1

Cardinal Utility Approach

What is utility?• A want satisfying capacity of a commodity

or service.

• Utility is found in both useful and harmful goods.

• Utility is relative – Person, Place, Time

• Utility is Psychological, Subjective and Internal

• Utility depends on intensity of wants

2

Concept of Total Utility

TU is a function of the quantity of the commodity consumed.

MU is the utility of an additional unit

3

Cardinal Utility Assumptions• Utility is Quantifiable entity.• Utility is both measurable and additive.• Utility is independent (of other

commodities)• MU of money remains constant• Introspection- Experience of ‘A’ is

supposed to be the same for B,C,D, etc.

4

• Assumption of Rationally.

• Fixed Income and Price.

• Stability of tastes (Short Run Theory)

• Assumption of divisibility

5

Law of Diminishing Marginal Utility

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

Prof. Boulding

6

Assumptions of Law

• Utility can be measured in cardinal numbers.

• All other things remain constant- income etc (Fashion, Tastes, habits etc)

• Commodity should not be indivisible

7

Causes of its operations

• Wants are unlimited and can not be satisfied but want for a commodity can be fully satisfied.

Does the law of DMU apply to money?

Yes and No

8

Exceptions to the law

• Misers, Drunkards, size of initial units, love of power and display, rare and curious things

Conclusion: Tendency of law of DMU is so widely prevalent that it would not be wrong to call it a universal law.

9

Importance of law• Bases of Equi-Marginal

utility.

• and law of demand.

• Helps in price determination.

• Basis of socialism/ Progressive Taxation.

10

Equi-Marginal Principle

An input should be so allocated that the value added by the last unit is the same in all cases. A consumer seeking maximum utility from his consumption basket will allocate his consumption budget on goods and services such that

MU1 = MU2 = MU3 = MU4

MC1 MC2 MC3 MC4

11

Similarly, a producer seeking maximum profit would use that technique of production or input-mix which would ensure

MRP1 = MRP2 = MRP3 = MRP4

MC1 MC2 MC3 MC4

12

Law of Equi-Marginal Utility

“The household maximizing utility will so allocate its expenditure between commodities in such a way that utility of last penny spent on each is equal.”

Lipsey

13

Importance of law of Equi M utility

Consumption- To get maximum satisfaction.

Production – Earn maximum profits.

Exchange & Price Determination- Exchange is nothing but substitution. Law reduces the scarcity of commodities experiencing rising prices/ shortages by shifting to cheaper substitutes.

14

Public Finance – Taxes are levied in a manner that the marginal sacrifice of each tax payer is equal.

Similarly, the marginal benefit of each type of public expenditure should be equal.

International Trade – Countries follows the principle of substitution export a commodity which has lower MU and import a commodity by having higher MU.

15

Determinants of consumer Equilibrium

• Single commodity with single use: Mu=P

What happens if Mu>P or Mu<P?

When commodity is free

P = Mu

o = o

16

Single commodity several uses

Mua = Mub = Muc and so on.

Several commodities with same price = Mux = Muy = Muz

Several commodities with different price =

Mu of a = Mu of B = Mu of x

P of a P of B Price of x

17

Law of Diminishing Marginal Rate of Substitution

“The MRS of x for y is the amount of y the consumer is just willing to give up to get one more unit of x and maintain the same level of satisfaction.MRSxy – (-) ∆y

∆xMRS is always negative because you can have more by having less of y.

18

Why MRs Diminishes?

The law of DMRS is an extension of law of diminishing marginal utility.

Fundamental Assumptions

Rational consumer, ordinal utility, DMRS, Two Goods Model.

19

Substitution Effect

Given a constant income of the consumer, a change in the relative price of the two commodities may force a consumer to rearrange his purchases. The consumer will buy more of the commodity which becomes comparatively cheaper. The amount by which the money income of the consumer is changed so that the consumer is neither better off nor worse off than before is called compensating variation in income. Compensating variation in income is a change in the income of the consumer which is just sufficient to compensate the consumer for a change in the price of a good.

20

Substitutions Effect

Substitution effect refers to the change in the consumption or demand for two goods as a result of their relative change in prices, real income remaining constant.

21

Assumptions of Hicksian Substitution Effect

• Money income of the consumer remains the same

• The relative prices of two goods change in such a way that one commodity becomes cheaper than the other.

22

• The Cheapness of one commodity and expensiveness of the other cancel each other by compensating variation technique and therefore consumer is neither better off nor worse off than before.

• No Change in consumer’s Tastes and Preferences.

23

Ordinal Utility ApproachOrdinal utility technique is based upon the comparablities of utilities and avoids quantification of utilities.

It helps in making a right choice amongst several goods and decide how much of one commodity should be substituted for how much of another, so that the consumer’s level of satisfaction remains the highest.

24

Ordinal utility asks, “Is ‘A’ preferred to ‘B’. This does not require that we know how much ‘A’ is preferred to B.

What is an indifference curve?

“A single indifference curve shows the different combinations of x and y that yield equal satisfaction to the consumer.”

25

Properties of indifference curve

• Indifference curve slopes downwards from left to right.

• Convex to the origin.• Indifference curve can not intersect/

touch each other.• Higher IC represent higher level of

satisfaction.• IC touch neither x axis nor y axis.

26

Price Line or Budget LineThe Budget line or price line shows all the different combinations of two goods that a consumer can purchase given his money income and the price of two commodities. Slope of price line = Px

Py• Price line when income of the

consumer changes.• Price line when price of x and y

changes.

27

Indifference Map

A set of indifference curves is a indifference map. In indifference map all combinations on one indifference curve yield same satisfaction but higher indifference curve represents higher level of satisfaction.

28

Conditions of Consumer Equilibrium

• The Price line should be tangent to IC.

• IC should be convex to the point of origin.

MRSxy = Px

Py

29

Price Effect as Combination of Income & Substitution Effect

• Income Effect: Effect on the purchase of the consumer caused by changes in income, if prices of goods remain constant.

• Positive Income Effect: Normal goods.

• Negative Income Effect: Inferior goods.

30

Price EffectThe price effect shows how much the satisfaction of the consumer varies due to the change in the consumption of two goods as the price of one changes, the price of the other and money income remains constant.Price effect = Income effect + Substitution effect.

31

Price effect = Movement from E to E1

Substitution effect = Movement from E to E2

Income Effect = Movement from E2 to E1

PE = SE +IE

32

Consumer SurplusThe difference between what a consumer is willing to pay and what he actually pays is called consumer surplus. Or The gap between total utility of a good and its total market value is called consumer surplus.Because consumers pay the price of last unit for all units consumed, they enjoy a surplus of utility over cost.

Consumer surplus

• The money value of consumer surplus

• can be measured as the area under the demand curve but above the price line.

33