Money constant: Assumption of constant MU of money

Money is not a suitable measuring rod as marginal utility of money does not remain constant in fact. In real life consumer can merely compare the utility of different goods. The observed human behaviour reveals this fact.

Therefore, this unrealistic assumption should be dropped. 2. Utilities of goods are not independent:Utility analysis assumes that utility of a commodity is independent of other goods. This assumption states that the utility function of different goods is additive. But this is not true.

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The utility of complementary goods and as well as of substitute goods cannot be in depend of each other. For example, the utility of Pakora cannot be independent of source. 3. Marginal utility of money cannot be constant:Assumption of constant MU of money is crucial importance to utility analysis. MU of money to the consumer does not change even when he purchases more units of the goods he warns. But this is not true in real life. When a consumer spends more on a goods, the amount of money with the consumer decreases and MU of money rises.

Due to the assumption of constant MU of money many other drawbacks are present in the utility analysis: (i) It ignores income effect of change in price. (ii) Marshall failed to understand the composite character of price effect. (iii) Valid only in case of one commodity model. (iv) It failed to explain the Giffen paradox. 4. Limited to one commodity model:Professor Hicks has argued that Marshalls assumption of constant MU of money and independent utilities reduced the validity of his law to one commodity case only. Utility demand theorem and constant MU of money are inconsistent except in a one commodity case. Utility analysis fails to explain the demand theorem when a consumer purchases more than one goods.

We know that a consumer is in equilibrium when: MUx/ Px = MUy/ Py = MUm Now suppose the price of goods X rises, then the demand of X goods will fall and consequently the expenditure incurred on goods X may increase or decrease or remain constant. It will depend on elasticity of demand. There can be three situations: (i) If elasticity of demand equals unity, then total expenditure on the goods will remain the same. Thus no adjustment in expenditure is needed. (ii) If elasticity of demand is greater than one then the new expenditure on the goods will fall as a result of increase in price and vice- versa. (iii) When elasticity of demand is less than one then expenditure on the goods in question will increase with rise in price and vice- versa.

It follows that in second and third situations, the consumer will have to make changes in the demand of goods other than X. But in utility analysis of demand this further adjustment in expenditure an goods other than X can occur if the MU of money is revised. But Marshall assumes marginal utility of money constant.

Thus, utility analysis is limited to one commodity model only. 5. Fails to divide price effect into income effect and substitution effect:Price effect is a combination of income effect and substitution effect. Utility analysis does not divide the price effect into income effect and substitution effect. It does not explain that when as a result of change in price of a goods, demand changes, how much of this changed demand is due to change in real income (income effect) and how much due to substitution of cheaper goods for the costlier one, i.e.

, substitution effect. 6. Measurement of utility in terms of money is challenged:To calculate utility in terms of money, the marginal utility of money must remain constant.

Prof. Marshall asserts, “Utility is not only measureable in principle but also measureable in fact.” But MU does not remain constant when a consumer buys two or more goods. Thus, MU of money cannot be measured in fact.

However, if utility is measurable in principle and not in fact then it practically gives up coordinal measurement of utility and comes to ordinal measurement of utility. 7. Fails to explain Giffen paradox:Utility analysis does not break-up ‘price effect’ into ‘income effect’ and substitution effect. Due to this the demand theorem derived by Marshall could not explain Giffen paradox, i.

e. positive relation between price and demand of Giffen goods (most inferior goods). He treated it as exception of the demand theorem. 8.

Too many assumptions:Marginal utility analysis assumes too much and explains too little. Therefore, the theory has little realism. From the above discussion it is clear that there are many a gaps and limitations in utility analysis. At best it is applicable in only one commodity situation. Marshall theory left the distinction between income and substitution effect of the price change unexplained.

It is an empty box crying out to be filled and this gap is filled by indifference curve technique of consumer behaviour.


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