Economics

Principles &
Applications
Dr. Manoj Mishra
Concept of
Utility
CNLU, PATNA
Cardinal Utility Vs Ordinal Utility
• Utility – Power of satisfaction (eg. Car over taxi - time utility,
possession utility, ATM over bank – time utility, place utility)
• 1. Rationality:
• The consumer is rational. He aims at the maximization of his utility subject
to the constraint imposed by his given income.
• 2. Cardinal Utility:
• The utility of each commodity is measurable. Utility is a cardinal concept.
The most convenient measure is money: the utility is measured by the
monetary units that the consumer is prepared to pay for another unit of
the commodity.
Cardinal Utility Vs Ordinal Utility
• 3. Constant Marginal Utility of Money:
• This assumption is necessary if the monetary unit is used as the
measure of utility. The essential feature of a standard unit of
measurement is that it be constant. If the marginal utility of money
changes as income increases (or decreases) the measuring-rod for
utility becomes like an elastic ruler, inappropriate for measurement.
Cardinal Utility Vs Ordinal Utility
• Assumptions:
• The ordinal utility approach is based on the following assumptions:
• A consumer substitutes commodities rationally in order to maximize his
level of satisfaction.
• A consumer can rank his preferences according to the satisfaction of
each basket of goods.
• The consumer is consistent in his choices.
Cardinal Utility Vs Ordinal Utility
• Assumptions:
• .It is assumed each goods is divisible.
• It is assumed that the consumer has full knowledge of prices in the market.
• The consumer's scale of preferences is so complete that consumer is
indifferent between them.
• Two commodities are used by the consumer. It is also known as two
commodities model.
• Two commodities X and Y are substitutes of each other. These
commodities can be easily substituted in various pairs.
Cardinal Utility Vs Ordinal Utility
• Ordinal Utility Approach:
• The basic idea behind ordinal utility approach is that a consumer keeps
number of pairs of two commodities in his mind which give him equal level of
satisfaction. This means that the utility can be ranked qualitatively.
• The ordinal utility approach differs from the cardinal utility approach (also
called classical theory) in the sense that the satisfaction derived from various
commodities cannot be measured objectively.
• Ordinal theory is also known as neo-classical theory of consumer equilibrium,
Hicksian theory of consumer behavior,  indifference curve theory, optimal
choice theory. This approach also explains the consumer's equilibrium who is
confronted with the multiplicity of objectives and scarcity of money income.
Cardinal Utility Vs Ordinal Utility
• The important tools of ordinal utility are:
• The concept of indifference curves.
• The slop of I.C. i.e. marginal rate of substitution.
• The budget line.
Consumer Surplus
• What is consumer surplus?
• What is producers surplus?
• What is Total Surplus?
Consumer Surplus
 Price of Items used in festivals on the D-
day
 Positive (what is ) normative (what
should be)
 Markets good way to organize economic
activity
 Price balances the supply and demand
Consumer Surplus
 Willingness to pay
 Ram – 1000
 Shyam – 800
 David - 700
 Rafi - 600
 Eager to buy at a price less than willingness to
pay
 If the price is 500 what is the consumer surplus?
Consumer Surplus
 Using demand curve to measure
consumer surplus

1000 Ram’s Willingness to Pay

800 Shaym’s Willingness to Pay

700 David’s Willingness to Pay

600 Rafi’s Willingness to Pay

500
How a lower price raises Consumer Surplus
 How much does a buyers well being raise due to lower price?

 Area above the price is consumer surplus.

 Lower price increases consumer surplus.

 Existing and new buyers both enjoy greater consumer

surplus
What does Consumer Surplus Measure?
 Policy maker attempting to design a good economic system

 It measures the benefit buyers receive from a good as the

buyers themselves perceive it.
 Consumer Surplus is a good measure of economic well being

 Policy makers respect the preference of buyers

 Exceptions drugs, mostly it does reflect good.

Producers Surplus
 Benefits sellers receive in participating in market

 COST AND WILLINGNESS TO SELL

 Cost of four possible sellers

 Ram – 900
 Shyam – 800
 David - 600
 Rafi - 500
Producers Surplus
 Each painter is willing to undertake the cost

 The cost is the opportunity cost and includes the out of

pocket expenses (paint brush etc.)
 It measures the willingness to sell

 Each would be eager to sell at a size greater than the cost

 At the cost equal they would be indifferent to the sales and

may to undertake it.
Producers Surplus
 The amount a seller is paid minus the cost is producer
surplus.
 It is a measure of benefit to sellers of participating in a
market.
Using supply curve to measure producers surplus

 How a higher price raises Producers surplus

Benevolent Social Planner

Total Surplus = Value to buyers – Cost to sellers
Evaluating the market Equilibrium
 Free market allocate the supply of goods to buyers who value
them most highly, as measured by their willingness to pay.
 Free market allocate the demand for goods to sellers who can
produce them at least cost.
Consumer and Producer Surplus at market
equilibrium

Supply

Consumer EQUILIBRIUM
Surplus

Producers
Surplus

Demand
Consumer and Producer Surplus at market
equilibrium

Supply

EQUILIBRIUM
Price

Value to
Buyers Cost to
sellers

Cost to Value to
Demand
sellers Buyers
Quantity
Consumers
Equilibrium
CNLU, PATNA
The decision making process of the consumer

Preference set Constraints

Optimal decision

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Assumptions
• Completeness {whatever the product is it is complete in
all spheres - whole}

• Transitivity {if a =b ‘n’ b = c than a=c}

• Non satiation {people will ever reach a point where they

will not need a certain product – buying n using will
continue till infinity} {desired will be of more and will not
be satisfied}

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Utility and Optimization
• Utility:
- reflects a rank ordering of preferences.
- is a magnitude indicating the direction of
preferences
• Optimization: {in a given condition
(constraints) what is best is optimization}
- Cardinal Approach and Ordinal Approach

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Optimization
The Cardinal Approach
• Utility is cardinally measurable and the objective
is to maximize utility
• The Law of Diminishing Marginal Utility
• Optimization Rule 1:
When only one good is consumed and is available
for free, consume till Example of ice cream one wants to
eat till a certain n also every time he
eats its marginal utility (satisfying
MUx = 0 ability) decreases
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Optimization
When available for price –
• Optimization Rule 2: consume till it reaches the
price u can afford
When only one good is consumed and is available for a price:
Consume till MUx = Pricex
• Optimization Rule 3:When more than one good is
consumed and the goods’ prices are different:
Consume till MUx/Px = MUy/Py = MUz/Pz

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Optimization- The Ordinal approach
• Rank ordering of preferences
• Combinations of goods

Two inputs required to arrive at optimal combination:

1. Preference set
2. Opportunity set

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Preference Set- Indifference Curves
• Indifference Curve:
Combination of goods that yield the same level of
satisfaction.
• Properties of Indifference curves:
- Slope downward
- Convex to the origin
- Non intersecting
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Shapes of Indifference curves

MRS decreasing MRS Constant=1 One fixed proportion

Normal substitutes perfect substitutes Complements

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Opportunity Set
• Defined by Budget Constraint.
6x + 3y = 60
Given Px = 6 and Py = 3
Graphically, Y

20
-Px/Py is the Slope

10 X
Consumer’s Equilibrium- The Optimal
Combination

y
e

x
At ‘e’ slope of the budget line is equal to the slope
of the Indifference curve.
Consumer’s Equilibrium
• Slope of the budget line: - Px/Py

• Slope of Indifference curve: MUx/MUy

• Equilibrium : MUx/MUy = Px/Py

or MUx/Px = MUy/Py
Changes in equilibrium when prices change
• Relative price changes get reflected in changes in
slope of the budget line.

• New point of tangency between the indifference

curve and the new budget line
Changes in equilibrium
• Joining all these points of tangency gives the Price
Consumption Curve. (PCC)

Y
PCC

Price of X is falling.

X
Derivation of the demand curve
• Data contained in the PCC:
- Optimal level of consumption of X
- Optimal level of consumption of Y
- Prices of X and Y
• Demand curve for X requires –
- Price of X.
- Quantity consumed of X.
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Demand Curve
• Every point on the PCC gives the price of X and quantity
demanded/consumed of X
Thus,
Px

Qx
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Changes in equilibrium when income
changes
• Income changes show up as parallel shifts of the budget line

• New points of tangency between indifference curves and the

new budget lines

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Changes in equilibrium
• Joining all these points of tangency gives the
Income Consumption Curve (ICC)

ICC

X
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Slope of the ICC
• If the goods are ‘Superior’, the ICC is upward sloping

• If one of the goods is ‘Inferior’, the ICC is downward

sloping

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Slope of the PCC

• If the goods are normal, PCC is upward sloping

• If PCC is downward sloping, then one of them is a Giffen

Good

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Giffen good
Income effect
• Price effect +
Substitution effect
• Substitution effect is inversely related to price.
• Income effect can be inversely related to changes in income
– Inferior Good
• Income effect can be positively related to income-Superior
good
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Giffen Good

• If income effect is inverse and large enough to offset the

substitution effect, then it is a Giffen Good

• The Demand curve for Giffen Good will have a positive

slope

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Applications of Indifference curves
• Welfare effects of a Direct tax Vs Indirect tax:
- Indirect tax changes slope of Budget line.
- Consumer shifts to a lower indiff curve.
- Direct tax (income tax) shifts the budget line parallel
inwards.
-Consumer shifts to lower indiff curve but..

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Applications
• .. Higher than in the Indirect tax case

Why??

Indirect tax changes price structure.

So, imposes both substitution and income effect

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Applications

• Whereas direct tax imposes only income effect.

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Applications
• Another application: Work –leisure choice

• Two goods- Leisure and other goods

• Boils down to – Leisure and work

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Applications
• Budget line: c = w(T- n)
T is max no: of work hours
n is no: of leisure hours
• Opportunity cost of leisure is ‘w’(wages)
• Therefore, c = wT – wn
• Slope of the Budget line is ‘w’.

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Applications
• If w increases , leisure becomes costlier.
• If w decreases, leisure becomes cheaper.
• Substitution effect of a change in ‘w’ :
if ‘w’ increases, leisure becomes costly and hence less leisure
and more work.
• Income effect of a change in ‘w’:
if ‘w’ increases, preference for leisure increases (since leisure is
a superior good)
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Applications
• If substitution effect is > income effect,
then,
‘w’ increase will lead to more work
• If income effect is > substitution effect,
then,
‘w’ increase will lead to more leisure.

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Applications
• At higher levels of ‘w’, income effect becomes > substitution effect.
So we have a backward bending Supply curve such as:

QL

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Diminishing marginal utility

• 4. Diminishing Marginal Utility:

• The utility gained from successive units of a
commodity diminishes. In other words, the marginal
utility of a commodity diminishes as the con­sumer
acquires larger quantities of it. This is the axiom of
diminishing marginal utility.
Indifference curves
• Properties of Indifference curves:
- Slope downward
- Convex to the origin
- Non intersecting
Application of Consumer surplus in building competitiveness

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