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Cardinal Utility

The document discusses consumer behavior, focusing on the study of individual economic behavior and utility theory, which explains how consumers maximize satisfaction within budget constraints. It outlines various theories of consumer behavior, including Cardinal and Ordinal utility theories, and the Law of Diminishing Marginal Utility, which states that additional satisfaction decreases as consumption increases. Additionally, it addresses concepts like consumer surplus and the paradox of value, illustrating how utility influences consumer decisions and market prices.

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4 views36 pages

Cardinal Utility

The document discusses consumer behavior, focusing on the study of individual economic behavior and utility theory, which explains how consumers maximize satisfaction within budget constraints. It outlines various theories of consumer behavior, including Cardinal and Ordinal utility theories, and the Law of Diminishing Marginal Utility, which states that additional satisfaction decreases as consumption increases. Additionally, it addresses concepts like consumer surplus and the paradox of value, illustrating how utility influences consumer decisions and market prices.

Uploaded by

liiiyanehh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Consumer Behaviour

• Study of economic behaviour of individual consumer.

• Prequel to study of demand for goods and services in product


(commodities) market.

• Utility theory.

• Theories- foundation for the law of demand.

• How and why consumers respond in particular ways to factors


(prices, income, tastes) in the market.

• Consumer behaviour- how consumers optimize within budget


constraints.
Utility
• Consumer theory -theory of utility (or satisfaction)
maximization.
•
• The utility of a consumer-a measure of the satisfaction the
consumer derives from consumption of goods and services.

• Utility-want-satisfying power.

• -“Utility” and “usefulness” -not synonymous. (Paintings).

• Utility is subjective-vary widely from person to person.


(Eyeglasses)
• Utility-difficult to quantify.

• But for illustration we assume-people can measure


satisfaction with units-Utils.

• Util is a unit of utility(imaginary units).

• Eg., 100 utils of satisfaction from an ice cream, 10 utils of


satisfaction from a candy bar.

• Convenient-quantifying consumer behavior -explanatory


purposes.
• Individual’s consumption bundle- set of all the goods and
services an individual consumes.

• Utility function-relationship between an individual’s


consumption bundle and the total amount of utility it
generates for that individual.
Cardinal Utility and Ordinal Utility
The Law of Diminishing Marginal Utility

Additional satisfaction a consumer gets from one more unit of a good or service
declines as the amount of that good or service consumed rises

Marshall- “The additional benefit a person derives from a given increase of his
stock of a thing diminishes with every increase in the stock that he already has”.
• .
.
.
.
Theories of Consumer Behaviour

• Two major approaches to the theory of utility maximization:

1. The Cardinal theory


2. Ordinal theory.
3. A third approach- the Revealed Preference theory, -
upgrade to the Ordinal theory .

• All 3 approaches lead to the same conclusion -as the price of a


good falls, the quantity demanded increases(Law of Demand)
The Cardinal utility theory

• Oldest version of utility theory.

• Concept of measurable utility.

• Measurement in money, or in subjective units called Utils.

• Marshall (1890).
Assumptions of the Cardinal utility theory

1. Rational behaviour.

2. Cardinal Utility.

3. Constant marginal utility of money.

4. Diminishing marginal utility for a commodity.

5. Additivity.
Theories based on Cardinal Utility Approach

1. The Law of Diminishing Marginal Utility(Alfred


Marshall) or Gossen's First Law.

2. The Law of Equi-Marginal Utility or Gossen’s


Second Law.
I. The Law of Diminishing Marginal Utility
(Theory)

Maximisation of Utility- Consumer equilibrium (one commodity


case)
• The condition of equilibrium ,
MUx = Px

• If MUx > Px, the consumer can increase welfare by purchasing


more of x commodities.

• If MUx < Px, the consumer can increase his total satisfaction by
cutting down his purchase of x commodities .
.
Derivation of Demand Curve from MU curve (from law of
diminishing marginal utility)
The law of equi-marginal utility (Consumer equilibrium in two-
commodity case)

• Equi-marginal utility-Marshall.

• ‘Other things being equal, a consumer gets maximum total


utility from spending his given income, when he allocates his
expenditure to the purchase of different goods in such a way
that the marginal utilities derived from the last unit of
money spent on each item of expenditure tends to be equal.’

• Last dollar spent on each product yields the same amount of


extra (marginal) utility
• Ratios of marginal utility of money are equalised- consumer
redistribute his expenditure on commodities (buying less of
one more of another) till these ratios become equal.
• Example:-
• Consumer -income of Rs. 24.
• Three different goods a, b, and c.
• Prices- Rs.2 per unit of ‘a’, Rs. 3 per unit of ‘b’ and Rs.5 per
unit ‘c’.
• Consumer is rational and seeks to maximize his satisfaction.

Computation of the ratios of the law of equi-marginal utility

Units Mua Mub Muc Mua/Pa Mub/Pb Muc/Pc

1 30 24 15 15 8 3
2 20 15 10 10 5 2
3 16 9 8 8 3 1.6
4 8 6 5 4 2 1
5 6 3 1 3 1 0.2
6 4 1 0 2 0.3 0
Computation of the ratios of the law of equi-marginal utility

Units Mua Mub Muc Mua/Pa Mub/Pb Muc/Pc

1 30 24 15 15 8 3

2 20 15 10 10 5 2

3 16 9 8 8 3 1.6

4 8 6 5 4 2 1

5 6 3 1 3 1 0.2

6 4 1 0 2 0.3 0

Consumer maximises his satisfaction when he purchases 5 units of


commodity a, 3 units of commodity b and 1 unit of commodity c.

Evidently, the consumer’s optimum allocation of expenditure:

Rs.10 on commodity ‘a’ thus purchasing 5 units (5 x2= 10)


Rs. 9 on commodity ‘b’ thus purchasing 3 units (3 x 3 = 9)
Rs. 5 on commodity ‘c’ thus purchasing 1 unit (5 x 1 = 5)
Consumer will allocate his given income -he will purchase OA goods of unit ‘a’,
OB units of good ’b’, OC units of good ‘c’.

Consumer equalizes the marginal utilities of each commodity purchased-


maximizing his total satisfaction.
Limitations

• Difficult to know the MU of different goods.

• Difficult to find goods which give consumers greater


satisfaction.

• Consumers acquire habits and customs, they ignore MU.

• Goods sometimes purchased out of impulse.

• Consumers may not always behave Commodities are not


always divisible for the equalization of MUs.
Importance of the law

• Guides the consumers-spend their limited income judiciously.

• Optimal combination of factors of production- last unit of


investment expenditure brings equal productivity.

• Modern states are welfare states-maximization of social


benefits.

• The principle of ‘maximum social advantage’- revenues must


be distributed in such a way that the last unit of expenditure
brings equal welfare.
.
Paradox of Value (Adam Smith) in Wealth of
Nations-Water-diamond paradox.

Water-necessity-provides more utility- but value less.


Diamonds- non essential to life- very expensive
Paradox- water cheaper than diamonds.

MU theory solves the paradox-MU (Not TU) fixes the


price.
Water-plentiful-MU is low.
Diamond-scarce- MU is high-Scarcity raises MU and Price
• Equality of marginal utilities per dollar holds
true for diamonds and water(Equi-MU).

• High MU from diamonds divided by the high


price of a diamond=( the result is a number)=
low MU from water divided by the low price of
water.
Value and Consumer Surplus
• Another way -paradox of value-consumer surplus.

• Supply of water - part (a) - perfectly elastic at price


PW-quantity of water, QW -large consumer surplus.

• Supply of diamonds - part (b)-perfectly inelastic -


quantity QD-price PD-small area consumer surplus.

• Water is cheap-large consumer surplus.

• Diamonds are expensive-small consumer surplus.


.
Consumer Surplus
• Benefit surplus received by a consumer
• Difference between the maximum price a consumer
is (or consumers are) willing to pay for a product and
the actual price.
• It is the sum of the vertical distances between the demand curve and the $8
equilibrium price at each quantity up to Q1.
• it is the sum of the gaps between maximum willingness to pay and actual price.

• Consumer surplus and price are inversely (negatively) related-higher prices reduce
consumer surplus; lower prices increase it.
Applications of Consumer Surplus
• Public Finance- judging the relative merits of
different types of taxation-tax raises the price and
reduces consumer surplus.

• Determining monopoly prices.


Limitations of Consumer Surplus
• Difficult to measure the price each consumer will be ready to
pay.

• Necessaries- the marginal utilities of the earlier units are


infinitely large-consumer’s surplus is always infinite.

• Affected by the availability of substitutes.

• No simple rule for deriving the utility scale of articles with


prestige value (e.g., diamonds).

• Consumer’s surplus cannot be measured in terms of money –


MU of money changes as purchases are made.

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