CARDINAL APPROACH

Who is a Consumer?
• A consumer is an individual who purchases goods and services from firms for the
purpose of consumption.
• As a manager of a firm you are interested not only in who consumes the good, but in who
purchases it.
• E.g:A six month old baby consumes goods, but is not responsible for purchase
decisions.

What is Consumer Behaviour?

• It is the behaviour of the consumer when he/she is engaged in the process of
consumption.
• More precisely it deals with
1. How individual consumers allocate their incomes among the various goods and services
available to them.
2. Given a certain budget, how does a consumer decide which goods and services to buy or
factors affecting consumers’ choices?

Economic Approaches Towards C.B

1. Cardinal Approach (Utility can be measured in Cardinal numbers 1,2,3 etc)
2. Ordinal Approach (Ordering/ranking of preferences First,second,third etc)
3. Modern/behavioural Approaches (based on the assumption that consumers are not
rational always)
Cardinal Approach
• This approach was propounded by English philosopher Jeremy Bentham (1748-1832) :
Utilitarianism
• Developed further by Marginalist school :Jevons,Walras &Menger(1870s)
• Alfred Marshall perfected the theory of Utility in his book ‘Principles of
Economics(1890).

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Distinction between Cardinal & Ordinal Approaches

Cardinal Ordinal

Utility Approach Indifference curve approach

Utility can be measured in Utility cannot be measured as it is a

exact cardinal subjective concept. It can be ranked on the
numbers(Utils) basis of consumers’ scale of preferences

Cardinal Approach
Consumption: The process of using goods or services to satisfy wants.
Ultimate aim of consumption: Utility maximization
Utility: Want satisfying power of a commodity
Features of Utility – The Central Theme of Cardinal Analysis
• Utility” and “usefulness” are not synonymous.
E.g: Paintings by Leonardo Da Vinci may offer great utility to art connoisseurs but are useless
functionally (other than for hiding a crack on a wall!!).
 Utility is subjective. The utility of a specific product may vary widely from person to
person.
E.g: Eyeglasses have tremendous utility to someone who has poor eyesight but no utility to a
person with a perfect vision.
• Utility is difficult to quantify. But for purposes of illustration we assume that people can
measure satisfaction with units called utils (units of utility).
These imaginary units of satisfaction are convenient for quantifying consumer behaviour for
explanatory purposes

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 Assumptions of Cardinal Approach

Rationality: Consumers try to maximize utility subject to budget constraints.

Limited Money Income

Utility maximization goal

Cardinal measurement of utility

Independent Utility – Utility derived from the consumption of one commodity is independent
of the utility derived from the consumption of another commodity

Additive utility – Total utility derived from the consumption of various units of the same
commodity can be found by adding the utility received from various units.

Diminishing MU

Constant MU of money – Utility from an additional unit of money is the same for all
individuals, irrespective of their existing income levels.

Introspective analysis – analysis based on observation of consumer behaviour

Cardinal Theories/Concepts
1. The Law of Diminishing Marginal Utility
2. The Law of Equi-Marginal Utility
3. Consumer Surplus
Utility Concepts

Total Utility(TU):The sum total of satisfaction received by consuming various units of the
same commodity.

Marginal utility: Addition to TU due to the consumption of an additional unit of a commodity.

MU = ∆TU/∆Q

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LAW OF DIMINISHING MU
Propounded by H.H Gossen –Gossen’s ‘First Law of Consumption’.
Assumptions
• Rationality of the consumer
• Constant Money Income
• Cardinal measurement of utility
• Consumption should happen without any time gap.
• Constant MU of money
• Constant Tastes & Preferences
• Suitable quantity
• Homogenous units of the commodity – various units of the commodity should be similar
in all the attributes like colour,size,shape etc.
• Applicable in the case of divisible goods.
Statement of the Law
If a consumer keeps on consuming various units of the same commodity without, any time gap,
utility from additional units(MU) declines.

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Graphical Representation of LDMU

Relationship between TU&MU

• So long as TU is increasing,MU is positive.
• When TU is constant MU is zero. Point of Satiety
• When TU starts declining MU becomes negative
Equilibrium Condition

MUx = Px

A consumer will consume a commodity up to the point where the MU of that commodity is
equal to the price of that commodity.
If MUx > Px Increase the purchase of X,so that MUx declines and gets equated to Px.
If MUx < Px Reduce the consumption of X,so that MUx increases and gets equated to Px
Limitations of the Law
• Various units of the commodity need not be homogenous
• The law doesn’t work if there is time gap between the consumption of various units.
• Tastes & preferences are not constant.
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 • Income of the consumer is not constant.
• MU of money is not constant. It is high for poor people and low for the rich.
Exceptions to LDMU
• Alcoholics
• Misers
• Money
• Reading
• Hobbies & rare collections
Applications of the Law
• Price determination
• Solution to water - diamond paradox
• Explains the reason for downward sloping demand curve
• MU of money Useful in the field of direct taxation

1. Price determination
• Price depends on MU and MU depends on the availability of the commodity.
• Direct relationship between price and MU.
• Higher MU, higher price and lower MU, lower price.
2. Solution to Water – Diamond Paradox(Paradox of Value)
The paradox of value (also known as the diamond–water paradox) is the apparent
contradiction that, although water is on the whole more useful, in terms of survival, than
diamonds, diamonds command a higher price in the market. The philosopher Adam Smith is
often considered to be the classic presenter of this paradox
Solution to the paradox
The more there is of a commodity, the less is the relative desirability of its last little unit. It is
therefore clear why water has a low price and why an absolute necessity like air can become a
free good.
In both the cases, it is the large quantities that pull the marginal utilities so far down and thus
reduce the prices of these vital commodities.
Water :Supply is more, MU is less, Price is less.
Diamond: Supply is less, MU is more, Price is more.
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Derivation of Demand Curve from MU

The law of diminishing marginal utility explains why the demand curve for a given product
slopes downward. If successive units of a good yield, smaller and smaller amounts of marginal,
or extra, utility, then the consumer will buy additional units of a product only if its price falls.
The marginal benefit (utility) diminishes as more of the product is
bought, then the price must fall in order to induce you to buy the next unit.
Volume Pricing/ Discount
• The law of diminishing marginal utility states that– the more a person consumes a
particular product, the less he or she will value the product.
• So, to make the customers consume more cups of a product, a volume discount is given.
As the quantity increases, per unit price decreases.
3. Direct Taxation – Progressive Income Tax
For rich MU of money is less as they have more money, so tax them more.
For the poor MU of money is more as they have less money, so exempt them from tax.
• Diminishing marginal utility has also been used as an argument on behalf of a
progressive income tax.
• A progressive tax means that the percent of income paid as tax rises as one's income
rises.

• The idea is that everyone should sacrifice equally --- sacrifice being in terms of utility.
• Suppose Joe and Bill are both married with five children. Joe has an income of
$10,000.Bill has an income of $100,000,000.
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• Now let us tax each equally; each is to pay $2,000 in tax.
• Who is making the larger sacrifice?
• Obviously, the answer is Joe.
• After Bill had already spent $99,998,000, the goods and services sacrificed by not
spending the last $2,000 have very little, if any, value. This is a result of diminishing
marginal utility.
• On the other hand, the $2,000 sacrificed by Joe represents a great amount of utility. This
could means some clothes, or even a place to live.
• Therefore, equal taxation does not generate equal sacrifice of utility.
• What about equal tax rates?
• Suppose both are to pay 20% of income as tax. This is a so-called flat tax. For Joe, this is
the same $2,000. For Bill, this is $20,000,000. But Bill is still left with $80,000,000.
• Due to the law of diminishing marginal utility, the sacrifice Bill makes by giving up the
last $20,000,000 is not large. Bill has already bought $80,000,000 worth of goods and
services for the year.
• Therefore, Joe is still making the larger sacrifice in terms of utility

Differential Tax Rates:

• The principle that is argued is that equal sacrifice in utility requires that Bill pay a higher
percentage of his income as tax than Joe.
• No one has ever figured out how much tax would indeed represent equal sacrifice. And
this is just one argument in the debate over the progressive income tax.
• There are many other concerns in this matter. But the point here is to show how the law
of diminishing marginal utility was used to justify a position in a matter of public policy.

Tax Rates in India FY 2019-20

https://www.myloancare.in/tax/income-tax-slabs-rates

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 Vending Machines and Marginal Utility
Newspaper dispensing devices and soft-drink vending machines are similar in their basic
operations. Both enable consumers to buy a product by inserting coins. But there is an
important difference in the two devices. The newspaper dispenser opens to the full stack
of papers and seemingly “trusts” the customer to take only a single copy, whereas the
vending machine displays no such “trust,” requiring the consumer to buy one can at a time.
Why the difference???
Most consumers take only single copies from the newspaper box because the marginal
utility of a second newspaper is nearly zero. They could grab a few extra papers and try to
sell them on the street, but the revenue obtained would be small relative to their time and
effort. So, in selling their product, newspaper publishers rely on “zero marginal utility of
the second unit,” not on “consumer honesty.” Also, newspapers have little “shelf life”; they
are obsolete the next day. In contrast, soft-drink sellers do not allow buyers to make a single
payment and then take as many cans as they want. If they did, consumers would clean out
the machine because the marginal utility of successive cans of soda diminishes slowly and
buyers could take extra sodas and consume them later. Soft-drink firms thus vend their
products on a pay-per-can basis.
• In summary, newspaper publishers and soft-drink firms use alternative vending
techniques because of the highly different rates of decline in marginal utility for their
products.
• The newspaper seller uses inexpensive dispensers that open to the full stack of papers.
• The soft-drink seller uses expensive vending machines that limit the consumer to a single
can at a time. Each vending technique is optimal under the particular economic
circumstance.
LAW OF EQUI-MARGINAL UTILITY
• An extension of the LDMU.
• Gossen’s Second Law of consumption
• It explains the behaviour of the consumer in distributing his limited income among
various goods and services.
• How a consumer allocates money income between different goods to maximize his
satisfaction or utility.
Working of the Law
Consider two goods X and Y on which the consumer has to spend his given income.
Consumers’ decision is based on two factors;
1. Marginal utilities of Goods X and Y.(MUx and MUy)
2. Prices of Goods X and Y(Px and Py).
Equilibrium Condition
MUx = MUy = ……… MUn
Px Py Pn

Statement of the Law: Utility Maximizing Rule

A consumer maximizes his utility when he allocates his limited income for the purchase
of various commodities in such a way that the ratio of marginal utilities and prices are
equalized in purchasing various commodities.
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 Numerical Example

Px=Rs.2
Py=Rs.3
Income of the Consumer= Rs.24
Assumption: Consumer needs to spend his entire income

Units MUx MUy

1 20 24
2 18 21
3 16 18
4 14 15

5 12 9

6 10 3

Question: Indicate how many units of X & Y,the individual should purchase to maximize his
utility ?

Combinations of X and Y which fulfill the eqm condition MUx/Px = MUy/Py

3x+1y (3x2)+(1x3) = 9
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4x+2y (4x2)+(2x3) = 14
5x+3y (5x2) +(3x3)= 19
6x+4y (6x2) +(4x3)= 24 is the equilibrium combination(because it allows consumer to spend
his entire income and gets the maximum no of units of X and Y).
Sample Question
Qx MUx Qy MUy

1 10 1 5

2 6 2 4

3 4 3 3

4 2 4 2

5 0 5 1

Total Income of the Consumer = $10

Px = $2
Py =$1
1. Indicate how many units of X & Y,the individual should purchase to maximize his utility
?
2. Show that the condition for constrained utility maximization is satisfied when the
individual is at his/ her optimum?
3. Find out the total utility the individual receives when he or she maximizes utility.

Combinations
1x +1y = (1x2) +(1x1) = 3
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 2x +3y = (2x2) +(3x1) = 7
3x +4y = (3x2) +(4x1) = 10
4x +5y = (4x2) +(5x1) = 13
Considering the income constraint of $10,utility maximizing combination is 3x +4y

Limitations
1. Ordinary consumers are governed by customs and habits. They may not calculate
compare MU from different commodities when they consume commodities.
2. Cardinal measurement of utility is not possible.
3. It is not possible to compare and adjust the MU of indivisible goods.

How is Utility(Satisfaction) is measured Today?

In reality, I cannot say that a banana is a 10 and and strawberry is a 6.
Today, utility (satisfaction) is typically measured in dollars/rupees according to the willingness-
to-pay(WTP) principle.
To value a sandwich, we ask: “what is the most that you are
willing to pay for that sandwich?".
To value a second sandwich, we ask: "given that you have
just eaten the first sandwich, what is the most that you are willing to pay for a second sandwich?"

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And so on. The law of diminishing marginal utility tells us that you will be willing to pay less for
the second sandwich than for the first
Rational Decision Making
Rational decision-making making requires us to compare the marginal benefit to the marginal
cost (that is, the price) for each unit.
The marginal benefit (utility) is measured as the most money one would be willing to pay.
Marginal cost is measured in terms of the price that you pay.
So we start with unit #1. Should you buy this?
What is the most you are willing to pay for Unit #1? What is the price of
Unit #1?
If you are willing to pay more than the price you must pay, buy Unit #1.
Go on to number two. And so on.
What is the most you are willing to pay for a second unit given that you
have already bought the first unit? What is the price of the second unit) given that you have
already bought the first unit?
As noted, the as we consider subsequent units of the product, marginal benefit (utility) will
diminish.
In this case, the marginal cost (the price) will stay the same as we consider subsequent units of
the product.
When the marginal benefit (the most you are willing to pay) becomes less than the price, you
should not buy that unit.
Buyers will continue buying a product up to that unit for which the marginal benefit (the most
one is willing to pay) is equal to the price..

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CONSUMER SURPLUS
• First used by Dupuit(1844) and popularized by Alfred Marshall.
• Consumer surplus is the difference between what individuals would have been willing to
spend to purchase a given amount of a good and what they had actually had to spend.

Consumer Surplus = Maximum Price the consumer is willing to pay – Price he/she actually pays

• Consumer surplus exists if the Marginal Benefit (Marginal Utility) is greater than the
Marginal Cost(Price)
•
Consumer Surplus = MU-Price

• As price increases, consumer surplus comes down and vice versa.

• Consumer surplus provides a measure of the benefit to consumers of the market
exchange for the good.

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Four Possible Buyers’ Willingness to Pay

Willingness to Pay to The Demand Curve

Measuring Consumer Surplus with the Demand Curve

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Measuring Consumer Surplus with the Demand Curve

How Does Price Affects Consumer Surplus?

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Case Study: Uber Consumer Surplus

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