HIMACHAL PRADESH

NATIONAL LAW
UNIVERSITY
SHIMLA

MICROECONOMICS

SUBMITTED BY: SUBMITTED TO:

SHASHWAT DADWAL MR. DIGVIJAY SINGH KATOCH

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1120181905 ASSISSTANT PROFESSOR MICROECONOMICS

CARDINAL
UTILITY
ANALYSIS

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 ACKNOWLEDGEMENT

This assignment would not have been possible without the support of many people. I wish to
express my gratitude to my subject teacher, Mr. Digvijay Singh Katoch who was abundantly
helpful and offered invaluable assistance, support and guidance. Deepest gratitude is also due
to the faculty and members of Himachal Pradesh National Law University, without whose
knowledge and assistance this assignment would not have been successful. Special thanks
also to all my friends, for sharing the literature and invaluable assistance.

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 INDEX

● INTRODUCTION
● CARDINAL UTILITY
● ADVANTAGES AND DISADVANTAGES
OF MARGINAL UTILITY ANALYSIS
● APPLICATIONS OF CARDINAL UTILITY
THEORY
● LIMITATIONS OF CARDINAL UTILITY
THEORY
● BIBLIOGRAPHY

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 INTRODUCTION
Human wants are unlimited and they are of different intensity. The means at the disposal of a
man are not only scarce but they have alternative uses. As a result of scarcity of recourses,
the consumer cannot satisfy all his wants. He has to choose as to which want is to be satisfied
first and which afterward if the recourses permit. The consumer is confronted in making a
choice.

For example, a man is thirsty. He goes to the market and satisfy his thirst by purchasing coca
cola instead of tea. We are here to examine the economic forces which make him purchase a
particular commodity. The answer is simple. The consumer buys a commodity because it
gives him satisfaction. In technical term, a consumer purchases a commodity because it has
utility for him. We now examine the tools which are used in the analyzes of consumer
behaviour.

CARDINAL UTILITY

In economics, a cardinal utility function or scale is a utility index that

preserves preference orderings uniquely up to positive affine transformations. Two utility
indices are related by an affine transformation if for the value of one index u, occurring at any
quantity of the goods bundle being evaluated, the corresponding value of the other
index v satisfies a relationship of the form for fixed constants a and b. Thus the utility
functions themselves are related by
The two indices differ only with respect to scale and origin. Thus if one is concave, so
is the other, in which case there is often said to be diminishing marginal utility.
Thus, the use of cardinal utility imposes the assumption that levels of absolute
satisfaction exist, so that the magnitudes of increments to satisfaction can be
compared across different situations.
The idea of cardinal utility is considered outdated except for specific contexts such
as decision making under risk, utilitarian welfare evaluations, and discounted
utilities for intertemporal evaluations where it is still applied.[3] Elsewhere, such as in
general consumer theory, ordinal utility with its weaker assumptions is preferred
because results that are just as strong can be derived.

Concept Of Cardinal Utility Analysis

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 Cardinal utility analysis is based on the cardinal measurement of utility which assumes that
utility is measurable and additive. This theory was developed by neo-classical economists
like Marshall, Pigou, Robertson etc. It is expressed as a quantity measured in hypothetical
units which called utils. If a consumer imagines that one mango has 8 utils and an apple 4
utils, it implies that the utility of mango is twice than of an apple.

Dr. Deepashree, Introductory Microeconomics (2017)

Assumptions Of Cardinal Utility Analysis

1. Rationality

It is assumed that the consumers are rational, and they satisfy their wants in the order of their
preference. This means they will purchase those commodities first which yields the highest
utility and then the second highest and so on.

2. Limited Resources (Money)

The consumer has limited money to spend on the purchase of goods and services and thus
this makes the consumer buy those commodities first which is a necessity.

3. Maximize Satisfaction

Every consumer aims at maximizing his/her satisfaction for the amount of money he/she
spends on the goods and services.

4. Utility is cardinally Measurable

It is assumed that the utility is measurable, and the utility derived from one unit of the
commodity is equal to the amount of money, which a consumer is ready to pay for it, i.e. 1
Util = 1 unit of money.

5. Diminishing Marginal Utility

This means, with the increased consumption of a commodity, the utility derived from each
successive unit goes on diminishing. This law holds true for the theory of consumer behavior.

6. Marginal Utility of Money is Constant

It is assumed that the marginal utility of money remains constant irrespective of the level of
a consumer’s income.

7. Utility is Additive

The cardinalists believe that not only the utility is measurable but also the utility derived
from the consumption of different commodities are added up to realize the total utility.

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Thus, the cardinal utility approach is used as a basis for explaining the consumer behavior
where every individual aims at maximizing his/her utility or satisfaction for the amount of
money he spends on the consumption of goods and services.

Dr. Deepashree, Introductory Microeconomics (2017)

Comparison between ordinal and cardinal utility functions

The following table compares the two types of utility functions common in economics:

Level of Existence
Represents preferences on Unique up to Mostly used in
measurement proved by

Consumer
Ordinal Increasing monotone
Ordinal scale Sure outcomes Debreu (1954) theory under
utility transformation
certainty

Game
Increasing Von Neumann-
Cardinal Random outcomes theory, choice
Interval scale monotone linear Morgenstern
utility (lotteries) under
transformation (1947)
uncertainty

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Dr. Deepashree, Introductory Microeconomics (2017)

Advantages of the Marginal Utility Analysis

● Production
In the case of a consumer, the goal is to attain maximum satisfaction. Similarly, the goal of
any entrepreneur would be to get maximum profit. In order to achieve maximum profit, the
producer has to increase output with least cost. Towards this end, the producer employs all
factors of production according to the following condition:
MPL/PL = MPc/Pc = MPX/PX or MPL/MPc = PL/Pc
where,
MPL = marginal product of labor
MPc = marginal product of capital
MPX = marginal product of n (‘X’ refers to any other factor of production)
PL = price of labor
Pc = price of capital
PX = price of X
According to the principle of marginal utility, when a producer employs all factors of
production as per the condition mentioned above, he or she is able to attain maximum output
with least cost.
● Distribution
In distribution, what we are looking at is how the rewards (wages) are distributed among
various factors of production. From demand curve from marginal utility curve, we learned
that the price of a commodity is equal to its marginal utility (click here for an explanation).
Likewise, the reward is equal to the marginal product of a factor of production.
● Consumption
As stated earlier, the aim of a consumer is to attain maximum satisfaction from his or her
limited resources. Here, the consumer faces a unique problem of multiple choices. The
question now is how the consumer is able to achieve maximum satisfaction with limited
resources and multiple choices. In order to achieve maximum satisfaction, a rational
consumer arranges expenditures in such a way that

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MUx/Px = MUy/Py = MUz/Pz

https://accountlearning.blogspot.com/2014/01/concept-of-cardinal-utility-analysis.html

When consumer arranges expenditure in this way, he or she gets maximum satisfaction.
Furthermore, the concept of marginal utility helps to distribute income between savings
(future needs) and consumption (present needs) rationally. Marshall explains that a rational
human being tries to distribute resources between consumption and savings in such a way
that the marginal utility of the last dollar put on saving is equal to the marginal utility of the
last dollar spent on consumption.
● Public Finance
In public finance, the principle of marginal utility helps to attain maximum social welfare.
Professors Hicks and Dalton attributes that in order to achieve maximum social welfare, the
revenue should be distributed in such a way that the last unit of expenditure on various
programs brings equal welfare.
● Time Management
We all are endowed with limited time, i.e., twenty-four hours a day. The concept of marginal
utility helps to utilize the limited time optimally. According to Prof. Boulding, a person
should spend his limited time among various works such as reading, playing, cooking,
earning and gardening in such a way that the marginal utility from all these works are equal.

Disadvantages of the Marginal Utility Analysis

Though the marginal utility analysis is helpful in various fields of economics, it has certain
limitations as well. Some economists such as Prof. Hicks feel that the analysis may be useful
to explore elementary economic behavior. However, the concept may be of no use when it
comes to an advanced analysis of consumer behavior. The following are the important
weaknesses of the marginal utility approach:
Unrealistic Assumptions
This is one of the most common criticisms against theories of social sciences. The theory of
marginal utility is also subject to this criticism. According to critics, too many unrealistic
assumptions haunts over Marshall’s utility theory. Because of these unrealistic assumptions,
the theory becomes too vague. Critics confront the following assumptions of the theory:
● Constant marginal utility of money
The theory states that marginal utility of money is constant. However, this is not the case in
the real world. When money in your hand increases, the marginal utility derived from it
decreases because of abundance. In real world, you can see affluent people being extravagant
in their expenditures. Hence, according to the critics, money, as assumed by the theory,
cannot be a measuring rod, as its own utility changes.

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 ● Utility is measurable
Cardinal utility theory claims that utility is measurable in cardinal numbers (1, 2, 3).
However, utility is a subjective phenomenon, which can be felt by a consumer
psychologically, and cannot be measured.

https://accountlearning.blogspot.com/2014/01/concept-of-cardinal-utility-analysis.html

● Complements and substitutes

The Marshallian utility theory ignores complements and substitutes of the commodity under
consideration. The theory states that no complement or substitute of a commodity influences
the utility derived from it. However, in real life, there are various complements and
substitutes for a commodity. Hence, the utility derived from the commodity under
consideration is subject to all those goods. For instance, the utility derived from a car depends
upon fuel price also
● Rationality
The theory assumes that the consumer is rational. However, various factors such as
advertisement and ignorance can influence the consumer’s decision.

Applications of Cardinal Utility Theory:

1. The Diamond-Water Paradox:

The Cardinal utility theory throws light on the diamond-water paradox. This paradox points
out that water, the most useful good, has a lower market value than diamonds which are less
useful. Thus the paradox contrasts the ratio of the total utilities of water and diamonds to their
price ratio.

Cardinal utility resolves this paradox by pointing out that total utility has no bearing on the
market price of any good. The market price of any good cannot exceed its demand price,
which is the marginal worth of the quantity purchased. Thus the marginal worth of the good
sets the ceiling to the price that can be charged for any quantity sold.

A lower price for water than for diamonds, suggests that the marginal worth of water is less
than diamonds. This is merely saying that the marginal utility of water is less than that of
diamonds. The marginal utility of water is lower because it is plentiful when compared to
diamonds, whereas the marginal utility of diamonds is high because their availability is loW.

This follows from the law of diminishing marginal utility. By this law, if the availability of
water were also to become low, like diamonds, its marginal utility would also be high. This
would raise its marginal worth and hence its market value. The chain of causation proposed
by some early utility theorists to explain the diamond-water paradox runs as follows –
scarcity determines marginal utility, marginal utility determines value.

2. Consumer’s Surplus and Consumers’ Surplus:

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The consumer purchases goods only because his purchases generate a net surplus in his
satisfaction. An economic measure of this surplus satisfaction is the consumer’s surplus.

http://www.microeconomicsnotes.com/essay/cardinal-utility-theory/essay-on-the-cardinal-utility-theory-theories-microeconomics

https://accountlearning.blogspot.com/2014/01/concept-of-cardinal-utility-analysis.html

Consumer’s Surplus:
Surplus satisfaction can be expressed in rupees, by measuring it in terms of the marginal
utility of money. This is an economic measure of surplus satisfaction, which Marshall calls
the consumer’s surplus. Thus, according to Marshall –

Consumer’s Surplus = Surplus Satisfaction/μm

Every point of the marginal worth curve shows the worth in rupees of an extra unit purchased
at that quantity. Thus, it shows the price that the consumer would be willing to pay for that
marginal purchase. Hence, the difference between the marginal worth curve and the price
shows the consumer’s surplus for each marginal purchase.

In the figure we estimate the consumer’s surplus by summing up this difference from zero till
q1. This is given by A-B. This is the consumer’s surplus when he purchases q1 at the price p1.
Unfortunately, the marginal worth curve can only be measured in a laboratory and cannot be
observed in economic activity. Hence we need an operational measure of the consumer’s
surplus. That is to say, we need a procedure by which we can measure the consumer’s surplus
from observable economic behaviour.

Consumers’ Surplus and its Applications:

The use of market demand curves to measure the consumers’ surplus opens up attractive
possibilities. Marshall used this to analyse the effects of taxes and bounties on the consumers’
surplus in different situations. Even in very recent times, the method of measuring the
consumers’ surplus through market demand curves has stimulated some empirical research.

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Thus, because of its simplicity, the concept of consumers’ surplus continues to have some
appeal even in modern times.

However, the use of demand curves to measure the consumers’ surplus suffers from some
limitations. In fact, even the concept of consumer’s surplus as an economic measure of the
individual consumer’s surplus satisfaction has limitations.

http://www.microeconomicsnotes.com/essay/cardinal-utility-theory/essay-on-the-cardinal-utility-theory-
theories-microeconomics

Limitations of Cardinal Utility Theory:

1. There are no inferior goods (or alternatively all are inferior goods) in the cardinal utility
theory.

2. There are no Giffen goods. Since Giffen goods are a class of inferior goods, they are
automatically excluded when there are no inferior goods. But even if we manipulate
assumptions in order to let all goods become inferior, by assuming ∂μm /∂M > 0, there would
still be no Giffen goods.
The reason is simple. If the consumer is to be in equilibrium, the marginal utility of each
good must diminish as its availability increases. But if marginal utility diminishes, marginal
worth declines and the demand curve slopes down to the right. Hence there can be no Giffen
goods.

3. There are no gross substitutes or complements in the model. The change in the price of one
good does not affect the demand for any other good.

To understand this, recall that the demand for any good is determined by its marginal worth
curve—described by MUx/μm. We can show that both the numerator and the denominator do
not change when the price of another good changes. Firstly, the change in the price of another
good does not change the denominator — μm (marginal utility of money) which is constant
by assumption.
Secondly, the change in price of another good changes the consumption of that good only,
without affecting the marginal utility of any other good because marginal utilities are
independent.

Hence the numerator MUx, is unaffected by a change in the price of another good. Since both
the numerator and the denominator are unaffected, the marginal worth curve remains constant
and the demand for any good is not affected by the change in price of another good. Thus
constancy of the marginal utility of money, and the independence of marginal utilities of
goods ensure that all cross price effects are zero.

4. The marginal utility of money is not necessarily constant in reality. If marginal utility of
money is variable, diminishing marginal utility is not sufficient for equilibrium. Moreover
with a variable μm, the concept of consumer’s surplus becomes ambiguous.

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http://www.microeconomicsnotes.com/essay/cardinal-utility-theory/essay-on-the-cardinal-utility-theory-
theories-microeconomics

5. The strongly additive form of the utility function is not justified. Usually, the utilities of
goods are not independent. The consumption level of one good affects the satisfaction
obtained from the other. On the same logic, marginal utilities are not independent either. But
if these criticisms are granted, and the additive utility function is dropped, diminishing
marginal utility no longer suffices to ensure the consumer’s equilibrium.

6. The amount of money at the disposal of the consumer m depends less on his consumption
expenditure and more on his investment expenditure. This is because money is an asset like
other investment goods and durables. Hence the satisfaction from holding money is better
introduced in a theory of asset portfolios, rather than in a theory of consumption.

7. Diminishing marginal utility may indeed be obtained for every good beyond some critical
level of availability. But the moot question is whether consumers have indeed crossed this
critical level. If not, they may still experience increasing marginal utility.

For instance, it is not implausible to find a consumer reporting that an extra unit of consumption
gives greater extra satisfaction, but still refraining from purchasing it pleading a ‘budget
constraint’. Thus we may frequently observe increasing marginal utility in consumer
equilibrium. Is such a consumer irrational, or is our theory over-restrictive?

8. The law of diminishing marginal utility rests on a strong cet. par. clause. The assumptions
involved may be justified by examples from the dining table, but not from the situation in the
market place. But it is the consumer’s market behaviour that needs to be explained.

9. The marginal utility of money may not decline as income rises. In fact, the desire for
money not spent, may rise with income, since it depends upon the value of transactions that
one has to carry out, and these may be expected to grow with incomes.

10. Utility cannot be measured ‘cardinally’. That is, it is not possible to say that the extra
utility from the consumption of two apples is exactly n times the extra utility from consuming
one apple.

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http://www.microeconomicsnotes.com/essay/cardinal-utility-theory/essay-on-the-cardinal-utility-theory-
theories-microeconomics

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