it has the same marginal utility in all. For if it had a greater marginal utility in one use than another, he would gain by taking away some of it from the second use and applying it to the first. This is called law of substitution.” -Prof. Marshall

2. “The utility will be maximised, when the marginal unit of expenditure in each direction brings in the same increments of utility.” –Prof. J. R. Hicks

3. “If a commodity can satisfy many wants within a given period of time, then in order to get the greatest satisfaction from a given quantity of it, its amount should be so distributed between various wants as to make its marginal utility, with reference to given period of time, as nearly equal in all cases as possible.”

Thus, the law of equi-marginal utility explains that wants of every consumer are unlimited, but the resources available with him to satisfy these wants are limited, that too having alternative uses. Therefore, he spends these resources in a manner that he may get maximum satisfaction.

OTHER NAMES OF LAW

(1) Law of Equi-Marginal Utility

(2) Law of Substitution

(3) Law of Consumption

(4) Law of Maximum Satisfaction

(5) Law of Economy

(6) Law of Indifference

(7) Second Law of Gossen

Explanation of Law with the Help of Example

Suppose a consumer has 12 units of money and he wants to spend these units on three commodities: wheat, sugar and milk. His utility schedule for all the three commodities is as follows:

He will spend his first rupee on wheat because he is getting maximum utility there. His second rupee will be spent on sugar and third on milk. Thus, he will be purchasing live units of wheat, four units on sugar and three units of milk. In this manner, he will be getting maximum total utility. Graphically, it can be presented as above.

On a change in Expenditure. If the consumer spends one more unit of his income on the purchase of wheat, he will loose 3 units of marginal utility because he will get only 25 units of marginal utility from 6th unit of wheat, while he will have to sacrifice 28 units of marginal utility, which he is getting on the consumption of 4th unit of sugar or 3rd unit of milk. This situation can be explained with the help of diagram given below :

In above diagram, SS is equi-marginal utility curve. The consumer is spending 5 units of his income on the consumption of wheat and 3 units on sugar. If he consumes one additional unit of wheat, he will get additional marginal utility equal to EFGH area and he will loose marginal utility to ABCD area due to less consumption of sugar. The area of loss is larger than the area of gain. Therefore, the consumer will be a looser.

MODERN INTERPRETATION OF LAW

Modern economists have presented the law of equi-marginal utility in a new and scientific manner. They have nained it as the law of proportional marginal utility. According to these economists, every consumer should spend his money in such a manner that marginal utility of money spent on all the heads may be equal.

Technically, marginal utility of expenditure (MUE) and marginal utility of price ratio (MUPR) should be equal. He must divide his income in such a manner that marginal utility of all the heads of income may be equal, so that he may get maximum satisfaction. Thus, if the price of a commodity is less and its marginal utility is comparatively more, the consumer should purchase more units of it. Mathematically a consumer may get maximum satisfaction when the following equation holds true :

ASSUMPTIONS OF LAW

(1) Rational Behaviour of Consumer. This law assumes that the consumer is a rational man and spends his income very rationally.

(2) Constant Marginal Utility of Money. It assumes that there is no change in the marginal utility of money even if the income of a consumer changes.

(3) Constant Purchasing Power of Money. The law assumes that there is no change in the purchasing power of money. It assumes no change in price level.

(4) Measurement of Utility. This law is based on the assumption that utility is an objective concept and it can be measured in terms of money.

(5) No Change in Fashion, Taste, Preferences and Nature of Consumer. Utility of a commodity is considerably affected by fashion, taste, preferences and nature of consumer. Therefore, there should be no change these factors.

EXCEPTIONS TO THE LAW

(1) Consumers are not Rational. This law assumes that the consumer are very rational but in real life, they are not so rational and calculative.

(2) Ignorance of Consumers. In many cases, consumers do not have complete knowledge of market conditions. As a result, they do not spend their income in most rational manner.

(3) Indivisibility of Goods. This law assumes that a commodity can be used in small units also. But some are the commodities that cannot be so divided such as car, house etc.

(4) Fiabits, Customs and Fashion. An important limitation of this law is regarding the goods of habits, customs and fashion etc. This law does not apply on these goods.

(5) Maximum Total Utility does not Necessarily mean Maximum Satisfaction. This law can help in obtaining maximum utility but maximum utility does not necessarily mean maximum satisfaction.

(6) Non-Availability of Goods. Sometimes a particular commodity is not available in the market and consumer has to consume other commodities which may not provide him equal satisfaction.

(7) Complementary Goods. This law does not apply on complementary goods. Example: A consumer purchase a scooter, he will have to spend on petrol and repair also but it is not necessary to provide him equal satisfaction.

(8) Other Exceptions. (i) Utility cannot be measured in terms of money, (ii) Utility of two or more commodities cannot be compared as assumed by this law, (iii) Marginal utility of money does not remain constant.

Although there are certain exceptions to the law of equi-marginal utility, yet its importance cannot be overlooked. This law is an important law of consumption. In the words of Prof. Chapman, “We are not, of course, compelled to distribute our income according to the law of substitution or equi-marginal utility as a stone thrown in air is compelled in a sense to fall back on the earth, but as a matter of fact, we do so in a certain rough fashion because we are reasonable.”

IMPORTANCE OF THE LAW

(1) Importance in Consumption. Law of equal-marginal utility explains how does a consumer spend his limited resources on his consumption. This law states that every consumer allocates his resources in the manner that he may get maximum satisfaction.

(2) Importance in Production. Every producer allocates his productive resources in the manner that he may get maximum production at minimum cost. He has to take the help of this law. He will continue to replace costly resources by cheaper resources until the marginal productivity of both resources is equal.

(3) Importance in Exchange. A consumer exchanges commodity having more utility for him with the commodity having less utility till the marginal utility of both commodities is equal. In case of exchange with money also, consumers try to equalise the marginal utility of money with that of commodity.

(4) Importance in Distribution. Reward of various factors of production is also detrmined with the help of this principle.

(5) Importance in Public Finance. Government allocates its resources on various heads of social expenditure in the manner that marginal social utility of all the heads may be equal. Taxes are imposed in the manner that marginal sacrifice of all the tax-payers may be equal.

Thus, it may be concluded that law of equi-marginal utility has great importance. Commenting upon its importance, Prof. Marshall said, “The application of the principle of substitution extends over almost every field of economic enquiry.”

RELATIONSHIP BETWEEN THE LAW OF EQUI-MARGINAL UTILITY AND THE LAW OF DIMINISHING MARGINAL UTILITY

Law of equi-marginal utility and the law of diminishing marginal utility are closely inter-related. Law of equi-marginal utility states—how to use the limited resources on unlimited wants to get maximum satisfaction. He goes on substituting more useful goods and services in place of less useful goods and services till the marginal utility of all the goods and services is almost equal.

This law is based on the law of diminishing marginal utility which states that as and when a consumer goes on consuming a particular commodity, marginal utility of every additional until goes on diminishing. Had this law not been in operation, the consumer would have been consuming only one commodity. It is due to the application of the law of diminishing marginal utility only that he spends his income on different goods and services. Thus, these two laws are closely interrelated. The fact is that one is incomplete in the absence of another.

 

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