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Concept of Tax and Classification of Taxes

Concept of Tax


A tax is a compulsory levy and liability imposed upon the tax assesses, who may be an individual, group of individual or other legal entities. It is a liability to pay on account of the fact that the tax assesses have income of the specified amount from specified source, or own specified tangible or intangible property, or carry-on certain economic activities which have been legally accepted as criterion for taxation. The taxpayers are to pay taxes irrespective to any direct return or benefit of goods and services from the government. In other words, there is no quid pro quo in taxation.

Features of Tax

  1. Taxes are the main source of government revenue.
  2. Tax is the compulsory contribution.
  3. Tax is imposed only by the government.
  4. Tax is a legal receipt.
  5. There is no quid pro quo in taxation.
  6. Tax payment involves sacrifice by the taxpayers.
  7. Tax is paid out of taxpayers’ income.
  8. Receipt from tax is spent for social welfare.
  9. Tax is one of the fiscal instruments.


Classification of Taxes 


Taxes are classified in different ways. One way of classifying is single and multiple tax system. The single tax system comprises tax on only one source of income. 

In 18th.century, the physiocrats advocated tax only on the agricultural income. Similarly, the Mercantilists, in 19th.century, advocated tax only on the business income. But modern governments have a multiple tax. Since there are many potential areas of taxation, need to minimize the possible ill-effects of individual tax, need to attain multiple objectives and to generate substantial amount of revenue, the multiple tax system is common in practice.

Another way of classification is on the basis of the rates or progression. A tax is regressive when the burden of tax lies relatively more on low income people than the high income people, even though the amount of tax is the same. A tax is proportional when the tax liability increases in the same proportion to the increase in the tax base. 

Tax is progressive when the tax liability increases in both the absolute amount and relative terms (i.e. rates) with the increase in the tax-base. A tax is digressive when the rate is decreasing with the increase in tax-base after certain maximum limit. 

Another way of classification is direct and indirect taxes. The accepted way is on the basis of the determination of tax-liability. Accordingly, in case of direct tax, the liability is determined with direct reference to the tax-paying ability of the taxpayer. Whereas, in case of indirect tax, the liability is determined indirectly. And also, taxes on income and property are accepted as direct, and that on production and consumption as indirect. In case of direct tax the impact and incidence of tax lies on the same person, and in case of indirect tax the impact lies on the person who pays at first, but the incidence is shifted to others (fully or partially).

Objectives of Taxation


The basic objective of taxation is to raise government revenue. Besides, taxes are levied for other economic objectives like:
  1. Protection of local industries against foreign competition
  2. Restriction of general consumption level as well as harmful products
  3. Make contribution to government revenue even by the common people
  4. Promotion of capital formation and economic growth
  5. Maintain economic stability and optimum level of employment
  6. Reduction of inequalities national income and wealth among the people and
  7. Help in environmental protection.
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Government Revenue and Categories of Government Revenues

Concept of Government Revenue

The income of government from all sources is generally called government revenue or receipt. But Dalton has defined public income in a broad and narrow sense as public receipt and public revenue. Accordingly, public receipt includes all incomes of the government. Whereas, public revenue includes income from taxes, prices of goods and services supplied by enterprises, revenue from administrative services and gifts and grants.

According to Sundharam & Andley, public revenue may be categorized as:

(i) Revenue based on compulsion 
  • Taxes
  • Fines for offences committed;
  • Compulsory loans, generally raised during war and
  • Tributes and indemnities arising out of war (or for other reasons) from defeated nations (as imposed on Germany after First World War)

(ii) Revenue on voluntary payment
  • Income from public property as royalty
  • Receipts from public enterprises
  • Fees for administrative services and 
  • Voluntary public loans.

(iii) Revenue based on partly compulsion and partly voluntary
  • Income from public enterprises using monopoly power
  • Betterment levy
  • Income from issue of fresh currency and
  • Voluntary gifts.
However, government revenue generally includes Tax revenue and Non-tax revenue.

Tax-revenue
  • Customs duty
  • Taxes on production and consumption of goods and services (excise and VAT)
  • Taxes on income, profit and property and 
  • Taxes on property transfer registration

Non-tax Revenue
  • Fees, fines, forfeiture and escheat
  • Income from sale of government services
  • Royalty & sale of public assets/property
  • Dividend
  • Principal and interest receipt
  • Money creation
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Concept of Public Finance with Its Nature, Scope, Functions and Subject Matter

Concept of Public Finance

Significance and scope of government involvement in economic decisions depends upon the political ideology of government structure and roles to a great extent. History has revealed that there have been three types of economic systems.

In a capitalistic economy economic decisions (and thereby the economic activities) are done by the private sector. Each economic unit operates in accordance with the economic rationality being guided by the market mechanism with an objective of income maximizing criteria. In such system government has only limited role, mainly as the facilitator and regulator.

A communist (controlled) economy is dominated by the state where economic decisions and activities would not be guided only by the economic maximizing criteria. Market mechanism is assigned a marginal role. 

In a mixed economy there is the co-existence of both the private and public sectors in economic activities. Government is to perform the role of an investor, facilitator and regulator. However, in modern times, almost all countries have mixed economy where the scope and involvement of public and private sector may vary. It is fairly common to justify the need for and presence of government involvement and intervention in economic activities besides the fundamental (basic) functions.

Public sector economics or Public finance deals with the questions of collective wants (i.e. the wants of the community as a whole) and their satisfaction. Public finance aims at maximizing social welfare or social benefits by efficient use of social goods. Collective wants are those which are demanded by all members of the community in equal or, more or less equal measure. Defense, education, public health, infrastructural facilities like power, transportation and communications, etc. are examples of the collective wants. Goods and services produced to satisfy collective wants are known as social goods. The features of social goods are: 
  • Social goods are not divisible;
  • There is some compulsion in providing social goods; and
  • There is no exclusion in social goods.
The grounds for state involvement and interference in economy are: 
  1. Distortions in production structure and failure to create reasonable employment by market mechanism;
  2. Need for the maintenance of economic stability with control of trade cycles (mainly in the developed countries); and
  3. To promote the rate of economic growth and distributive justice {mainly in the developing countries).


DEFINITIONS OF PUBLIC FINANCE


“The term public finance has come by accepted usages, to be confined to a study of funds raised by governments to meet the costs of government.” - Carl C. Plehm

“Public finance deals with the income and expenditure of public authorities, and the manner in which one is adjusted to another.” - Dalton

“Public finance is the study of the principles underlying the spending and raising fund by government”. - Findlay Shirras

“Public finance deals with the finance of the public as an organized group under the institution of government. It thus deals only with the finance of government. The finances of the government including the raising and disbursement of government funds.” - Bastable

“The complex of problem that center around the revenue - expenditure process of government is referred to traditionally as public finance. While operations of public household involve money flows of receipt and expenditure, the basic problems are not the issues of finance. We must think of our task as an investigation into those aspects of economic policy that arise in the operation of the public budget.” - Musgrave

“Public finance is a field of inquiry that treats the income and outgo of governments. In modern times, this includes four major divisions: public revenue, public expenditure, public debt and certain problems of the fiscal system as a whole such as fiscal administration and fiscal policy.” - Harold Grooves

NATURE AND SCOPE OF PUBLIC FINANCE


The nature and scope of public finance has been changing with the changes in the nature and scope of governmental activities as per the need of the economy (society). The scope of governmental activities is to a great extent by the political ideology of the state/government.

In broad sense, the nature of public finance may be categorized as the neutral or non-regulatory and regulatory, mainly on the basis of interfering and influencing the economy. The nature and scope in different periods is determined being guided by different theories.
  1. Pure theory of Public Finance (1776-1880’s): Early classical economists like Seligman, Say, Ricardo advocated the scope of public finance limited to the study and analysis of only the operation of the treasury just for performing the minimum necessary activities by government without any considerations of welfare concept.
  2. Socio-political Theory (1880’s-1930): The neo-classical writers like Wagner, Marshall, Pigou, Edgeworth advocated the social welfare considerations to included in the scope of public finance.
  3. Functional finance Theory: Since 1930’s depression, Keynes, Dalton, Lerner, Hansen like economists advocated government involvement and interference in the economy as per the necessity for maintenance of economic stability, and thus, the nature of public finance being a regulatory one.
  4. Activating finance theory: After the Second World War {mainly since 1d950’s), with the concern about economic development of the developing countries, public finance is to activate the economy with the government involvement as an investor, facilitator and regulator.


FUNCTIONS OF PUBLIC FINANCE

  1. Allocation function: It is concerned with the use of economic resources on what type of goods and services’ production with the objective of growth promotion as well as whether to produce in the public sector or private sector.
  2. Distribution function: It is concerned with the distribution of national income in n equitable way as accepted by the society, mainly to promote the distributive justice.
  3. Stabilizing function: It is concerned with the maintenance of economic stability with the control of economic fluctuations, inflation and correction of adverse balance of payments (BOP).


SUBJECT MATTER OF PUBLIC FINANCE

The subject matter of public finance is the areas of study in relation to the operation of the treasury and the repercussion of different policies operated by the treasury. The subject matter includes:
  1. Public Revenue:- Includes the concept of government revenue and tax, principles of taxation and its effects and role in the economy.
  2. Public Expenditure:- Includes the study of the concept, principles underlying the allocation of public expenditure, and its effects in the economy.
  3. Public Debt:- Includes the study of the concept, sources, need, burden and principles of public debt management.
  4. Financial Administration:- Includes the study of the concept, theories and process of government budgeting.
  5. Fiscal Policy:- Includes the study of mainly the concept and the use and adjustments of the public financial instruments to achieve the desired economic objectives like economic stability, growth and distributive justice.
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Consumer’s Surplus: Concept, Importance and Criticisms

Consumer’s surplus, the concept was introduced by A. J. Dupit, a French engineer in 1844. But he could not have developed it. The credit goes to Alfred Marshall for developing this concept. Marshall first named this concept as ‘consumer’s rent’ in his book ‘Pure Theory of Domestic Value’ and later renamed consumer’s surplus in the book ‘Principles of Economics’. Prof. K. E. Boulding has named it ‘Buyer’s Surplus’.

In our daily expenditure, we find generally that the satisfaction derived from a commodity is higher than the price we pay for the commodity. So, we are prepared to pay more than we actually have to pay. In other words, consumer’s surplus is the difference between what we are prepared to pay and what we actually pay. As for example, we are prepared to pay $12 per kilo for apple, but the actual price in the market is $10 per kilo. Hence, consumer’s surplus is 12 – 10 = $2. Another way to explain the concept is that consumer’s surplus is the total utility minus total amount spent.

According to Marshall – “The excess of the price which the consumer would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of his surplus satisfaction. It may be called consumer’s surplus.”

In the words of Watson and Getz – “The difference between the amount a consumer would pay for the quantity of a commodity bought and the amount the consumer does pay is called consumer’s surplus.”

Consumer’s Surplus
Units of orange
P ($)
MU
CS
1
2
3
4
5
6
5
5
5
5
5
5
10
9
8
7
6
5
5
4
3
2
1
0
PU = 6
TE = 30
TU = 45
15

Suppose that the price per unit of orange is $5. The consumer purchases six units of orange. He purchases up to the point where marginal utility is just equal to price. Now comparing total utility with the total cost (expenditure) we can get consumer’s surplus as:

Total utility = sum of marginal utilities
= $10 + 9 + 8 + 7 + 6 + 5 = $45

Total cost = sum of cost of each unit
= $5 x 6 = $30

Consumer’s surplus = Total utility – total cost
= $45 - $30 = $15

The total utility derived by the consumer from 6 units of orange is $45, but the consumer has paid only $30. So, he gets the consumer’s surplus of $15. Hence, the consumer’s surplus is the difference between what the consumer would be willing to pay ($45) and what he actually has to pay ($30). The concept of consumer’s surplus can be illustrated by the help of a figure below.

Consumer's Surplus

In the figure, the addition of the six rectangles reflecting the marginal utilities gives total utility. The area of the large rectangle OPE 6 (p x q) represent the total cost. The striped area (between price line and demand schedule) that remains after subtracting total cost from total utility is the consumer’s surplus.

The first unit costs $5 but MU or the price willing to pay is worth $10. So, CS = $5. The second unit also costs $5, but MU is worth $9. So, CS = $4 and so on. Adding excess of utility over cost on each unit purchased, we get $15. The area between price line and demand schedule shows this. There is no surplus on the last unit purchased. Because, the consumer purchases up to the point where marginal utility of the last unit is equal to price.

This concept can be presented in simple way by the help of a smooth demand curve as shown in the figure below. Here we assume that the commodity is divisible into small units so that smooth demand curve can be drawn.
Consumer's Surplus

The consumer purchases 6 units at a price of $5 per unit. Consumer’s surplus is the triangular area PTE between the demand curve and the price line. It is equal to the areas of rectangle above the price line in figure. But due to the use of smaller and smaller units, we get smooth line rather than discrete steps. In figure, the total utility from OQ units is OTEQ and the total cost is OPEQ. The difference PTE is consumer’s surplus.

Criticisms of Consumer’s Surplus


The concept of consumer’s surplus has been criticized by many economists like Ulisse Gobbi, Bevenport, Cannan, Nicholson and J. K. Hicks. The criticisms made by them are as follows:
  1. Imaginary concept: The concept of consumer’s surplus has been criticized as an imaginary concept. Because, we have to imagine how much a person is prepared to pay and we will have to deduct the amount he actually pays to get consumer’s surplus. Beside, a man may be prepared to pay different amounts. So, it is an imaginary concept.
  2. Utility is immeasurable quantitatively: We should measure utility obtained by a consumer quantitatively to ascertain that the consumer is willing to pay given sum of money. Utility is a psychological phenomenon. It depends on a person’s mental situation. We cannot there, ascertain the quantity of utility. Some commodity may yield different utility to different persons. So, utility cannot be measured quantitatively.
  3. Bare necessaries: Utility is immeasurable in case of bare necessaries. A man dying of hunger may be prepared to pay any sum of money for a commodity. In such a case, the consumer’s surplus is very high.
  4. Constant marginal utility of money: This concept is based on the assumption that marginal utility of money remains constant. But unlike this assumption, the amount of money declines after expenditure. As a result of this, marginal utility of money to a consumer increases.
  5. Potential price less than actual price: There is a possibility that potential price may be less than the actual price of the commodity. In such a case, there is no consumer’s surplus but loss.

Importance of Consumer’s Surplus


The concept of consumer’s surplus is not imaginary. We feel the operation of this concept in our daily life. It has an important place in economic theory. The importance of this concept can be explained as follows:
  1. Public Finance: This concept is useful in imposing taxes and fixing tax rates. The government should impose taxes on those commodities in which people are prepared to pay more than they actually pay or where consumer’s surplus is large. Such taxes bring more revenue to the government. Because, people do not stop buying commodities because of taxes. Likewise, the imposition of new taxes will not cause any suffering to the people.
  2. Price determination: This concept is useful in price determination of goods and services. It is, therefore, useful to the monopolist and businessmen. The people are prepared to pay more for a commodity having large consumer’s surplus. The sellers, particularly a monopolist can raise price without any fall in sales.
  3. Measurement of the benefit from international trade: This concept also measures the benefit from international trade. We import the commodities for which are paying more in our country. We import the goods since they are cheapest and enjoy consumer’s surplus. Larger the surplus, larger the benefit we get from international trade.
  4. Compare economic condition of people: The concept of consumer’s surplus makes it easier to compare the economic condition of the people of two different countries. The availability of more goods at cheaper rate means that people are enjoying more consumer’s surplus. Hence the people of that country are better off. Likewise, the concept help to compare the advantage of living in two different places. A place with availability of greater amenities at cheaper rates will be better to live in. The consumers there may enjoy larger surplus satisfaction.
  5. Implement law of maximum satisfaction: This concept also helps to implement the law of maximum satisfaction. It guides people to spend the limited money to those goods, which give more consumer’s surplus. This maximizes satisfaction, which is the main aim of the consumer.
  6. Distinction between value-in-use and value-in exchange: This concept tells clearly the distinction between value in use and value in exchange. The commodities like salt, matchbox have great value in use (utility) but have small value in exchange (price). Being necessary and cheaper things, they give large consumer’s surplus.
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Law of Substitution, Equi-marginal Principle

The law of substitution was at first pointed bout by H. H. Gossen. Hence, this law is called Gossen’s Second Law. This law is also known as law of equi-marginal utility and law of maximum satisfaction. 

We know that human wants are unlimited whereas the means to satisfy those wants are limited. So a consumer tries to get maximum satisfaction out if his expenditure. For this he allocates his expenditure among several uses in such a way so as to maximize satisfaction. According to Watson and Getz –“The best, or optimum allocation is one that causes the marginal utilities in each use to be equal”. He will get maximum satisfaction only when he obtains equal marginal utilities from the consumption of different commodities. If this does not happen, the consumer can improve his satisfaction by reducing expenditure in one use and expanding in another words, he substitutes one commodity for another until the marginal utilities from all commodities are equal. This law can be illustrated by the help of a table below.

Law of Substitution
Units
MU of Orange
MU of Apple
1
2
3
4
5
6
10
8
6
4
2
0
8
6
4
2
0
-2

Suppose that the consumer has $7 to spend on orange and apple. The price of orange is $1 per unit. The utility obtained from different units of orange and apple is presented in table. According to the law, the consumer will purchase that unit of orange and apple, which gives him maximum satisfaction. He will therefore, purchase 4 units of orange and 3 units of apple. The marginal utilities of both orange and apple are same, i.e. 4. He derives total utility = 10 + 8 + 6 + 4 = 28, 8 + 6 + 4 = 18 = 46. So, the total utility is equal to 46.

Any other combination or arrangement will not give him so much satisfaction or utility. As for example, if he purchases 3 units of orange and 4 units of apple, total utility will be equal to only 44 which is less than 46. In brief, the consumer obtains maximum satisfaction when marginal utilities from all goods purchased are equal.

The law of equi-marginal utility can be illustrated by the help of figure below. In the figures below, OX axis represents units of money and OY axis represents marginal utility. Suppose that money can be spent on commodities apple and orange. MUA and MUO curves relate to commodity apple and orange respectively. The shapes of curve MUA indicates that the desire for commodity apple is stronger. This means that the marginal utility of any quantity of money in commodity orange is greater than that of the same quantity in commodity apple. Because MUO curve is farther from the vertical axis than MUO curve. Likewise MUO curve begins from the vertical axis at a higher point than does curve MUA.

Equi-marginal Principle

Now suppose that the consumer has $7 to spend on apple and oranges. In the figure, the best allocation is $3 in commodity apple and $4 in commodity orange. Because, with these quantities, the marginal utilities are equal in both commodities, i.e. PM = P’M’. Hence, this is the best allocation of money. Any other combination will give less total satisfaction.

If $4 is devoted to commodity apple and $3 to commodity orange, the gain would be the area between 3 and 4 under MU curve in commodity apple. But there would be loss of area between 3 and 4 under MU curve in commodity orange. It is clear that the loss of utility from reduced consumption of orange is greater than the gain of utility from increased consumption of apple. Hence the total utility of new combination is less. Any other allocation will make a loss in utility greater than gain in utility.

The total utility of any quantity is always the area under the marginal utility curve. When marginal utilities in two commodities are equal, total utility or the entire shaded area in the figure is at a maximum. Any change in allocation of $7 can only reduce total utility.

The equi-marginal principle can be generalized. Any decision maker can obtain maximum return from a given quantity of a resource that has two or more uses of the allocated units of resources in such a way that the marginal returns in each use are equal.


Limitations of the Law of Substitution

There are several limitations of this law, which can be explained as follows:
  1. Increase of marginal returns: For this law to hold, marginal returns must diminish as more and more units of a resource are applied to any one of its uses. Hence, this law may not apply if the marginal utility increases instead of diminishing.
  2. Custom and fashion: When people are influenced by traditions, custom and fashion, they may not behave rationally. They do not try to spend so as to maximize satisfaction. This implies that they spend more where marginal utility is less.
  3. Ignorance: The ignorance of people prevents them from making good uses of money. They cannot judge where utility is higher or where utility is lower. They cannot maximize satisfaction by equalizing marginal utilities in all uses.
  4. Unlimited resources: This law has no use in case of goods available in unlimited quantity. As for example, the free gift of nature like sunshine, air is found in abundance. People need not make rational use of them.
  5. Indivisibility: Some durable consumer goods like motorcar, TV, refrigerator, smartphone is indivisible. For this law to hold goods should be divisible and substitutable. Hence, this law cannot be applied effectively in case of the indivisible goods.
  6. Instability in prices: The consumer may be able to adjust expenditure so as to maximize satisfaction in case of the frequent changes in prices. Because, utility is always weighted in terms of prices of goods.


Importance of the law of substitution

The resources are always limited with the people. So, they should make the best use of available resources. Due to this, the law of substitution has great practical importance. The importance of this law can be explained as follows:
  • Consumption: This law is of special significance to the consumers. The consumers have limited money income. But their wants are unlimited. Hence, they should make the best use of money so as to maximize satisfaction. They should substitute the goods with low utility by goods with high utility.
  • Production: This law holds goods even in production. The aim of a firm or producer is to maximize profit. For this he should select the best combinations of factors of production. He should spend more on the factors, which yield highest returns. He should substitute one factor for another till the marginal productivity of all the factors is equal.
  • Exchange: This law has significance even in exchange. The exchange, in reality, is the substitution of one commodity for other. People get money by selling vegetable. They buy clothes with that money. So, clothes has greater marginal utility to them than vegetable. They have in fact, substituted clothes for vegetable.
  • Distribution: One of the important theories of distribution is that factors of production should be rewarded on the basis of their marginal productivity. A firm uses each factor to the point where the marginal productivity of a factor is equal to the marginal product of other factors. This implies the substitution of one factor for other.
  • Public Finance: This law is relevant even in the field of public finance. The public expenditure is made to as to maximize social welfare. Hence, the government diverts resources from less productive to the more productive sectors. The government imposes more taxes to the rich than to the poor, so that the burden of taxation is equal. Likewise, the government spends more on welfare of the poor than the rich so that benefit of expenditure is equal.

In this way, the law of substitution has wide application in all branches of economic theory. Besides, it has also practical significance. The men follow this law either consciously or unconsciously. As opined by Chapman- “We are not compelled to distribute all income according to the law of satisfaction as a stone thrown into the air is compelled to fall back to earth. But as a matter of fact, we do it in a certain rough fashion because we are reasonable.”
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Law of Diminishing Marginal Utility

The law of diminishing marginal utility expresses the universal human experience. This law was at first pointed out by H. H. Gossen. So, this law is known as Gossen’s First Law. This law was developed by W. S. Jevons in England and by Karl Menger in Austria about the same time (1871) and modified by Alfred Marshall. This law states that if a person consumes more and more units of a commodity, its marginal utility declines. In other words, larger the stock possessed by a person, the smaller the utility he derives from an additional unit of the commodity.

According to Marshall, “The additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock that he has.”

In the words of K. E. Boulding, “As a consumer increases the consumption of any one commodity, keeping constant the consumption of all other commodities, the marginal utility of the variable commodity must eventually decline.”

The law can be express in another way as well. As opined by Watson and Getz, “The more you have of anything, the less important to you is any one unit of it.” So, when a consumer gets more and more unit of a commodity he puts it to less and less urgent uses. We can illustrate it by the help of W. J. Baumol’s interesting example. If a man has a cake, he gives it to his child. If he has two cakes, he gives the second cake to his wife. If he has three cakes, he keeps the third one for himself and if he has four cakes, he gives the fourth one to his mother-in-law. This clearly indicates the declines in marginal utility of cake.

There are several reasons for the decrease in marginal utility. They are:

a) Physical and psychological

The consumption or possession of too many units of a commodity brings physical satisfaction. The response to a repeated stimulus diminishes.

b) Possibility of having everything

If a consumer could have everything he wants free of cost, he would choose those quantities of each good that would make the marginal utility of each one zero. This implies that he would maximize total utility for each goods. Marginal utility therefore, would have to diminish to get to zero.

c) Several uses of commodity

Each commodity may have several uses. Each consumer ranks the uses. If the consumer has one unit of a commodity, he puts it to most important use. If he has more units, he puts them to less and less important uses. Marginal utility diminishes, because of the successively less important uses of additional quantities of a commodity.

This law can be illustrated by the help of a table and diagram as shown below:
Marginal and Total Utility
Units of Orange
Marginal Utility
Total Utility
1
2
3
4
5
6
7
8
10
8
6
4
2
0
-2
-4
10
18
24
28
30
30
28
24

The table shows that as the consumer consumes more and more units of orange, the additional utility obtained from successive units goes on declining. It means that the marginal utility declines. As for example, marginal utility from first unit is equal to 10, from 2nd unit is 8, from 3rd unit is 6 and so on. Marginal utility at of 6th unit is zero. The zero marginal utility means that the consumer has all he want of the commodity. He does not want another unit. If he further consumes, marginal utility will be negative or the commodity will have dis-utility. Negative marginal utility means that the consumer has so many units of same thing. He would rather like to have fewer.
Diminishing Marginal Utility

In the figure, OX axis represents quantity (units) of orange and OY axis represents marginal utility. If we join points of marginal utility and quantity combination from point A to F, we get marginal utility curve MU. The MU curve slopes downwards to the right. This means that marginal utility goes on declining. The consumer gets marginal utility equal to 10 from 1st unit, 8 from 2nd unit, 6 from 3rd unit and so on. Marginal utility derived from 6th unit is zero and from 7th unit marginal utility is negative.

Exceptions/ Limitations or Assumptions of Law of Diminishing Marginal Utility


There are should exist certain conditions for the law of diminishing utility to hold. In the absence of these conditions, the law does not apply. The law does not apply in the following conditions.
  1. Similar units: The different units of a commodity should be similar or homogeneous. If the consumer is supplied with superior quality after consumption of first, his marginal utility will increase.
  2. Suitable units: The units of commodity consumed by a consumer should be suitable. It must not be too small. Hence, the units of the commodity must be relevantly defined. The law holds good for a pair of shoes, but not for a single shoe. Likewise, if a man is very thirsty and he gets only a glass of water, the 2nd glass of water will yield him more utility than the first. “In fact this law begins to operate only after certain point, called the ‘origin’ until the origin is reached-that is, until the minimum amount of commodity that can be used effectively has been used – successive increments will show decreasing utility.”
  3. Suitable period: There must not be time-gap in the consumption of different units. If a man takes ‘lunch’ in the morning and ‘dinner’ in the evening, his marginal utility will not diminish. Hence, the commodity must be consumed continuously.
  4. Change in taste: The law holds for individual commodity desired by an individual consumer with given tastes. But if the taste of the consumer changes during the process of consumption, and he likes the commodity more, then the marginal utility of any unit of that commodity increases.
  5. Rare collection: The law may not hold in case of rare collection. The persons with habit of collecting coins, stamps are never satisfied. But it does not mean that the law does not hold. Because, the man does not like to collect same type of article over and over again.
  6. Normal persons: The person should be normal for this law to hold good. The law does not apply to misers, drunkards and gamblers.
  7. Fashion, habit and income: The fashion, habit and income of the consumer must remain same. If a dress, out of fashion comes to the fashion, a nonsmoking man develops habit of smoking or a man unable to purchase motorbike is able to purchase, the marginal utility of the dress, cigarettes and motorbike increase respectively.
  8. Indivisible goods: According to the law, marginal utility diminishes when the commodity is bought in small units, such as orange, biscuit, milk and so on. Such commodities are said to be divisible. But the law is silent as to the commodities that are brought one at a time at long intervals. Such commodities are indivisible goods such as automobile, T.V. set, refrigerator etc. Likewise, the law is silent about the marginal utility of the commodities that are usually purchased once in a lifetime.

Despite the aforementioned exceptions, this law is regarded universal in its application and is a general law of life. There is hardly any situation under which this law does not apply. As for example, we don’t like to hear the same music, see the same movie over and over again. In fact, this law applies to everything.

Importance of Law of Diminishing Marginal Utility


The law of diminishing utility has both theoretical and practical importance as follows:
  1. Basis of other laws: Some of the laws of economics and laws of consumption are based on this law. As for example, the law of demand, law of maximum satisfaction, law of consumer’s surplus is based on this law.
  2. Theory of taxation: This law also serves as the basis of theory of taxation. The more tax is imposed on the rich while less tax is imposed on the poor. Because, the utility of money is less to the rich and more to the poor.
  3. Advocacy of equal distribution of income and wealth: People advocate equal distribution of income and wealth among the people of the country. Because the poor people get more utility from money whereas the rich people get less utility from money.
  4. Determination of market price: This law is also useful in determination of market price. The increase in stock of a commodity gives less utility. Hence the people can be induced to buy more only by lowering price. In other words, when supply increases, price falls.
  5. Regulates daily expenditure: This law regulates the daily expenditure of people. People do not spent all their money in same commodity. They spend part of their money in buying other commodities.

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Theory of Consumer Behavior

Those who buy goods and services for their own consumption are called consumers in economics. The study of the behavior of the individual consumer is called the theory of consumer behavior. There are two approaches to the theory of consumer behavior i.e. consumer behavior – cardinal utility and ordinal utility. The concept of cardinal utility was popularized by the classical economists of late 18th and 19th centuries. The 20th century version of this theory is known as neo-classical utility theory. The concept of ordinal utility was popularized by the economists like J. R. Hicks and R.G.D. Allen. The cardinal theory assumes that utility is measurable like 1, 2, and 3. But the supporters of ordinal theory assume that ‘Quantities of utility are inherently immeasurable, theoretically and conceptually as well as practically.’ According to them utilities or satisfaction can be only ranked as 1st, 2nd, 3rd and so on. Both these theory study about consumer behavior.
 
An important common feature of these two approaches is that they assume that the consumer behaves rationally. It means, “The consumer calculates deliberately, chooses consistently, and maximizes utility.” The consumer attempts to maximize satisfaction from given amount of money. When they succeed we say that they have achieved optimum position.

Total Utility and Marginal Utility


The power of a commodity to satisfy human wants is called utility. The satisfaction that consumer derives from the goods they buy is called their utility. A consumer may like orange more than mango. Because, orange has more utility. This property is common to all commodities wanted by a person. Hence, utility resides in the minds of the computer. The consumer knows the utility by introspection.

The concept of utility is ethically neutral. If someone wants it, a good or service has utility for that person. The consumption of drug may be harmful or immoral. But it has a utility, since it satisfies the want of a consumer.

The word ‘marginal’ has been used in economic theory for many decades. It means the rate of change of total. Hence, marginal utility means utility derived from the marginal or last unit.

According to Watson and Getz- “The marginal utility (MU) of any quantity n is the total utility (TU) of that quantity minus the total utility of one less. Thus, MU of n = TU of n – TU of (n – 1)”. 

On the other hand, total utility is the utility derived from total units consumed. As quantity consumed increases, total utility increase. Because two units of a commodity yield more utility, three unit yield still more and so on. Marginal utility is defined as the net addition made to total utility by the consumption of additional unit. The concept of total utility and marginal utility can be illustrated by the help of a table below.

Total Utility and Marginal Utility
Units of Orange
Marginal Utility
Total Utility
1
2
3
4
5
6
10
8
6
4
2
0
10
18
24
28
30
30

The table shows that the marginal utility derived from 1st unit of orange is 10, from 2nd is 8, from 3rd is 6 and so on. Likewise, the total utility from 1st unit is 10, from second is 18, from 3rd is 24 and so on.

As the quantity increases, TU increases. But TU increases at a diminishing rate. The successive increases become smaller and smaller.

The relation between total utility and marginal utility has been shown in the figure below:
Total Utility and Marginal Utility

In the upper part of the figure, TU is the total utility curve. The total utility curve is upward sloping but the amount of the rise is less and less as more and more are consumed. Thus the marginal utility curve is declining: each successive consumption adds to total utility but each adds less than their predecessor. Hence, the TU curve shows how total utility continues to increase as more and more units are added. The lower part of the figure shows only the increase in total utility. So, MU is the marginal utility curve. It shows the marginal utilities of different units of the commodity. When the total utility is maximum (30) at point M, marginal utility is zero at point N.
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Factors Determining Elasticity of Demand

It is difficult to say whether the demand for a commodity is elastic or inelastic. Whether the demand for a commodity is very elastic or less elastic depends on several factors. The main factors determining elasticity of demand can be explained as follows:
  1. Nature of commodity: The elasticity of demand depends on nature of the commodity. The goods are classified as necessary, comfort and luxury. In general, the demand for necessaries of life such as food grain, salt is inelastic. The increase in price does not reduce demand. In general, the demand for comfort and luxury such as T.V., car, smartphones is elastic. The decrease in price increases the demand for the demand these goods. But necessary and luxury are relative terms. So, for the same commodity, elasticity may differ from person to person. As for example, the demand for car is a necessary to the rich but luxury to the poor. Hence, demand for car may be inelastic for the rich and elastic for the poor.
  2. Existence of substitutes: The existence of substitutes also affects the elasticity of demand. As for example, tea and coffee are substitutes. If the price of tea increases people substitute coffee. So, the demand for tea is elastic. But the demand for the commodities having no substitute such as salt, potato, onion is relatively inelastic.
  3. Number of uses: When the commodities have several uses, the demand for such commodities is elastic. As for example, electricity. If the price of electricity fall, it is put to several uses such as in cooking, pressing clothes, using fan etc. The elasticity of demand may be different in different uses. As for example, the demand for electricity for cable car is inelastic, since it does not have alternative. But for domestic purpose such as for cooking, electricity can be substituted by gas. So, demand is elastic.
  4. Possibility of postponement: When the possibility of postponement of consumption of a commodity exists, the demand is elastic. As for example, the consumption of Coca-cola can be postponed. But in case of consumption of goods, which are urgently needed, demand will be inelastic. The consumption of rice cannot be postponed.
  5. Level of Prices: If the price is too high or too low, the demand for a commodity will be inelastic. In case of expensive goods like T.V., car, camera, phones, demand will be inelastic. This implies that a small change in price, say $100 will not have effect on demand. The demand will be elastic only if the price change is high. Likewise, the demand for low-priced goods such as salt, onion, newspaper is inelastic. A small change in price will not affect demand. Because, all might have already purchased the required quantity.
  6. Proportion of income spent: if the persons spend a small amount in a commodity, a change in its price will not affect demand or demand will be inelastic. As for example, the demand for cheaper goods such as salt, matches is inelastic. But in case of expensive commodity such as car, demand is elastic.
  7. Habit and custom: If the commodities are demanded or account of habit and custom, demand will be less elastic. As for example, the increase in price of cigarettes or wine does not reduce the demand. Likewise, due to custom, the increase in gold price does not reduce the demand for wedding ring.
  8. Consumer’s incomes: Generally, the higher a person’s income the more inelastic will be his demand for commodities. The demand of millionaire for all commodities may be unaffected by any change in price. For most people, however, choice has to be made. Lower the person’s income, the higher the need of choice.
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Measurement of Price Elasticity: Total Outlay Method

In general, elasticity of demand means price elasticity. The concept of price elasticity is widely used in demand analysis. There are three methods of measuring price elasticity – total outlay method, point method and arc method. Here we concentrate only on total outlay method.

Total Outlay Method or Expenditure Method


In total outlay method, we see the change in expenditure as a result of change in price. Then on the basis of change in expenditure, we say whether the elasticity is equal to unity or greater than unity or less than unity. This can be illustrated by the help of schedule and figures.

1. Elasticity of Demand Equal to Unity (Ed = 1)

If the change in price does not change the total expenditure, the elasticity of demand is said to be equal to unity. In the table, the price falls from $10 to $9 to $8, but the total expenditure (PQ) remains unaltered at $10,000. So, the elasticity of demand is equal to unity.

Demand Schedule with Different Elasticities
Elastic Demand
Unit Elastic Demand
Inelastic Demand
P
Q
PQ (TE)
P
Q
PQ (TE)
P
Q
PQ (TE)
$10
$9
$8
1,000
2,000
3,000
10,000
18,000
24,000
10
9
8
1,000
1,111
1,250
10,000
10,000
10,000
10
9
8
1,000
1,050
1,100
10,000
9,450
8,800
Adapted from Watson & Getz: Price Theory & Its Uses

The unitary elastic demand can be illustrated by the help of a figure below.

Unitary Elastic Demand

In the figure, at initial price OP, quantity demanded is OM and total outlay (PXQ) is equal to rectangle OMRP. When the price falls to OP1, quantity demanded increases to OM1, and total expenditure is equal to rectangle OM1R1P1. The total expenditure falls by the area marked (-) and rises by the area marked (+). The area (-) is equal to area (+). So, the spending remains unaltered. In other words, new total expenditure OM1R1P1 = initial total expenditure OMRP. So, elasticity of demand is equal to unity. When the demand curve is rectangular hyperbola, the elasticity of demand on all points of it is equal to unity.

2. Elasticity of Demand Greater than Unity (Ed > 1)

If the total expenditure increases with fall in price, elasticity of demand is said to be greater than unity. As shown in table, as the price falls from $10 to $9 to $8, the total expenditure increases from $10,000 to $18,000 to $24,000. So, the elasticity of demand is greater than unity. This can be illustrated by the help of following figure.

Greater Than Unity

In the figure, the total expenditure at price OP is equal to rectangle OMRP. When price falls to OP1, the total expenditure increases to the rectangle OM1R1P1. The total expenditure falls by area marked (-), but rises by the area marked (+). The area (+) exceeds the area (-). The total spending increases. Hence, the elasticity of demand is greater than unity.

3. Elasticity of Demand Less than Unity (Ed < 1)

If the total expenditure falls with fall in price, the elasticity of demand is said to be less than unity. As shown in table, as the price falls from $10 to $9 to $8, the total expenditure falls from $10,000 to 9,450 to $8,800. Hence, elasticity of demand is less than unity. This can be illustrated by the help of a figure below.

Less Than Unity

As shown in the figure, when price is OP, the total expenditure is equal to rectangle OMRP. When price falls to OP1, the total expenditure falls to the rectangle OM1R1P1. The total expenditure falls by the area marked (-) but rises by the area marked (+). The area (+) is smaller than the area (-). The total expenditure falls. Hence, elasticity of demand is less than unity.
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