Utility and Cardinal Utility analysis

By

Dr. Mahendra Parihar

Associate Professor,
MPSTME, NMIMS Mumbai
 Introduction to Utility Analysis
Meaning of Utility

 Utility means - The power of a commodity that satisfy the wants of

consumer - want satisfying power

 Introduced by Jermy Bentham

 Measurement ‘Utils’
 Subjective entity
Cardinal Utility analysis and Ordinal Utility Analysis
 Cardinal Utility analysis and Ordinal Utility Analysis

Utility Analysis

Cardinal Utility analysis Ordinal Utility Analysis

• Alfred Marshal • J. R. Hicks & R.G.D. Allen

• can be measured •Cannot be measured but compared
• ‘Utils’
• Law of Diminishing Marginal as rank
Utility • Indifference Curve analysis
• Quantitative
. Subjective entity or Personal
•Law of Equi-marginal Utility
•Marshallian Analysis
 Utility…..
• FORM

• PLACE

• TIME
etc….
Total Utility(TU) and Marginal Utility(MU)
 Total Utility(TU) and Marginal Utility(MU)

Unit of Total Marginal

•Total Utility is the sum utility derived from Mango Utility Utility
the consumption of bundle of commodity 1 10
2 20
3 29
4 37
•Marginal Utility is the rate of change of TU
5 43
from one more unit of extra consumption
6 48
7 51
8 52
MUn = TUn – TUn-1 9 52
10 50
MU =∆TU/∆Q
 Total Utility(TU) and Marginal Utility(MU)

Unit of Total Marginal

•Total Utility is the sum utility derived Mango Utility Utility
from the consumption of bundle of 1 10 10
commodity 2 20 10
3 29 9
4 37 8
5 43 6
•Marginal Utility is the rate of change
6 48 5
of TU from one more unit of extra 7 51 3
consumption 8 52 1
9 52 0
MUn = TUn – TUn-1
10 50 -2

MU =∆TU/∆Q
 Cardinal Utility Analysis

a) Assumptions of Cardinal Utility analysis

b) Law of Diminishing Marginal Utility

c) Law of Equal-Marginal Utility

 Assumptions of Cardinal Utility analysis

1. Rationality of consumer
2. Cardinal measurability of utility
3. Marginal Utility of Money is constant
4. Diminishing Marginal Utility
5. Utility is Additive – TU= Ux+ Uy+ Uz+…….+ Un
6. The hypothesis of Independent Utility
etc….
 Law of Diminishing Marginal Utility

• Gossen first law

•According to Alfred Marshall ‘the additional utility which a person derive
from the consumption a commodity diminishes, that is Total Utility increase
at an diminishing rate ‘
 Law of Diminishing Marginal Utility

‘the additional utility which a person derive from the consumption a commodity
diminishes, that is Total Utility increase at an diminishing rate ‘

Unit of Total Marginal

Mango Utility Utility

1 10
2 20
MUn = TUn – TUn-1 3 29
4 37
MU =∆TU/∆Q
5 43
6 48
7 51
8 52
9 52
10 50
 Law of Diminishing Marginal Utility

‘the additional utility which a person derive from the consumption a commodity
diminishes, that is Total Utility increase at an diminishing rate ‘

Unit of Total Marginal

Mango Utility Utility

1 10 10
2 20 10
3 29 9
4 37 8
5 43 6
6 48 5
7 51 3
8 52 1
9 52 0
10 50 -2
 Law of Diminishing Marginal Utility

‘the additional utility which a person derive from the consumption a commodity
diminishes, that is Total Utility increase at an diminishing rate ‘

Unit of Total Marginal

Mango Utility Utility

TU
1 10 10
TU
2 20 10
3 29 9
4 37 8 No of mango
5 43 6
6 48 5
7 51 3 MU
8 52 1
9 52 0
10 50 -2
No of mango
MU
 Law of Diminishing Marginal Utility

Saturation Point MU =0 or TU is maximum

TU
TU

No of mango

MU

No of mango

MU
 Application of Law of Diminishing Marginal Utility

1. Bases of law of demand- why demand curve slops downward

2. Law of equi- marginal utility is derived
3. Consumer surplus derived
4. Progressive Tax can be justified
etc….
 Law of Equal-Marginal Utility
Consumer’s Equilibrium under Marshellian analysis
(Goosen’s Second Law)
 Law of Equal-Marginal Utility
Consumer’s Equilibrium under Marshellian analysis

•Gossen Second Law

•Explain how consumer is maximize his satisfaction by allocating his income with
different commodity at various prices.

• Condition for consumer equilibrium two commodity

MUx
/Px = MUy
/Py = MU m
• Condition for consumer equilibrium more commodity

MUx
/Px = MUy
/Py = ……………………. MUn/P n = MU m
 Consumer Surplus
• Consumer Surplus - the difference between the price
buyers pay for a good and the maximum amount
they would have paid for the good.

• Example:
• I’m willing to pay $6 for a case of soda
• Soda is on sale for $5 a case
• Consumer surplus = $1
 Critical evaluation of Cardinal Utility analysis

• Utility is not Cardinally measurable

• Marginal Utility of money is not constant

• Utilities are interdependent.

• Failure to explain Giffen Paradox

• Failure to distinguish income effect and

substitution effect

etc….
 Ordinal utility

 Ordinal utility holds that utility

cannot be measured but can be ordered
according to consumers’ preferences.
 Different product combinations may
be viewed as having same utility,
 And these combinations of same
utility consist of one Indifference Curve
(IC). 21
 Indifference Curve

Indifference Curve (IC) contains points representing

market baskets among which the consumer is indifferent.

U  f ( X1, X 2 )

22
• indifference curve
A locus of points representing different
bundles of goods and services, each of which
yields the same level of total utility.

23
 Indifference
curve （ IC ）
X2 Increasing
satisfaction

I3
I2
I1
O
X1
24
The important things of IC
1. IC is convex to the origin.
2.Every indifference curve must (?)
slope downward and to the right;
3. Indifference curves cannot
intersect.

25
Another important but not mentioned
thing about IC:
A consumer has many indifference
curves;

How do you understand this attribute?

26
X2
U = f （ X11 ， X22 ） = U11
A
IC
ΔX2

B ΔX2 /ΔX1
ΔX1=1
C

ΔX1=1

O X1 27
 Marginal Rate of Substitution (MRS)
MRS is defined as the number of
units of good Y that must be given up if
consumer is to receive an extra unit of
good X and to maintain a constant level
of satisfaction.

28
 To calculate MRS

X 2
MRS12 
X 1

29
 Not all indifference curves
must slope downward.

 Can you name some other

cases?

 What will the IC of substitutes

& complements? 30
 IC of substitutes

X2

I2

I1

O X1
31
 IC of compliments

X2
I2

I1

X1
32
 The budget line
 Consumers want to be most
satisfactory, but to be constrained by
their income (budget).
 Budget refers to various possible
combinations of products that
consumers can buy when their income
& products’ prices are set. 33
 The budget line

X2

I / P2

Budget Space

I / P1 X1
34
 Variation of budget line
Discuss
• P1& P2 hold constant while I changes;
• I holds constant while P1&P2 change
proportionately;
• I holds constant while P1 or P2
changes;
• I, P1&P2 increase or decrease
proportionately at the same time.
35
 “I” changes I P1
X2 X2   X1
P2 P2

I / P2 I decrease I increase

X1
I / P1
36
 P1 changes
X2
I P1
X2   X1
I / P2 P2 P2

P1 increases P1 decreases

I / P1 X1

37
Question

What if P2 changes ?

And I, P1 & P2 change?

38
The Equilibrium of Market Basket
 Consumers want to be most
satisfactory;
 But they are constrained by
their income (budget).
 Consumers (rational) want to
maximize their utility with limited
income.
39
Budget line & Indifference curve

X2 Discuss:
How do you
understand E?
B
E

I2
I1
C I3
O
X1
40
 If only prices change

Y Price changes
→ PCC
PCC
E3
Price-Consumption
E1 E2
curve
I3
I2
I1
O
XE1 XE2 XE3 X
41
 If only income changes

Y
ICC Income changes
A3 → ICC
A2 E3
E2
A1
I3
E1 I1 I2
O
XE1 XE2 XE3 X
42
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