GROUP TWO

a) Discuss the assumptions of cardinal and ordinal approach

In economics, the terms "cardinal approach" and "ordinal approach" refer to different ways
of measuring utility, which is the satisfaction or happiness that a consumer derives from
consuming goods and services.

The cardinal approach treats utility as a measurable quantity that can be assigned numerical
values. This means that the utility derived from consuming a good or service can be quantified
and compared across different goods and services. The cardinal approach assumes that
individuals can rank their preferences for different goods and services in a precise and consistent
manner, and that the differences in utility between two goods can be expressed in terms of a
specific numerical value.

In contrast, the ordinal approach measures utility in terms of the preferences of consumers.
This approach does not assign numerical values to utility, but rather treats it as a ranking of
preferences. Under the ordinal approach, consumers can only determine whether they prefer one
good to another, but they cannot quantify the difference in utility between two goods.

The ordinal approach is more commonly used in modern economics, as it avoids some of the
difficulties and assumptions associated with the cardinal approach. For example, the cardinal
approach assumes that individuals can measure and compare their utility levels with certainty,
which may not be realistic in the real world. However, the cardinal approach can still be useful in
certain contexts, such as in the study of consumer behavior and demand theory.

The cardinal and ordinal approaches are two methods used in consumer theory to analyze how
consumers make choices to maximize their utility or satisfaction from consuming goods and
services. These approaches are based on different sets of assumptions:

Cardinal approach assumptions:

Quantifiable utility:
The cardinal approach assumes that utility is quantifiable and can be measured in units called
utils. This means that the satisfaction derived from consuming goods and services can be
assigned specific numerical values.

Comparability of utility:

The cardinal approach assumes that the utility derived from different consumption bundles can
be compared and ranked. This means that a consumer can say that one bundle provides twice as
much utility as another bundle.

Diminishing marginal utility:

This assumption states that as a consumer consumes more of a good, the additional satisfaction
(marginal utility) derived from each additional unit of the good decreases. In other words, the
first unit of a good provides more satisfaction than the second unit, the second unit provides
more satisfaction than the third unit, and so on.

Independence of utilities: The cardinal approach assumes that the utility derived from
consuming one good is independent of the utility derived from consuming other goods. This
means that the satisfaction from consuming a good does not depend on the presence or absence
of other goods.

Ordinal approach assumptions:

Ranking of preferences:

The ordinal approach assumes that consumers can rank their preferences for different
consumption bundles but cannot assign specific numerical values to the utility derived from
these bundles. This means that a consumer can say that they prefer one bundle over another, but
cannot quantify how much more utility they derive from it.

Transitivity of preferences:

This assumption states that if a consumer prefers bundle A over bundle B and prefers bundle B
over bundle C, then the consumer must also prefer bundle A over bundle C. This ensures that the
consumer's preferences are consistent and can be represented by a set of indifference curves.
Non-satiation:

The ordinal approach assumes that more is always preferred to less. This means that, all else
being equal, a consumer always prefers a bundle with more of a good to a bundle with less of the
same good.

Convexity of indifference curves:

This assumption states that the consumer's indifference curves are convex to the origin, which
implies diminishing marginal rates of substitution. As a consumer substitutes one good for
another, they are willing to give up less and less of the other good to obtain an additional unit of
the first good.

The cardinal approach, with its assumption of quantifiable utility, is considered less realistic than
the ordinal approach. The ordinal approach is more widely used in modern consumer theory
because it relies on weaker assumptions about consumers' ability to quantify and compare their
satisfaction from consuming different goods and services.

Furthermore

 Existence of two products X and Y in a commodity space where both the products are
normal and the consumption combinations are positive definite.
 The utility function is dependent which can be written as U = f (x, y) and I.C considers
related product where both the products are substitute to each other.
 The level of satisfaction is ordinarily measurable which means ranking of different
combinations is possible according to the preference of the consumer.
 The relationship may be indifferent, i.e. if the combinations on A & B or B & C are
equally preferable then the combination of A & C must be equally preferable to the
consumer.
 The relation may be transitive.
 Application of the diminishing marginal rate of substitution.
  (The marginal rate of substitution of X for Y (MRSx,y) is defined as the no of units of
good Y that must be given up in exchange for an extra unit of good X, so that the
consumer maintains the same level of satisfaction.)

b) Explain with the aid of the diagram how the normal demand curve is generated under
the cardinal approach

The normal demand curve under the cardinal approach is generated as follows:

1. The consumer ranks all the alternatives in terms of preferences. The most preferred alternative
is ranked 1, the next preferred alternative is ranked 2 and so on. This is known as the preference
scale.

2. A utility score is assigned to each alternative based on its ranking on the preference scale. The
higher the ranking, the higher the utility. For example, the alternative ranked 1 gets the highest
utility, the alternative ranked 2 gets the second highest utility and so on.

3. The utility scores are then plotted on the Y-axis and the quantities of the good are plotted on
the X-axis. The points are then joined to obtain the utility curve for the good.

4. The marginal utility of the good is calculated by taking the change in total utility divided by
the change in quantity. The marginal utilities are plotted on the Y-axis and quantities on the X-
axis to obtain the marginal utility curve.

5. The demand curve is obtained by equating the marginal utility and the price. At the point
where marginal utility equals price, the consumer achieves maximum satisfaction or utility. The
quantities corresponding to the points where marginal utility equals different prices are then
joined to obtain the demand curve.

The demand curve so generated will be downward sloping showing the inverse relationship
between price and quantity demanded, ceteris paribus. The slope of the demand curve will
depend on how fast or slow marginal utility is diminishing with additional units of consumption.
So in summary, the normal demand curve is derived from the marginal utility curve under the
cardinal approach based on the utility scores assigned to alternatives. The downward sloping
shape of the demand curve reflects the diminishing marginal utility effect.

MUx = TU/ Qx = d/dQx (TUx).

There are also some Assumptions of Cardinal Utility Theory:

1. Rationality: Consumers are rational & aims at the maximization of his/her utility
subject to the given income constraints.
2. Cardinal Utility: The utility of each commodity is measurable.
3. Constant marginal utility of money: If the monetary unit is used as the measure of
utility, it should be constant.
4. Diminishing marginal utility: The utility gained from successive units of a
commodity diminishes.

The total utility of a ‘Basket of goods’ depends on the individual commodities, i.e. if there are
n commodities in the bundle with quantities X1, X2, ……… Xn the total utility is U = f (X1,
X2, ……. Xn).As it is assumed that the total utility is addictive, so, U = U1(X1) + U2(X2) +
…………… + Un(Xn). This additivity assumption was dropped later.

Law of Diminishing Marginal Utility

The diagram below shows the diminishing marginal utility.

U = f (X)
“The diminishing marginal utility is the basic hypothesis of Cardinal Utility Theory, which
states that the Marginal Utility of a good diminishes as an individual consumes more units of a
good or the law states that with every successive increase in the consumption of a commodity,
the marginal utility of the commodity will fall. Here the marginal Utility Declines and the total
utility increases at a decreasing rate. In order to maximize the total utility, consumer will
spend his income on a combination of goods.” Katz and Harvey (1991).

The law is based on two important facts: When an individual no longer wants anymore units
of goods, marginal utility of the good become zero and the different goods are not perfect
substitutes for each other in the satisfaction of various particular wants.

Assumptions: Goods are homogeneous, No time gap between the consumption of the different
units, Consumers are rational, Taste, Preferences Fashions remain unchanged and Income of
the consumer is constant.

The optimization rules of cardinal approach

Optimization Rule 1: When only one good is consumed and is available for free, consume till

MUx = 0

Optimization Rule 2: When only one good is consumed and is available for a price:

Consume till MUx = Pricex

Optimization Rule 3: Law of Equal Marginal Utility or Law of Substitution: The law states
that the consumer will spend his income on different goods in such a way that marginal utility
of each good is proportional to its price i.e. when more than one good is consumed and the
goods’ prices are different:

Consume till MUx/Px = MUy/Py = MUz/Pz

Cardinal Approach has some Limitation towards the consumer behavior or theory, which is as
follows; Utility cannot be measured cardinally, Utility is not additive, Utility is interdependent
and decisions are seldom taken in isolation, and Unrealistic assumption.

ORDINAL APPROACH

According to the Ordinal Approach a consumer has a given scale of preferences for different
combination of two goods. Ordinal approach states that utility can be measured in order of
preferences.

The assumptions of this theory are: Rationality; Aim to maximize utility under condition of
certainty, Complete Ordering: All possible goods can be offered into preferred, Consistency: If
consumer prefers bundle B to bundle A at the same time he does not prefer bundle A to bundle
B, Transitivity: If Commodity basket A is preferred to B is preferred to C implies that, A is
preferred to C and Non Satiety: Bigger is preferred to a small bundle. This theory can also be
described with the help of Indifference Curve Approach.

According to McCulloch an Indifference curve is the locus of points indicating particular

combinations of goods or the baskets of two commodities from which the consumer derives the
same level of utility or satisfaction.” (1977) The I.C. is the locus of successive indifferent points
or combinations which yield equal level of satisfaction. This curve is also known as Iso Utility
curve and the different point on the curve represents the same level of satisfaction. Economists
following the lead of Hicks, Slutsky and Pareto believe that utility is measurable in an ordinal
sense--the utility derived from consuming a good, such as X, is a function of the quantities of X
and Y consumed by a consumer.
The equation Indifference curve can be written as:

U = f(x, y)

Total Differentiation of the equation represents:

 dU = df/dx.dx + df/dy.dy
 = MUx.dx + MUy.dy
 Along in the I.C curve satisfaction is constant, so,

dU = 0, so dy/dx = - (MUx/MUy), so slope of the I.C. curve is < 0.

According to McCulloch the following are the Properties of Indifference Curve: “Indifference
curve is down wards sloping, it is Convex to the origin, and Higher Indifference curve
represents higher level of satisfaction, two Indifference curves never intersect each other,
Indifference curve never intersect the axis and the collections of Indifference curves are
known as indifferent Map.” (1977)

Marginal Rate of Substitution

Marginal Rate of Substitution is the rate at which a consumer is willing to substitute one good
for another good while remaining at the same level of satisfaction. That is the amount of good
X needed to replace one unit of (lost) good Y to keep the consumer’s level of satisfaction
(utility) unchanged.

MRS = Slope of the indifference curve

Along any given

indifference curve Δ U = MU x Δ X + MU y Δ Y =

ΔY MU x
Slope of an indifference curve= ---------- = - ----------
ΔX MU y

c) Compare the ordinal and cardinal approach and explain the limitations of each
approach

Here is a table comparing the ordinal and cardinal approach:

Approach Description Example

Ordinal Measures utility in terms of A consumer prefers a slice of
preferences and rankings pizza to a hot dog, but cannot
quantify the difference in
utility between the two
Cardinal Treats utility as a measurable A consumer assigns a utility
quantity that can be assigned value of 10 to a slice of pizza
numerical values and a value of 5 to a hot dog
Differentiate between Cardinal and Ordinal Utility in Tabular FormBasis of Comparison

LIMITATIONS OF EACH APPROACH:

Ordinal Approach:

Limitation 1:

The ordinal approach cannot measure the intensity or magnitude of preferences. Consumers can
only rank their preferences, but they cannot determine the degree to which they prefer one good
to another. This makes it difficult to compare the preferences of different consumers.

Limitation 2:

The ordinal approach assumes that consumers are consistent in their preferences and rankings.
However, consumers may change their preferences over time, or their preferences may depend
on the context in which they are consuming the good.

Cardinal Approach:

Limitation 1:

The cardinal approach assumes that utility is measurable and can be assigned numerical values.
However, it is difficult to measure and compare utility levels across different individuals, as
utility is subjective and varies from person to person.

Limitation 2:

The cardinal approach assumes that consumers are able to accurately measure and compare their
utility levels. However, consumers may not be able to accurately assess their own preferences
and the utility they derive from different goods and services.
In summary of this, both the ordinal and cardinal approaches have limitations and assumptions
that can affect their applicability in different contexts. The ordinal approach is more commonly
used in modern economics, as it avoids some of the difficulties associated with the cardinal
approach. However, the cardinal approach can still be useful in certain contexts, such as in the
study of consumer behavior and demand theory.

d) With illustrations, distinguish between income consumption curve and price

consumption curve

The income consumption curve and the price consumption curve are two graphical
representations used in microeconomics to illustrate the relationship between income, prices, and
the quantity of goods consumed. Here is a brief explanation and illustration of each curve:

1. Income Consumption Curve (ICC):

The income consumption curve shows how changes in a consumer's income affect their
consumption of a particular good, while holding the price of that good constant. It is derived by
plotting the different combinations of two goods that a consumer can afford at different levels of
income, while keeping the price of one good constant.

In the following example, the income consumption curve shows how the quantity of food
consumed changes as income increases, while the price of food remains constant:

As the consumer's income increases, they are able to purchase more food, which results in a
rightward shift of the income consumption curve. The slope of the curve reflects the marginal
propensity to consume (MPC), which is the change in consumption resulting from a change in
income.

Income effect shows this reaction of the consumer. Thus, the income effect means the
change in consumer’s purchases of the goods as a result of a change in his money income.
Income effect is illustrated in Fig. 8.28.
With given prices and a given money income as indicated by the budget line P 1L1 the
consumer is initially in equilibrium at point Q 1 on the indifference curve IC 1 and is having
OM1 of X and ON 1 of Y. Now suppose that income of the consumer increases. With his
increased income, he would be able to purchase larger quantities of both the goods.

As a result, budget line will shift upward and will be parallel to the original budget line
P1L1. Let us assume that the consumer’s money income increases by such an amount that the
new budget line is P 2L2 (consumer’s income has increased by L 1L2 in terms of X or P 1P2 in
terms of Y). With budget line P 2L2, the consumer is in equilibrium at point Q 2 on
indifference curves IC 2 and is buying OM 2 of X and ON2 of Y.

Thus as a result of the increase in his income the consumer buys more quantity of both the
goods Since he is on the higher indifference curve IC 2 he will be better off than before i.e.,
his satisfaction will increase. If his income increases further so that the budget line shifts to
P3L3, the consumer is in equilibrium at point Q 3 on indifference curve IC 3 and is having
greater quantity of both the goods than at Q 2.

Consequently, his satisfaction further increases. In Fig. 8 28 the consumer’s equilibrium is

shown at a still further higher level of income and it will be seen that the consumer is in
equilibrium at Q 4 on indifference curves IC 4 when the budget line shifts to P 4L4. As the
consumer’s income increases, he switches to higher indifference curves and as a
consequence enjoys higher levels of satisfaction.

If now various points Q 1, Q2, Q3 and Q4 showing consumer’s equilibrium at various levels of
income are joined together, we will get what is called Income Consumption Curve (ICC).
Income consumption curve is thus the locus of equilibrium points at various levels of
consumer’s income. Income consumption curve traces out the income effect on the quantity
consumed of the goods. Income effect can either be positive or negative.

Income effect for a good is said to be positive when with the increase in income of the
consumer, his consumption of the good also increases. This is the normal good case. When
the income effect of both the goods represented on the two axes of the figure is positive, the
income consumption curve ICQ will slope upward to the right as in Fig. 8.28. Only the
upward- sloping income consumption curve can show rising consumption of the two goods
as income increases.

However, for some goods, income effect is negative. Income effect for a good is said to be
negative when with the increases in his income, the consumer reduces his consumption of
the good. Such goods for which income effect is negative are called Inferior Goods. This is
because the goods whose consumption falls as income of the consumer rises are considered
to be some way ‘inferior’ by the consumer and therefore he substitutes superior goods for
them when his income rises.

When with the increase in his income, the consumer begins to consume superior goods, the
consumption or quantity purchased by him of the inferior goods falls. When the people are
poor, they cannot afford to buy the superior goods which are often more expensive. Hence
as they become richer and can afford to buy more expensive goods they switch to the
consumption of superior and better quality goods.

2. Price Consumption Curve (PCC):

The price consumption curve shows how changes in the price of a particular good affect the
quantity of that good consumed, while holding the consumer's income constant. It is derived by
plotting the different combinations of two goods that a consumer can afford at different prices of
one good, while keeping the consumer's income constant.

In the following example, the price consumption curve shows how the quantity of food
consumed changes as the price of food increases, while the consumer's income remains constant:

As the price of food increases, the consumer is able to purchase less food, which results in a
leftward shift of the price consumption curve. The slope of the curve reflects the price elasticity
of demand (PED), which is the responsiveness of quantity demanded to changes in price.

With given prices of goods X and Y, and a given money income as represented by the budget
line PL1, the consumer is in equilibrium at Q on indifference curve C 1. In this equilibrium
position at Q, he is buying OM1 of X and ON1 of Y. Let price of good id X fall, price of Y and
his money income remaining unchanged.
As a result of this price change, budget line shifts to the position PL 2. The consumer is now in
equilibrium at R on a higher indifference curve IC2 and is buying OM2 of X and ON2 of Y. He
has thus become better off, that is, his level of satisfaction has increased as a consequence of the
fall in the price of good X. Suppose that price of X further falls so that PL 3 is now the relevant
price line.

With budget line PL3 the consumer is in equilibrium at S on indifference curve IC3 where he has
OM3 of X and ON3 of Y. If the price of good X falls still further so that budget line now takes the
position of PL4, the consumer now attains equilibrium at T on indifference curve IC 4 and has
OM4 of X and ON4 of Y.

When all the equilibrium points such as Q, R, S, and T are joined together, we get what is called
Price Consumption Curve (PCC). Price consumption curve traces out the price effect. It shows
how the changes in price of good X will affect the consumer’s purchases of X, price of Y, his
tastes and money income remaining unaltered.
In Fig. 8.31 price consumption curve (PCC) is sloping downward. Downward sloping price
consumption curve for good X means that as the price of good X falls, the consumer purchases a
larger quantity of good X and a smaller quantity of good Y. This is quite evident from Fig. 8.31.

In elasticity of demand, we obtain downward-sloping price consumption curve for good X when
demand for it is elastic (i.e., price elasticity is greater than one). But downward sloping is one
possible shape of price consumption curve. Price consumption curve can have other shapes also.

In Fig. 8.32 upward-sloping price consumption curve is shown. Upward-sloping price

consumption curve for X means that when the price of good X falls, the quantity demanded of
both goods X and Y rises. We obtain the upward-sloping price consumption curve for good X
when the demand for good is inelastic, (i.e., price elasticity is less than one).

Price consumption curve can also have a backward-sloping shape, which is depicted in Fig. 8.33.
Backward-sloping price consumption curve for good X indicates that when price of X falls, after
a point smaller quantity of it is demanded or purchased. This is true in case of exceptional type
of goods called Giffen Goods.
Price consumption curve for a good can take horizontal shape too. It means that when the price
of the good X declines, its quantity purchased rises proportionately but quantity purchased of Y
remains the same. Horizontal price consumption curve is shown in Fig. 8.34. We obtain
horizontal price consumption curve of good X when the price elasticity of demand for good X is
equal to unity.
But it is rarely found that price consumption curve slopes downward throughout or slopes
upward throughout or slopes backward throughout. More generally, price consumption curve has
different slopes at different price ranges. At higher price levels it generally slopes downward,
and it may then have a horizontal shape for some price ranges but ultimately it will be sloping
upward. For some price ranges it can be backward sloping as in case of Giffen goods. A price
consumption curve which has different shapes or slopes at different price ranges is drawn in Fig.
8.35. 

In summary, the income consumption curve shows how changes in income affect consumption,
while holding price constant, and the price consumption curve shows how changes in price affect
consumption, while holding income constant.
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