Concept Of The Law Of Substitution

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11:11 PM

The law of substitution is also known as the law of equi-marginal utility or the law of maximum satisfaction. This law was first developed by H.H Gossen. Therefore, this law is also known as second law of Gossen. Prof. Marshall has developed and given the present shape of this law.

This law states that in order to get maximum satisfaction, a consumer should spend his limited income on different commodities in such a way that the last dollar spent on each commodity yield him equal marginal utility.

The law of substitution  is also known as " The Law Of Maximum Satisfaction" because the consumer can maximize his/her satisfaction by spending income in accordance with this law. It is called " The Law Of Substitution" because the consumer will go on substituting one commodity with higher marginal utility for another commodity with lower marginal utility till the marginal utility of each commodity is equal. Suppose, there are two commodities X and Y on which a consumer has to spend a given income. If he finds that the marginal utility of commodity X is higher than the marginal utility of commodity Y, he will substitute the former for the latter till their marginal utilities are equalized.

Concept Of Consumer's Surplus

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11:22 PM

The concept of consumer's surplus is one of the most important idea in economic theory especially in demand and welfare economics.

This law was first developed by French engineer A.J Dupuit in 1844 to measure the social benefits of public commodities like canals, bridges, national highways, etc. This concept was further refined and popularized by Dr. Alfred Marshall in 1890.

The essence of the concept of consumer's surplus is that people generally get more satisfaction or utility from the consumption of commodities than the actual price they pay for them. It has been found that people are willing to pay more price for the commodity than they actually pay for them. This extra satisfaction which the consumers obtain from buying a commodity has been called consumer's surplus by Marshall.

The amount of money which a person is prepared to pay for a commodity indicates the amount of utility he derives from that commodity. Greater the amount of money he is willing to pay, greater the satisfaction or utility he will obtain from it. Therefore, the marginal utility of a unit of a commodity determines the price a consumer will prepare to pay for that unit.

The total utility which a person will get from a commodity will be given by the sum of marginal utilities of the units of commodities purchased or the total price which he actually pays equal to the price per unit multiplied by the number of units purchased. Thus,

Consumer's surplus = what a consumer is prepared to pay minus what he actually pays.

So, C.S = Total Utility- Total amount spent

The concept of consumer's surplus is based on the law of diminishing marginal utility. As we purchase more units of a commodity, its marginal utility goes on diminishing. The consumer is in equilibrium when marginal utility become equal to the given price. 

Criticisms Of Consumer's Surplus

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9:48 PM

The concept of consumer's surplus has been criticized on several grounds as follows:

1. Imaginary

The concept of consumer's surplus is a purely imaginary idea. We just imagine what we are prepared to pay and subtract what we actually pay. It is all hypothetical.

2. Utility is not measurable

The concept of consumer's surplus is based on the assumption that utility can be measured quantitatively in term of money. But utility is a subjective concept. Therefore, utility cannot be measured quantitatively.

3. Marginal utility of money not constant

The concept of consumer's surplus supposes that the marginal utility of money remains constant throughout the process of exchange. But the marginal utility of money does not remain constant. When a consumer spends his given money income on the purchase of a commodity, the amount of money left him is reduced and its marginal utility to him increases. While calculating consumer's surplus, we do not take into consideration this change in the marginal utility of money.

4. Not applicable to necessaries

The concept of consumer's surplus does not apply to necessaries of life or conventional necessaries. The price of necessaries is very low whereas utility derived from them is very high. Therefore, consumer's surplus from them is infinite when a man is dying of thirst, he may be prepared to pay any amount of money for a glass of water.

5. Neglect complementary commodities

Marshall assumes that the utility of a commodity depends upon the supply of that commodity alone. He neglect the problem of complementary of commodities. Thus, he considers one commodity as independent of the others.

6. Neglect Substitutes

This concept assumes the absence of substitutes of the commodity from which the consumer derives the surplus because the presence of substitutes like tea and coffee would make the measurement of consumer's surplus difficult.

Significance Of Consumer's Surplus

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9:41 PM

The concept of consumer's surplus has great practical importance, which are as follows:

1. Importance in public finance

Consumer's surplus is useful to a finance minister in imposing taxes and fixing their rates. He will tax those commodities in which the consumers enjoying much surplus. In such cases, the people would be willing to pay more than they actually pay. Such tax will bring more revenue to the state.

2. Importance to businessman and monopolist

The concept of consumer's surplus is very useful to the businessman. He can raise price of those commodities in which there is a large consumer's surplus. The seller will be able to raise price if he is monopolist and control the supply of the commodity.

3. Comparing advantages of different places

The concept of consumer's surplus enables us to compare the advantages of environment and opportunities. A person living in a developed area enjoys greater consumer's surplus than a person living in a remote area because the former is able to get all the amenities of life cheaply and easily. It also enables us ti compare standard of living of the people living in different parts of the world. The larger the consumer's surplus the better off is the people.

4. Measuring benefits from international trade

We can measure the benefit from international trade with the idea of consumer's surplus. Suppose that before entering into trade with another country we are prepared to pay $ 1000 for a computer. But after establishing trade relation, we get it for $ 750. The difference between what we were prepared to pay for the computer and what we actually pay is the consumer's surplus which measures the benefit fro international trade.

5. Distinction between value in use and value in exchange

The concept of consumer's surplus helps us to distinguish between value in use and value in exchange. Value in use means utility and value in exchange means the price of a commodity. Commodities like salt, post card, match box etc. have a great value in use but a very small value in exchange. Consumer's surplus from such commodities is very large because we are prepared to pay much more for such commodities than we actually pay.

Significance Of The Law Of Diminishing Marginal Utility

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11:39 PM

The law of diminishing marginal utility is of great importance in economics:

1. Basis Of Economic Laws

Several very important laws of economics are based on the law of diminishing marginal utility e.g. the law of demand, consumer's surplus, elasticity of demand, the law of substitution, etc.

2. Basis Of Theory Of  Taxation

The law of diminishing marginal utility is applicable in the sphere of taxation. As a person's income increases, the rate of tax rises because the marginal utility of money to him falls with the rise in his income. The principle of progressive taxation is based on this law.

3. Basis Of Price Determination

This law also applies to the determination of market price. The price of a commodity falls when its supply increases. It is because with the increase in the stock of a commodity, its marginal utility decreases..

4. Basis For Consumer Expenditure

The law of diminishing marginal utility regulates our daily expenditure. We know that as we go on buying more of a commodity, its marginal utility falls.Having only a limited amount of money at our disposal, we cannot waste it unnecessarily on a large quantity of a particular commodity. Therefore, we stop further purchases at a point where marginal utility equals price.

5. Basis Of Distribution Of Wealth

According to socialists, the distribution of wealth and national income should be done on the basis of this law. They argued that excessive wealth in the hand of rich is not so useful from the social point of view. The excess wealth should be transferred to the poor. In the hand of poor, it will satisfy needs that are more urgent. It is due to diminishing marginal utility that beyond a certain point, wealth will have less utility

.of a rich man. If it is transferred to the poor, it will have greater utility.

Exceptions Of The Law Of Diminishing Marginal Utility

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11:04 PM

There are various limitations / exceptions of the law of diminishing marginal utility. Major limitations are as follows:

1. Homogeneous Commodity
The law of diminishing marginal utility assumes that there should be single commodity with homogeneous units. All units of the commodity should be of the same same size and quality. If the units are not identical, this law will not be applied.

2. No change in tastes, habits, customs, fashion and income of the consumer

There should not be changed in tastes, habits, customs, fashion and income of the consumer. If the income of a consumer increases, the marginal utility of a certain goods will increase. In such case, increase in consumption may yield greater satisfaction or utility.

3. Continuity

There should be continuity in the consumption of the commodity; otherwise the law of diminishing marginal utility will not apply. Units of the commodity should be consumed in succession at one particular time. If the interval between the various units of consumption is too long, marginal utility may become higher..

4. Suitable size of units

Units of the commodity should be of a suitable size. It must not be too small. For example, giving water to a thirsty man by spoon will increase the utility of the successive spoon of water.

5. Ordinary commodities

Commodities should be of an ordinary types. If the commodities are likes diamonds and jewels or hobby commodities like stamps, coins or paintings, the law of diminishing marginal utility does not apply.

6. Marginal utility of money not constant

Our intensity for money increases as we have more of it. No doubt the marginal utility of money does not become zero, but it definitely falls as a person gets more and more money.The marginal utility of money for a rich is less than a poor man.

7. Rational consumer

The consumer should be an economic man, who acts rationally. This law does  not apply to persons of special nature such as drunkard, druggist etc. Marginal utility of wine for drunkard increases with every peg of drinks.

Concept Of The Law Of Diminishing Marginal Utility And Its Assumptions

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11:02 PM

Concept Of The Law Of Diminishing Marginal Utility

This law was first developed by a German economist Hermann Heinrich Gossen. This law is also known as the first law of Gosse. The law of diminishing marginal utility states that the marginal utility derived from the consumption of every additional unit goes on diminishing, other thing remaining the same.

The law of diminishing marginal utility is based on two important facts :

1. Though human wants are unlimited, each single want is satiable.

2. Commodities are not perfect substitute for each other.

Therefore, as a consumer consumes more and more units of a commodity, intensity of his/her want for the commodity goes on falling and reaches a point where a consumer do not want any more units of the commodity. That is, when saturation point is reached marginal utility of a commodity becomes zero. Thus, as the amount of consumption of a commodity increases, marginal utility decreases. The second fact is that the different commodities are not perfect substitutes for each other. Hence, when an individual consumes more and more units of a commodity, the intensity of his particular want for the commodity diminishes.

Assumptions Of The Law Of Diminishing Marginal Utility

- Consumer should be rational.

- Utility can be measured in the cardinal number.

- Marginal utility of money remains constant.

- All the units of consumption are homogeneous.

- There is continuous consumption of the commodity i.e, there is no time gap between the successive units of consumption.

- The units of consumptions are suitable in size.

- There is no change in tastes, nature, fashion and habits of the consumer.