Accounting-Management

Concept Of Cardinal Utility Analysis And Its Assumptions

Concept Of Cardinal Utility Analysis
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 consumerimagines that one mango has 8 utils and an apple 4 utils, it
implies that the utility of mango is twice than of an apple.
Assumptions Of Cardinal Utility Analysis
1. Rationality
The consumer is assumed to the rational. He tries to maximize his total utility under the
income constraint.
2. Cardinal Utility
The utility of each commodity is measurable. Utility is cardinal concept. The most convenient
measure is money. Thus utility can be measured quantitatively in monetary units or cardinal
units.
3. Constant Marginal Utility Of Money
The utility derived from commodities are measured in terms of money. So, money is a unit of
measurement in cardinal approach. Hence, marginal utility of money should be constant.
4. Diminishing Marginal Utility
If the stock of commodities increases with the consumer, each additional stock or unit of
thecommodity gives him less and less satisfaction. It means utility increases at a decreasing rate.
5. Independent Utilities
It means utility obtained from commodity X is not dependent on utility obtained
fromcommodity Y. It does not affected by the consumption of other commodities.

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Anonymous said...
Thank U so much.
November 23, 2014 at 8:24 AM

Akaazua david said...

Am greatful sir
January 5, 2015 at 11:20 PM

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Cardinal Utility Analysis/Approach:

Definition and Explanation:

Human wants are unlimited and they are of different intensity. The means at the disposal of a man are not only s
result of scarcity of recourses, the consumer cannot satisfy all his wants. He has to choose as to which want is to
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
forces which make him purchase a particular commodity. The answer is simple. The consumer buys a commodit
technical term, a consumer purchases a commodity because it has utility for him. We now examine the tools whi
behavior.
Concept of Utility:

Jevon (1835 -1882) was the first economist who introduces the concept of utility in economics. According to hi
"Utility is the basis on which the demand of a individual for a commodity depends upon".
Utility is defined as:
"The power of a commodity or service to satisfy human want".
Utility is thus the satisfaction which is derived by the consumer by consuming the goods.

For example, cloth has a utility for us because we can wear it. Pen has a utility who can write with it. The utility
person to person. The utility of a bottle of wine is zero for a person who is non drinker while it has a very high u

Here it may be noted that the term utility may not be confused with pleasure or unfulness which a commodity g
satisfaction which consumer gets from consuming any good or service.
For example, poison is injurious to health but it gives subjective satisfaction to a person who wishes to die. We
Assumptions of Cardinal Utility Analysis:
The main assumption or premises on which the cardinal utility analysis rests are as under.

(i) Rationality. The consumer is rational. He seeks to maximize satisfaction from the limited income which is at
(ii) Utility is cardinally measurable. The utility can be measured in cardinal numbers such as 1, 3, 10, 15, etc.
cardinal numbers tells us a great deal about the preference of the consumer for a good.

(iii) Marginal utility of money remains constant. Another important premise of cardinal utility of money spen
should remain constant.

(iv) Diminishing marginal utility. It is also assumed that the marginal utility obtained from the consumption of
consumption is increased.

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Introduction to the Cardinal Utility Theory

By sundaramponnusamy

The Law of Diminishing Marginal Utility or Gossen's First Law

Indifference Curve Analysis: Assumptions, Indifference Schedule and the Meaning of

Marginal Rate of Substitution

Introduction
Utility analysis is the core concept of the theory of consumers behavior. Renowned classical
economists such as William Stanley Jevons, Karl Menger, Leon Walras and Gossen developed
the cardinal utility theory. However, significant contributions made by neo-classical economists,
particularly Alfred Marshall, led the theory being known as Neo-Classicial Utility Theory or
Marshallian Utility Theory.
What does Utility Mean in Economics?
All economic activities aim at fulfilling unlimited human wants. Utility can be regarded as the
potentiality of goods or services to satisfy a human want. Since utility refers to the inherent
quality of a commodity or service, it does not come under the purview of precise quantitative

measurement. A person can only realize how much utility he or she derives from a commodity.
Therefore, utility has no physical or material existence and the concept is purely subjective or
introspective.
Peculiarities of Utility
Utility and Satisfaction
Note that utility and satisfaction are not same. Utility refers to expected satisfaction and
satisfaction stands for realized satisfaction. Utility emerges when you think of buying a
commodity. On the other hand, you get satisfaction after you consume the commodity. Therefore,
a consumer can derive utility from a commodity even without purchasing it. However,
consumption alone yields satisfaction to the consumer.
Sometimes, utility may not be equal to satisfaction. This means that the satisfaction you derive
from a commodity may not meet your expectation. Though there are conspicuous differences
between utility and satisfaction, the entire theory of consumers behavior works based on the
assumption that the two concepts imply similar meaning. In other words, the assumption reads
that the expected satisfaction is equal to the realized satisfaction.
Utility is a Relative Phenomenon
Since the concept of utility is subjective, it differs from person to person depending upon the
personal needs and external circumstances. For example, a person, who is hungry, certainly
derives high utility from a delicious meal. On the other hand, the utility derived from the same
meal may be different for others. Similarly, the utility derived from a modern painting may be
insignificant for people who do not know how to interpret it. At the same time, the painting gives
tremendous utility to all connoisseurs. Therefore, utility is a relative phenomenon.
Utility is Ethically Neutral
Finally, the term utility possesses no ethical concerns or legal significance. For instance, tobacco
products are pernicious or injurious to health. However, tobacco products give great amount of
utility to a smoker. Similarly, possessing weapons is illegal; however, it gives immense utility to
terrorists. As long as an activity involves economics, utility derived from such an activity has no
moral or ethical connotation.
Cardinal and Ordinal Utility
Cardinal and Ordinal Numbers
Before looking at the concept of cardinal and ordinal utility, it is pertinent to learn what are
cardinal and ordinal numbers. The terms cardinal and ordinal are widely used in mathematics.
Cardinal numbers are 1, 2, 3, 4, 5, and so on. On the other hand, ordinal numbers are 1st, 2nd, 3rd,
4th, etc. As you notice, ordinal numbers imply ordering or ranking.

Cardinal Utility
The technique of cardinal utility traditionally precedes the ordinal utility method. The
cardinalists, usually identified as neo-classicists, enlighten the principle of consumers behavior
on the assumption that utility can be measured. As per the idea of cardinal utility, you are able to
measure and compare the utilities of two goods. The units of measurements are imaginary; they
are simply known as utils. For instance, let us consider apples and oranges. An apple may give
the utility of 30 utils to a person at the same time an orange may provide him or her with the
utility of 15 utils.
Measurement of Utility
Utility is a prejudiced or introspective notion associated with the internal perceptions and
feelings of the customer. Therefore, it is certainly not possible for you to gauge the utility of a
product to a shopper directly. However an indirect measure of utility is present in the price that is
paid by the consumer for the specific commodity. Higher the price compensated by the customer
for a product, greater will be its utility. Price could, therefore, be a measure of the utility of a
commodity.
If a shopper is willing to spend two dollars for an apple and one dollar for an orange, then the
utility of the apple to the buyer is twice that of the orange. To put it differently, the utilities of
two distinct goods to one particular customer could be measured by the prices that he or she
would like to pay for them. Money is, hence, a measuring rod, which is often used by the
economists to determine utilities of goods. However this method of measuring utilities, it needs
to be kept in mind, is not an ideal and trustworthy. It bears certain limitations and the economist
knows about them.
Ordinal Utility
The ordinalists uphold that amounts of utility are naturally non-measurable technically,
conceptually as well as practically. They consider that the basic principles of consumers
behavior could be described without the notion of quantifiable utility. As per the idea of ordinal
utility, the utilities resulting from the usage of goods can never be measured and is little
compared. The ordinal principle allows us to claim simply that the customer prefers an apple to
an orange; however, it fails to reveal by how much. It really does not allow us to compare the
volumes of utilities acquired from the two goods.
Theories based on Cardinal Utility Approach
There are two important laws to explain consumers behavior based on the cardinal utility
approach. They are the following:

The Law of Diminishing Marginal Utility or Gossen's First Law

The Law of Equi-Marginal Utility or Gossens Second Law

Assumptions of the Cardinal Utility Approach

The principle of cardinal utility is based on the following assumptions:
Utility is Measurable
The basic assumption of cardinal utility approach is that utilities of commodities are quantifiable.
According to Alfred Marshall, money acts as a measuring rod to measure utilities of
commodities. Utility is measured based on the amount of money that a customer is willing to pay
for the particular commodity.
Marginal Utility of Money is Constant
Marginal utility of money is assumed to be constant. This means that money must measure the
same amount of utility in all circumstances. In other words, the utility derived from each unit of
money is constant.This is necessary because money is used to measure utility of a commodity.
Utilities are Independent
The utility derived from one commodity is independent from the utility derived from another
commodity. In other words, a customers basket does not contain goods that are substitutes or
complements.
Therefore, TU = U1(x1) + U2(x2) + + Un(xn)
Where, TU is the total utility, U1(x1) is the utility derived from the first good alone (x1), and
U2(x2) is the utility derived from the second good alone (x2) and Un(xn) is the utility derived from
the nth good alone (xn).
Diminishing Marginal Utility
The marginal utility of a commodity diminishes as a person consumes more and more quantities
of it.
MUx = f(Qx)
The equation states that marginal utility of a commodity X (MUx) is a function of the quantity of
X (Qx). The greater the quantity, the lesser is its marginal utility.
Rationality
The cardinal utility approach assumes that the consumer is rational. This means that the
consumer tries to maximize his or her utility with given income.
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INTRODUCTION TO CONSUMER BEHAVIOUR

UNIT STRUCTURE
1. Learning Objectives
2. Introduction
3. Utility: Cardinal and Ordinal Approaches
4. The Cardinal Utility Theory
5. The Indifference Curve Technique
6. Price Effect, Substitution Effect and the Income Effect
7. Let Us Sum Up
8. Further Readings
9. Answers to Check Your Progress
10 Possible Question
.

LEARNING OBJECTIVES

After going through this unit, you will be able to:

appreciate the difference between cardinal and ordinal utility
determine the equilibrium of the consumer on the basis of the cardinal utility theory
explain the concepts of indifference curve and the budget line
derive the equilibrium of the consumer using these above two concepts and
indicate the price effect and split it up into substitution effect and income effect.

INTRODUCTION

The Theory of Consumer Behavior studies how a consumer spends his income so as to attain
the highest satisfaction or utility. This utility maximisation behaviour of the consumer is
subject to the constraint imposed by his limited income and the prices of the various
commodities he desires to consume. The consumer compares the different bundles of goods
that he can consume given his income and the prices of the goods in the bundles. And in the
process, he attempts to determine the bundle that will give him the maximum satisfaction.

UTILITY : CARDINAL AND ORDINAL APPROCHES

Utility is the satisfaction that a consumer derives by consuming a commodity. Thus, it is that
property of a commodity that satisfies the wants of the consumers. Utility is a subjective
concept and its perception varies among different individuals. In fact, the extent of desire for a
commodity by an individual depends on the utility that he associates with it.
Cardinal Approach to Utility :
The Cardinalist school asserts that utility can be measured and quantified. It means, it is
possible to express utility that an individual derives from consuming a commodity in
quantitative terms. Thus, a person may express the utility he derives from consuming an apple
as 10 utils or 20 utils.Moreover, it allows consumers to compare and define the difference in
utilities perceived in two commodites. Thus, it allows an individual to state that commodity A
(accruing an utility of 20 utils) gives double the utility of commodity B ( which accrues an
utility of 10 utils).
Ordinal Approach to Utility :
The ordinalist school asserts that utility cannot be measured in quantitative terms. Rather, the
consumer can compare the utility accruing from different commodities (as a combination of
them) and rank them in accordance with the satisfaction each commodity (or combination of
commodities) gives him.
Thus, the cardinal approach to the measurement of utility believes that utility derived from the
consumption of a commodity can be expressed in quantitative terms. The ordinalist approach
rejects this and states that the consumer at best can rank the various commodities (or
combination of them) in accordance with the satisfaction that he expects from their
consumption.
Total Utility and Marginal Utility :
Total utility (TU) is the aggregate utility derived by a consumer after consuming all the
available units of a commodity. Thus, it is the sum of all the utilities accruing from each
individual units of the commodity.
Marginal utility (MU), on the other hand, is the utility flowing from an additional unit of a
commodity, over and above what had been consumed.

THE CARDINAL UTILITY THEORY

The Cardinal Utility Theory developed over the years with significant contributiions from
Gossen (1854), Jevons (1871), Walras (1874) and finally Marshall (1890). The theory is
constructed on the basis of the following assumptions.
The consumer is rational in the sense that given his income constraints, he would always
attempt to maximise his utility.
Utility is a cardinal concept and it can be measured and expressed in quantitative terms.
For convenience, it is expressed in terms of the monetary units that a consumer is willing to
pay for the marginal unit of the commodity.
The law of diminishing marginal utility operates. This implies that as a consumer increases
his consumption of a commodity, the utility accruing from successive units of the
commodity decreases. In other words, the marginal utility of a commodity will keep falling
as a consumer goes on increasing its consumption (this is what we have seen in Activity 2.1
and figure 2.1)
Marginal utility of Money is constant. That is, as one acquires more and more money, the
marginal utility of money will remain unchanged. This assumption is critical because
money is used as a standard unit of measurement of utility, and, hence, cannot be elastic.
The total utility of a bundle of goods depends on the quantities of the individual
commodities. Thus: U = f (x1 , x2 ,...............,xn)
where U means total utility; x1, x2 ....................xn are the quantities of n number of
commodities.
Equilibrium of the Consumer :
Initially we derive the equilibrium of the consumer when he spends his money income M on a
single commodity x. Here, the consumer will be at equilibrium when the marginal utility of x is
equal to its market price .
Symbolically: MUx = Px
If:
MUx > Px , then the consumer can increase his welfare by consuming more of x. He will
continue to do that until his marginal utility for x falls sufficiently, to be equal with its
price.
MUx < Px , then the consumer can enhance his welfare by cutting down on his
consumption of x. He will be persisting on doing this, until his MUx increases to equal the
price Px. If more commodities are introduced into the model, then the consumer will attain
equilibrium when the ratios of the marginal utilities of the individual commodities to their
respective prices are equal for all commodities. That is,

Where, x,y,....................z are different commodities; and

l = marginal utility of money income.
This state is defined by the Law of equi-marginal utility, which states that a consumer will
distribute his money income among different commodities in such a way that the utility

THE INDIFFERENCE CURVE TECHNIQUE

The Indifference Curve Technique was conceived as an alternative to the cardinal utility
approach to the theory of consumer behaviour. A number of economists have contributed to
this technique as it has evolved over the years, with the latest refinements attributed to
Slutsky(1919), J.R. Hicks and R.G.D. Allen (1934).
The indifference curve technique rejects the concept of cardinal utility and asserts that utility
cannot be measured in quantitative terms. Instead, it adopts the principle of ordinal utility
which states that, while the consumer may not be able to indicate exactly the amount of utility
that he derives from the consumption of a commodity or a combination of commodities, he is
perfectly capable of comparing and ranking the different levels of satisfaction that he derives
from them.
Assumptions of the Theory:
The indifference curve technique is based on the following assumptions.
Utility can be ordinally measured: The consumer can rank various commodites or
combination of commdoties in accordance with the satisfaction that he derives from them.
The consumer is rational: Given the market prices and his income, a consumer will
attempt to maximise his satisfaction when he undertakes consumption.
Additive Utilities: The quantities of the commodities that is consumed determines the total
utility of the consumer.
Consistency of choices:The choice of the consumer is consistent in the sense that if he
chooses combination A over B in one period, he will not choose B over A in another period.
Symbolically : if A > B, then B < A.
Transitivity of consumer choice: If a consumer prefers combination A to B, and prefers B
to C, then, it can be concluded that he prefers A to C.
Symbolically : If A > B, and B > C, then A > C.
Equilibrium of the Consumer :
The equlibrium of the consumer is determined using indifference curves and the budget line.
Now, before discussing equilibrium of the consumer, we shall discuss these two important
concepts first.
Indifference Curves: An indfference curve is defined as the locus of the various combinations
of two commodities that yield the same satisfaction to the consumer, so that he is indifferent to
any one particular combination. In other words, all combinations of the two commodities in the

indifference curve are equally desired by the consumer.

An indifference curve is based on the indifference schedule, which represents the various
combinations of two commodities that give the consumer the same level of satisfaction. Given
below is an indifference schedule representing various combination of commodity x and y that
gives the consumer the same amount of satisfaction.

Putting the various combinations of the indifference schedule from the above table 2.A, we
obtain the IC1 indifference curve as in the following figure 2.2.

Figure 2.2: Indifference Curve

In the above figure 2.2, the slope of the indifference curve is indicated by the marginal rate of
substitution. The marginal rate of substitution of x for y is defined as the numbers of y that
has to be given up by the consumer to get an additional unit of x, so that his satisfaction
remains unchanged.
Thus, [slope of the indifference curve] = MRSxy.
It can be seen from the table 2.A that as the consumer gets more and more of x, the number of

y he is willing to give up for an additional unit of x successively falls. This is known as the
principle of diminishing marginal rate of substitution which states that the marginal rate of
substitution of x for y falls as more and more of x is substituted for y. This implies that the
indifference curve always slopes downwards to the left and is convex to the origin.
Indifference Map:
An indifference map, on the other hand, shows all the indifference curves which rank the
preference of the consumer. While combinations of commodities on the same indifference
curve yield the same satisfaction, combinations on a higher indifference curve yield greater
satisfaction and combinations on a lower curve yield less satisfaction. In the following figure
2.3, an indifference map has been shown.

In the above figure, we see an indifference map of a consumer. It is needless to say that the
rational consumer would prefer to be on a higher indifference curve (i.e. he would prefer to be
on IC2 than being on IC1 and on IC3 than on IC1 and IC2) rather than on the indifference
curve which is positioned lower (IC2 or IC1).
The Budget Line :
The budget line is an important concept in the indifference curve technique. It is defined as the
various combination of the two commodities (x and y) that a consumer can consume, given his
income (M) and the price of the two commodities (Px and Py).
The Budget line can be algebraically expressed as :
M = Px X + Py Y.
where X and Y indicates the quantities of x and y respectively.
If y = 100, Px = 10 and Py = 20, then -

(a) if the consumer spends all his income on x, then he can consume
X = M / Px = 100 /10 = 10
(b) and if he spends all his income on y, then the number of units of y that he can consumed is:
Y = M / Py = 100 /20 = 5
Thus , 10x and 5y are the two extreme limits of the consumers expenditures. However, he
usually prefers a combination of the two commodities within these two limits. In fact, the
budget line joins the two extreme consumption limits of the consumer, and the points within
those two limits indicate the combinations available to the consumer, given his income and the
prices of the two commodities.
The concept of budget line has been shown with the help of the following figure 2.4. In figure
2.4, AB indicates the budget line. In this budget line AB,

the consumer have the option of consuming 10x(0B) or 5y (0A) or some combination of the
two.
The slope of the budget line is the ratio of the prices of the two commodities. Geometrically,

Consumers Equilibrium:
Given his budget line, a consumer would like to maximise his satisfaction by climbing on to

the highest indifference curve. This has been shown in the following figure 2.5

It can be seen from the above figure 2.5 that the consumer is at
equilibrium at point e, where his budget line is tangent to the
indifference curve Id2. He has the option of consuming at a and b ,
but those combinations are rejected as they would place him on a
lower indifference curve Id1. The consumer would like to be on the
indifference curve Id3, but his budget line does not allow him to do
that.

Thus, at equlibrium,
[slope of the indifference curve] = [slope of the budget line] .

From figure 2.5, it can be seen that at equilibrium the consumer consumes 0x amount of x and
0y amount of y.
Indifference Curve Technique Vs Cardinal Utility Analysis:
The indifference curve technique is considered to be surperior to the Cardinal Utility Analysis
on the following grounds :
It avoids the unrealistic assumption of cardinal utility and instead adopts the concept of
ordinal utility.
It can be used to split the price effect into the substitution and income effects.
It is not based on the unrealistic assumption of constant marginal utility of money.
Limitations of the Indifference Curve Technique :
The indifference curve technique has been crticised on the following grounds:
The indifference curve technique does not tell us anything new, and it is only old wine in
new bottle.
It assumes that the consumer is very familiar with his entire preference schedule, which is
not the case in actual life.
The technique can be efficiently applied only to two commodities. Once more than two
commodities are introduced, the analyais become very complicated to illustrate.

ACTIVITY

1. Based on the definition and the discussion , try to determine the properties of an
indifference curve.

From the above discussion, we have seen that:

An indifference curve is the locus of the various combination of two commodities that
yield the same satisfaction to the consumer, so that he is indifferent to any one particular
combination.
An indifference map shows all the indifference curves which rank the preference of the
consumer. While combinations of commodities on the same indifference curve yield the
same satisfaction, combinations on a higher indifference curve yield greater satisfaction
and combinations on a lower curve yield less satisfaction.
A consumer is in equilibrium at the point where his budget line is tangent to the
indifference curve. Symbolically:

CHECK YOUR PROGRESS

1. What do u mean by 'consistency of consumer choices' and transivity of consumer

choices' in case of indifference curve analysis ?
2.What does an indifference schedule represent ?
3.Define ' Budget Line' .

THE PRICE EFFECT , SUBSTITUTION EFFECT AND THE

INCOME EFFECT

If a consumer consumes two commodities x and y, and given the

price of y, the price of x falls then the real income of the consumer
increases. This is because he now can consume more of x with his
same, given income. The increase in the consumption of a
commodity due to a fall in its price is referred to as the Price Effect.
In terms of the indifference curve technique,we have illustrated the
income effect with the help of figure 2.6 in the next page. It can be
seen from the figure that as a result of a fall in the price of x, given
the price of y, the budget line of the consumer pivots anticlock wise
from AB to AB. This enables the consumer to move from the initial
equilibruim at e, on IC1, to e2 on the higher indifference curve IC2.
In the process the consumer increases his consumption of x from
0X1 to 0X2, due to a fall in its price. This is the price effect.
The price effect has two components: the substitution effect and the
income effect. These two components can be derived using either the
Hicksian compensating variation method or the Slutskys costdifference method. In the following discussion we shall use the
compensating variation method to determine the substitution and the
income effect of a fall in price. The following figure 2.6 shows these
two components of the price effect.

In the above figure 2.6, a fall in the price of x has allowed the consumer to move to a higher
indifference curve IC2 which accrues him greater satisfaction. Now, to remove the income

LET US SUM UP

Theory of consumer behaviour studies how a consumer spends his income so as to attain
the highest satisfaction or utility.
Utility is a subjective concept and its perception varies among different individuals.
The Cardinalist school asserts that utility can be measured and quantified, while the
ordinalist school asserts that utility cannot be measured in quantitative terms.
The law of equi-marginal utility states that a consumer will attain equilibrium when the
ratios of the marginal utilities of the individual commodities to their respective prices are
equal for all commodities.
The theory has been criticised on the ground that utility can not be measured cardinally and
utility of money does not remain constant. The law of diminishing marginal utility is also
unrealistic as this is a psychological law, and cannot be established empirically.
An indifference curve is the locus of the various combination of two commodities that
yields the same satisfaction to the consumer, so that he is indifferent to any one particular
combination.
An indifference map shows all the indifference curves which rank the preference of the
consumer. While combinations of commodities on the same indifference curve yield the
same satisfaction, combinations on a higher indifference curve yield greater satisfaction
and combinations on a lower curve yield less satisfaction.
A consumer is in equilibrium at the point where his budget line is tangent to the
indifference curve. Symbolically:

The substitution effect and the income effect are two components of the price effect.
These two components can be derived using either the Hicksian compensating variation
method or the Slutskys cost- difference method.

FURTHER READINGS

1. Dewett, K.K (2005): Modern Economic Theory, S.Chand & Sons, 22nd Ed.
2. Chopra, P.N (2008) : Micro Economics, Kalyani Publishers, 2nd Ed.
3. Ahuja, H L (2006): Modern Economics, S. Chand, 12th Ed.
4. Sundharam, K.P.M. & Vaish, M.C.(1997): Microeconomic Theory, 20th Ed.
5. Baumol, W.J & Blinder, A.S.(2007) :Microeconomics - Principles and Policy,Thomson
South-Western, 9th Ed., Indian Ed. (1st).
6. Koutsoyiannis, A (1979): Modern Microeconomics, Macmillan, 2nd Edition.

ANSWERS TO CHECK YOUR PROGRESS

Check Your Progress 2.1

Q. No. Total utility (TU) is the aggregate utility derived by a consumer after consuming all the
1:
available units of a commodity. Thus, it is the sum of all the utilities accruing from
each individual units of the commodity.
Q. No. Marginal utility (MU) is the utility flowing from an additional unit of a commodity,
2:
over and above what had been consumed.
Check Your Progress 2.2
Q. No.
1:
Q. No.
2:

Some of the important contributors of the Cardinal Utility Theory are: Gossen (1854),
Jevons (1871), Walras (1874) and finally Marshall (1890).
According to the theory of cardinal utility, the total utility of a bundle of goods
depends on the quantities of the individual commodities.
Thus: U = f (x1 , x2 ,...............,xn)
where u means total utility : x1, x2 .....................,xn are the quantities of n
number of commodities.

Check Your Progress 2.3

Q. No. Consistency of choices in cardinal utility theory means that the choice of the consumer
1:
is consistent in the sense that if he chooses combination A over B is one period, he will
not choose B over A in another period.
Symbolically: if A > B, then B < A.
Again, transtivity of consumer choice in cardinal utility theory means that if a
consumer prefers combination A to B, and prefers B to C, then, it can be concluded that
he prefers A to C.
Symbolically: If A > B, and B > C, then A > C.
Q. No. An indifference schedule represents the various combinations of two commodities that
2:
give the consumer the same level of satisfaction. An indifference curve is drawn based
on a indifference schedule.

Q. No. A budget line is defined as the various combination of two commodities (say, x and y)
3:
that a consumer can consume, given his income (M) and the price of the two
commodities (Px and Py).
Thus, a Budget line can be algebraically expressed as:
M = Px X + Py Y.
where X and y indicates the quantities of x and y respectively.
Check Your Progress 2.4
Q. No. If a consumer consumes two commodities x and y, and given the price of y, the price of
1:
x falls then the real income of the consumer increases. This is because he now can
consume more of x with his given income. The increase in the consumption of a
commodity due to a fall in its price is referred to as the Price Effect.
Q. No. The increase in the consumption of x is brought about by substituting the relatively
2:
cheaper x for y is referred to as the substitution effect. Hence the substitution effect
takes place when the relatvie prices of the two commodities changes in such a manner
that the consumer concerned is neither better nor worse off than he was before, but is
obliged to rearrange his purchases in accordance with the new relative prices.

POSSIBLE QUESTIONS

1. Dislinguish between cardinal and ordinal utility. Which one of the concept is more
realistic?
2. State the law of Equi- marginal utility. How does it explain consumers equilibrium?
3. Derive the consumers equilibrium using the indifference map and the budget line as your
tools.
4 Derive the Price Effect of a price fall. Disintegrate the price effect into the substitution
effect and the income effect.
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17
Consumer Equilibrium
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Theory of ConsumerBehaviour
28
U N I T 5 C O N S U M E R E Q U I L I B R I U M : CARDINALAND
ORDINALAPPROACHES
Structure
5 . 0 O b j e c t i v e s 5 . 1 I n t r o d u c t i o n 5.2Cardinal utility
approach to consumer behaviour5.3The law of eventual diminishing
marginal utility5 . 4 C o n s u m e r s e q u i l i b r i u m 5 . 5 B a s i s o f l a w o f d e m a n d i n
t h e c a r d i n a l a p p r o a c h 5 . 6 C o n s u m e r s s u r p l u s 5.7The ordinal utility
approach to consumer behaviour: the indifference curveapproach5 . 8 C o n s u m e r s
b u d g e t c o n s t r a i n t 5.9Consumers equilibrium in the ordinal utility
approach5 . 1 0 S p e c i a l c a s e s 5.11Price-consumption curve5.12Income-consumption
curve5.13Price, substitution, and income effects5.14Derivation of the demand curve
for a good5.15Inferior goods and Giffen goods 5 . 1 6 L e t u s s u m u p 5 . 1 7 S o m e
k e y w o r d s 5 . 1 8 S o m e u s e f u l b o o k s 5.19Answers or Hints to Check Your
Progress Exercises
5.0OBJECTIVES
This unit will enable you to:
l
understand and analyse how a consumer attains equilibrium;
l
use cardinal utility theory to explain consumer behaviour;
l
describe the law of diminishing marginal utility;
l
explain consumers equilibrium in terms of the Marshallian law of equi-marginalutility. Also use
this law to explain the law of demand;
l
explain the concept of consumers surplus;
l
explain consumers behaviour in terms of ordinal utility theory, the Hicks-Allenapproach

l
describe consumers equilibrium condition in terms of ordinal utility theory;
l
decompose price effect into substitution effect and income effect;
l
graphically derive price consumption curve and income consumption curve, anddemand curve
for a good;
l
understand the difference between normal, inferior, and Giffen goods;
l
provide a comparative evaluation of the two competing theories.
5.1INTRODUCTION
In the previous unit we have introduced the concept of demand function, variousdeterminants of
demand and its elasticity. In this unit, we continue the discussion on

Consumer Equilibrium

29
demand and focus our attention on consumers behaviour in order to explain the lawof demand.
The law of demand says that when price of a commodity is lowered alarger quantity is
demanded, and when price rises a smaller quantity is demanded,other things remaining the same.
In other words, the law states that price and quantitydemanded are inversely related. In this unit
we will introduce you two contendingtheories - Alfred Marshalls
cardinal utility theory of demand
, and J.R. Hicks andR.G.D. Allens
preference approach
(or the indifference curve theory, or the ordinalutility theory) of consumer behaviour.In HicksAllen approach some of the restrictive assumptions of the
Marshallian
approach are dropped. Particularly, that utility is a cardinal concept and is measurableon a
numerical scale with an absolute zero and that marginal utility of money is constantare relaxed.
Marshallian
theory is also based on the law of diminishing marginalutility as well as on inter-personal
comparisons of utility. In the preference approachthese limitations are overcome with the help of
Hicks-Allen formulation, which isbased on the indifference curve technique. We will
first develop the properties of indifference curves. Using the indifference curves and in
conjunction with prices of goods and the consumers money income (or budget) we will be
showing how arational consumer attains equilibrium.Since consumers choice depends on prices and
money income, and as prices changeor money income changes, the consumers equilibrium
choice will also change. Weexplain how to derive the price-consumption curve and the income-consumption
curve.We will then show how the demand curve for a good can be derived from the
priceconsumption curve. This part of the discussion ends by pointing out the differenceamong
normal good, inferior good and Giffen good. It is only in the case of Giffengood that the law
of demand is violated and the demand curve for a good is upwardsloping rather than downward
sloping. The law of demand need not be violated incase of inferior good. As we will be showing
it, all depends on the working of twoopposing forces -the substitution effect and the income
effect.
5.2THE CARDINAL UTILITY APPROACH
Alfred Marshall (1842-1924), an important member of the neo- classical school of economics,
gave us the cardinal
utility theory
of consumer behaviour in his book
Principles of Economics
(1890). According to him, a consumer derives utility fromconsuming a commodity. Following
Jeremy Bentham
(1748-1832) the founder of the Utilitarian School of Ethics, utility is defined as the subjective sensation pleasure,satisfaction, wish fulfilment, cessation of need - which are derived from consuming
acommodity and the experience of which is the object of consumption. Marshall assumedthat utility (which is
the want satisfying power of a commodity) could be measuredquantitatively in the same way as
one can measure weights and heights. In otherwords, utility is cardinally measurable - numerical
or quantitative scale exists formeasuring it. See that this is a very highly restrictive assumption.
For instance, it ispossible to say that a person, say, Mili

gets 2 units of utility from a cup of tea. If utilityis a cardinal concept, then it requires
a complementary assumption specifying theunit of measurement
.
Bentham used a psychological unit of measurement calledUtils. However, it cannot be taken as a
standard unit for measurement due to itsvariation from individual to individual. Hence, Marshall
took money as the unit of measurement. It has the advantage of uniformity for all individuals in
the economy. Inthe illustration above Mili
would receive 2 rupees worth of utility from a cup of tea.Besides adopting money as a
measuring rod for utility, Marshall made another complementary assumption. He assumed
the marginal utility of money to remainconstant for each consumer. That implies the measuring
rod must remain constant.Cardinal measurability of utility also implies that utilities derived from the
consumptionof different quantities of a commodity can be added and also can be compared across

Theory of ConsumerBehaviour
30
various individual consumers. Thus, one can speak of total utility and marginal utilityderived from
consuming a commodity. Marginal utility (MU) is defined as the additionto total utility when an additional
unit of a commodity is consumed. Thus, MU is theratio of extra utility to an extra unit of the
commodity consumed.
I. Illustration of MU
Q
u
a
n
t
i
t
y
T
o
t
a
l
U
t
i
l
i
t
y
M
a
r
g
i
n
a
l
U
t
i
l
i
t
y
c
o
m
m
o
d
i
t
y
X
(
T
U
)
(
M
U
)
1
2
.
0
0
2
5
.
0
0
3
.
0
0
3
9
.
0
0
4
.
0
0
4
1
4
.
0
0
5
.
0
0
5
1
7
.
0
0
3
.
0
0
6

9
.
0
0
.
0
0
7
2
0
.
0
0
1
.
0
0
Forthefirst unitthemarginalutility
cannotbecalculated. Thedashsign intheillustrationindicates that. For the second unit of commodity X
consumed the total utility are 5.Hence marginal utility is (5-2)/(2-1)=3/1=3, since the change in
quantity is only oneunit (

X=1). In other words,(TU

2
- TU
1
)MU = -(

X = 1)Where TU
1
is utility derived from consuming one unit of X and TU
2
is total utilityderived from consuming two units of commodity X. In general, thenTU
n
- TU
n-1
MU = X
n
-X
n-1
where n and n - 1 are the number of units of the commodity consumed.Another important
assumption, which Marshall made, is independence of utility.What it means is that utility derived from,
say, consuming a
Samosa
is independentof utility derived from consuming, say,
Sandwiches
.Together, all these assumptions would imply that if our consumers taste can berepresented by
means of a utility function of the formU = f (X
1
;X
2
; Xn),then such a function will have the property of additivity and separability. This
wouldm
e
a
n
t
h
a
t
U
=
U
(
X
1
)+ U (X
2
)+...+U (X

n
)w
h
e
r
(
X
1
)=f
1
(X
1
)U (X
2
)=f
2
(X
2
)............................. . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Consumer Equilibrium
31
U (X
n
) = fn (X
n
).Utility derived from a good depends on the quantity consumed of that good alone.And
total utility or total satisfaction derived from consumption will depend on thesumof
utilities derived fromconsuming allthe commodities.Theobjectof consumptionis to make this total utility as high as
possible.It is important to remember that when a utility function is used to represent
aconsumers taste, like U =f(X
1
), marginal utility derived from consuming, say,commodity 1 is given
by the first partial derivative of U with respect to X
1
, thatis

U/

X
1
, marginal analysis is based on calculus technique. The use of calculusmethod
requires the assumption that each and every commodity must be perfectlydivisible or as
finely divisible as possible. So, consumption of any commodity can bevaried in
as small an amount as possible. This makes the utility function continuousand twice
differentiable.The
Marshallian
theory of consumer behaviour is also based on the nonsatiationassumption. In other words, consumers are never satiated with any good. Satiationwould
imply that the marginal utility of a good becomes zero. Non-satiation alsoimplies that more of a
good is preferred to less of the same good.
Check Your Progress 1
1. The following table shows the relationship between total utility derived fromconsuming
various quantities of milk. Calculate the marginal
utility.Q
t
y
.
o
f
m
i
l
k
(
g
o
o
d
X
)
i
n
l
i
t
r
e
s
1
3
5
8
1
2
T
o
t
a
l
U
t
i
l
i
t
y
(
i
n
R
u
p
e
e
s
)
1
0
1
5
2
8
4
0
5
6
5.3THE LAW OF EVENTUAL DIMINISHINGMARGINALUTILITY
The law of eventual diminishing marginal utility forms the basis of the
Marshallian
theory of demand. This law says that after sufficient quantity of a good is consumed,consumer
experiences diminishing marginal utility from additional units consumed. Toput it differently, the law states that
after sufficient quantity of a good has been consumedeach additional unit of consumption yields less and
less additional utility. This law isbased on introspection and has the following rationale: when a
fewer units of a goodare available, a utility maximising consumer would be using them to
satisfying themost pressing (urgent) needs. However, as more and more units of a good
becomeavailable, the needs to which they are used or put become less and less important
andhence yield less and less additional utility.Suppose that there is water shortage in your
residential area, and you get only onetumbler a day, how will you use it? Surely, you will use it
for drinking purpose only,and may be for cooking. But, suppose, you get one or two additional
tumblers a day.You may then use it for bathing and washing. As more and more water
becomesavailable you may start using it to satisfy less and less urgent needs, like cleaning
yourcar, watering your garden, and if enough water still remains available, you may eveninvolve
in water fights - activities that are far removed from the notion of water as anabsolute essential
for human survival. (J.QUIRK).

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Theory of ConsumerBehaviour
32
Total Utility TU
1
OX
1
X
2
Quantity OF X
1
Marginal UtilityOX
1
X
2
Quantity of X
1
MU
1
Fig. 5.1The upper segment shows total utility curve TU
1
and the corresponding MU
1
is in the lower segment. Note that at OX
1,
MU

1
is at its maximum and TU
1
shows the highest rate of rise. Beyond this point, TU
1
keeps rising, but atsmaller and smaller rates. It reaches its maximum at OX
2
when MU
1
falls tozero.
Asconsumptionincreasesfromaninitiallowlevel (say,fromzero),totalutilityincreasesat an increasing rate. This feature
implies that the marginal utility is increasing (uptoX
1
). Beyond OX
1
for all successive consumption of X
1
total utility starts increasing ata diminishing rate. As a result marginal utility tends to fall. Hence,
the law of eventualdiminishing utility starts operating from OX
1.
Let us examine some other aspects of the law of diminishing marginal utility throughan
example.When you are very thirsty, the first glass of water will give you a very high level
of utility. The second glass might give you even a higher utility. But as you go on takingglass
after glass of water, a point will be reached when you will not wish to have it anymore. At that
point you are completely satiated with it. In the diagram, at the quantityOX
2
total utility reaches a maximum and marginal utility becomes zero. Beyond OX
2
total utility decreases implying that marginal utility becomes negative. So, a utilitymaximiser
will not go beyond this point. In fact, we will be showing below that arational consumer will be
attaining equilibrium in the range OX
1
and OX
2
. That is therange where the law of diminishing marginal utility holds as well as the assumption
of non-satiation.
5.4 CONSUMERS EQUILIBRIUM
Let us assume that a consumer is consuming only two goods X
1
and X
2
. The utilitywhich she receives from consuming X
1
and X
2
is given by the utility function U=f (X

1
,X
2
) and satisfies the property of eventual diminishing marginal utility. The consumerhas a given
money income to be spent on these two goods during the period we areanalysing her
behaviour. She cannot influence the prices, P
1
and P
2,
, of the goods,through her own action. Prices are given as parameters in decisionmaking(consumption) as this consumer is one of the numerous consumers demanding X
1
andX
2
. Thus, she has no market power. Since she is required to spend her entire income

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Language:
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Theory of
ConsumerBehavi
our
28

UNIT
5CONSU
MER
EQUILIB
RIUM:CA
RDINAL

AND
ORDINAL
APPROAC
HES
Structure
5.0Objectives
5.1Introductio

n5.2Cardinal ut
ility
approach to co
nsumer behavi
our5.3The law
of eventual
diminishing
marginal utility
5.4Consumers

equilibrium5.5
Basis of law of
demand in
the cardinal
approach5.6Co
nsumers
surplus5.7The
ordinal utility
approach to

consumer
behaviour: the
indifference cur
veapproach5.8
Consumers
budget
constraint5.9C
onsumers
equilibrium in

the ordinal
utility
approach5.10S
pecial
cases5.11Priceconsumption cu
rve5.12Incomeconsumption
curve5.13Price,

substitution,
and income
effects5.14Deri
vation of the
demand curve
for a
good5.15Inferio
r goods and
Giffen

goods5.16Let
us sum
up5.17Some
key
words5.18Som
e useful
books5.19Answ
ers or Hints to
Check Your

Progress Exercis
es

5.0OBJEC
TIVES
This unit will
enable you to:
l

understand and
analyse how a

consumer
attains equilibri
um;
l

use cardinal
utility theory to
explain
consumer
behaviour;
l

describe the law

of diminishing
marginal utility;
l

explain
consumers
equilibrium in
terms of the
Marshallian law
of equi-

marginalutility.
Also use
this law
to explain the
law of demand;
l

explain the
concept of
consumers
surplus;

explain
consumers
behaviour in
terms of ordinal
utility theory,
the HicksAllenapproach
l

describe consu
mers equilibriu
m condition in t
erms of ordinal
utility theory;
l

decompose
price effect into
substitution effe

ct and income
effect;
l

graphically
derive price
consumption
curve and
income
consumption
curve,

anddemand
curve for a
good;
l

understand
the difference b
etween
normal, inferior,
and
Giffen goods;

provide a
comparative
evaluation of
the two
competing theo
ries.

5.1INTRO
DUCTION

In the previous
unit we have
introduced the
concept of
demand
function,
variousdetermin
ants of demand
and its

elasticity. In this
unit, we
continue the
discussion on

Consumer
Equilibrium
29

demand and
focus our
attention on
consumers
behaviour in
order to explain
the lawof
demand. The
law of demand

says that when

price of a
commodity is
lowered alarger
quantity is
demanded, and
when price rises
a smaller
quantity is

demanded,othe
r things
remaining the
same. In other
words, the
law states that
price and
quantitydeman
ded are

inversely
related. In this
unit we will
introduce you
two
contendingtheo
ries - Alfred Mar
shalls

cardinal utility
theory of
demand
, and J.R. Hicks
andR.G.D.
Allens
preference
approach

(or the
indifference
curve theory, or
the ordinalutilit
y theory) of
consumer
behaviour.In
Hicks-Allen
approach some

of the
restrictive
assumptions of
the
Marshallian
approach are
dropped. Partic
ularly, that
utility is a

cardinal
concept and is
measurableon a
numerical scale
with an absolute
zero and that
marginal utility
of money is

constantare
relaxed.
Marshallian
theory is also b
ased on the law
of diminishing
marginalutility
as well as on
inter-personal

comparisons of
utility. In the
preference
approachthese
limitations are
overcome with
the help of
Hicks-Allen
formulation,

which isbased
on the
indifference cur
ve
technique. We
will
first develop
the properties
of indifference

curves. Using
the indifference
curves and in
conjunction
with prices
of goods and
the consumers
money
income (or

budget) we will
be showing how
arational
consumer
attains
equilibrium.Sinc
e consumers
choice depends
on prices and

money income,
and as
prices changeor
money income
changes,
the consumers
equilibrium
choice will also
change.

Weexplain how
to derive the
priceconsumption
curve and the
incomeconsumption
curve.We will
then show how

the demand
curve for a
good can be
derived from
the
priceconsumpti
on curve. This
part of the
discussion ends

by pointing out
the
differenceamon
g normal good,
inferior good
and Giffen
good. It is only
in the case of
Giffengood that

the law
of demand is
violated and the
demand curve
for a good is
upwardsloping
rather than
downward
sloping. The law

of demand need
not be violated
incase of
inferior good.
As we will be
showing it, all
depends on the
working of
twoopposing

forces -the
substitution
effect and the
income effect.

5.2THE
CARDINAL
UTILITY A
PPROACH

Alfred
Marshall (18421924),
an important
member of
the neoclassical
school of econo

mics, gave us
the cardinal
utility theory
of consumer
behaviour in his
book
Principles of
Economics

(1890). Accordi
ng to him,
a consumer deri
ves utility fromc
onsuming
a commodity.
Following
Jeremy
Bentham

(1748-1832) the
founder of the
Utilitarian
School of Ethics,
utility is defined
as the
subjective
sensation pleasure,satisfa

ction, wish
fulfilment,
cessation of
need - which
are derived
from consuming
acommodity
and the
experience of

which is the
object of
consumption. M
arshall
assumedthat
utility (which is
the want
satisfying power
of a

commodity)
could be
measuredquanti
tatively in the
same way as
one can
measure
weights and
heights. In

otherwords,
utility is
cardinally
measurable numerical or
quantitative
scale exists
formeasuring it.
See that this is

a very highly
restrictive
assumption. For
instance, it
ispossible to
say that a
person, say, Mili

gets 2 units of
utility from a
cup of tea. If
utilityis
a cardinal
concept, then
it requires
a complementa
ry assumption

specifying
theunit of meas
urement
.
Bentham used a
psychological
unit of
measurement
calledUtils.

However, it
cannot be taken
as a standard
unit for
measurement
due to
itsvariation
from individual
to individual.

Hence, Marshall
took money as
the unit
of measuremen
t. It has the
advantage
of uniformity for
all individuals in
the economy.

Inthe illustration
above Mili
would receive 2
rupees worth of
utility from a
cup of
tea.Besides
adopting

money as a
measuring rod
for utility,
Marshall made
anothercomple
mentary
assumption. He
assumed the
marginal utility

of money to
remainconstant
for each
consumer. That
implies
the measuring
rod must
remain
constant.Cardin

al measurability
of utility also
implies that
utilities derived
from the
consumptionof
different
quantities of a
commodity can

be added and
also can be
compared
across
Theory of
ConsumerBehavi
our
30

various
individual
consumers.
Thus, one can
speak of total
utility and
marginal
utilityderived
from consuming

a commodity.
Marginal utility
(MU) is
defined as the
additionto total
utility when an
additional unit
of a commodity
is

consumed. Thus
, MU is theratio
of extra utility
to an extra unit
of the
commodity
consumed.
I. Illustration of
MU

Q u a n t i t y
To t a l U t
i l i t y M a r
g i n a l U t
i l i t y
c o m m
o d i t y
X ( T U )
( M U ) 1

2
0
2
0
3
0
9
0

.
0
5
0
.
3
.
4

.
0
0
.

0
4
.
5
0
7
0
0
9

0
1
0
.
5
.
3
0
.

4
0
0
1
0
.
6

0
0
.
0
0
7
2
0
.
0
0
1
.
0
0
For the first unit
the marginal
utility cannot be

calculated. The
dash sign in the
illustrationindica
tes that. For the
second unit of
commodity X
consumed the
total utility are
5.Hence

marginal utility
is (5-2)/(21)=3/1=3, since
the change in
quantity is only
oneunit (

X=1). In other
words,(TU
2

- TU
1

)MU =
-(

X = 1)Where TU
1

is utility derived
from consuming

one unit of X
and TU
2

is total
utilityderived
from consuming
two units of
commodity X. In
general, thenTU
n

- TU
n-1

MU =
X
n

-X
n-1

where n and n 1 are the numb

er of units of th
e commodity co

nsumed.Anothe
r important
assumption,
which Marshall
made,
is independence
of utility.What it
means is that
utility derived

from, say,
consuming a
Samosa
is
independentof
utility
derived from co
nsuming, say,
Sandwiches

.Together, all
these
assumptions
would imply
that if our
consumers
taste can
berepresented
by means of a

utility function
of the formU = f
(X
1

;X
2

;
Xn),then such a
function
will have the

property of addi
tivity and separ
ability. This
wouldm e a n
t h a t U =
U ( X
1

)+ U (X
2

)+...+U (X
n

)
w
U

)=f
1

(X
1

)U (X
2

)=f

e
(

r
X

(X
2

).......................
........................
.........