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Showing posts with label Economics. Show all posts
Showing posts with label Economics. Show all posts

Saturday, February 15, 2014

Limitations Of The Law Of Substitution

Economics ,
The law of substitution has several limitations as follows:

1. Ignorance Of Consumer

If the consumer is ignorant or blindly follows custom or fashion, he will make a wrong use of money. Due to his ignorance, he may not be aware of other more alternatives. In this case no substitution takes place and this law does not apply.

2. Commodities Indivisible

The law of substitution is based on the assumption that commodities are divisible and substituable. This is an unrealistic assumption. Though commodities may be divided according to the convenience of the consumer, it is not possible to divide all commodities in small units. There are certain commodities like fan or a radio which cannot be used in case of the indivisible commodities.

3. Utility Not Measurable

This principle of maximum satisfaction is based on the unrealistic assumption of the cardinal measurement of utility and the constancy of the marginal utility of money.

4. Customs And Fashion

Sometimes people are slave of customs or fashion and they are unable to become rational.Without being rational a consumer cannot substitute one thing for another. This is another limitation of this law.

5. Unlimited Resources

The law of substitution has no place when the resources are unlimited as in the case of free gift of nature. In such cases, there is no need to re-arrange expenditure because they can be used without any cost.

6. Choice Uncertain

The alternatives open to the consumer also assumed to be certain. But consumer choices are uncertain and even risky. In fact, it is expected utilities that determine consumer's choices of the various combinations he can buy with a given money income.
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Significance Of The Law Of Substitution

Economics ,
The law of substitution is of great practical importance in economics which are given below:

1. Basis Of Consumption

Consumer is assumed to be rational. He always tries to maximize his utility subject to budget constraint. The law of substitution helps every consumer to maximize his utility by equalizing the marginal utilities obtained from different commodities.

2. Important In The Field Of Production

The law of substitution is also of great importance in the field of production. The producer has to use several factors of production in order to maximize net profit. For this purpose, he will substitutes one factor for another till their marginal productivity are  made the same. For example, if the marginal productivity of one factor say labor, is greater than that of capital, he may substitute labor for capital. In this way, he will be able to maximize his profit.

3. Important In The Field Of Exchange

This law of substitution also applies in exchange, because exchange is nothing but the principle of substitution itself. When we sell a commodity say, sugar, we get money. With this money we buy another commodity, say, wheat.Therefore, we have really substituted sugar for wheat. We continue to substitute one factor for the other till their marginal returns from all factors are equalized.

4. Importance In Distribution

In the distribution, we are concerned with the determination of rewards of the various factors of production, i.e. determination of rent, wages, interest and profit.The use of each factors of production is pushed by the firm to a point where marginal productivity of one factor is equal of other factor's marginal productivity. The law of substitute helps to equalize their marginal productivity.

5. Importance In Public Finance

The law of substitution is also applies in public finance. Government must try to maximize welfare of the community. For this, the government must down all wasteful expenditure where the return is not proportionate and instead divert the resources on more productive sector.

6. Price Determination

The principle of substitution is also applicable in the determination of prices when a commodity becomes scarce and its price becomes high. In order to bring its price down, we start substituting an abundant commodity for it, its scarcity will end.
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Concept Of The Law Of Substitution

Economics ,
Law Of Substitution

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.
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Tuesday, February 4, 2014

Concept Of Consumer's Surplus

Economics ,
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.
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Criticisms Of Consumer's Surplus

Economics ,
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.
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