Cardinal Approach

8/2/2019 Cardinal Approach

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Theory of consumer behavior on the basis ofMeasurement of Utility

Cardinal Utility Theory ofConsumer Behavior

AndOrdinal Utility Theory of

Consumer Behavior

Seeks to explain the decision making behaviour of the consumer indemanding a Particular commodity.

Economists have offered theories on the basis of the

measurement of utility.


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Marshallian Cardinal Approach

or Marginal Utility Approach

or Marshallian Theory of Demand

1. Concept of Utility and its Cardinal

2. Law of Diminishing Marginal Utility

3. Law of Equi Marginal Utility (Income andSubstitution Effect)


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Behaviour of a

rational consumerwith demand curve(Law of Demand).

D curve is downward

sloping towards rightindicates consumertends to buy morewhen P falls.

-ve slope = inverserelationship betweenP and D.

UTILITY ANALYSIS OF DEMAND-MARSHALL

DP1

P2

Q1 Q2

D

Price

Qt. Demand


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Basic Assumptions of MUA

Cardinal utility-U is measurable.

Independent Utility.

Additive UConstant MU of Money

Diminishing Mu

RationalityIntrospective Analysis


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Law o m n s ng arg na t tyand The Law of Demand

Utility is the level of satisfactionfrom the product bought by thecustomer.

Utility is the satisfaction ofconsumer from consumption whichcan be measurable ( i.e. bequantified ) and discernible ( i.e.

comparable ). Marginal Utility (MU) is +nal U from

+nal unit purchased.

Law of Demand based on LMU.


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Law o m n s ng arg na t tyand The Law of Demand

From the observation of real life situation, the theorysuggests that ,

the total utility of a consumer will increasethrough consumption, but for successive units of thegoods consumed, the additional or extra units of utility

got - the marginal utility will gradually diminish

According to the law, the consumer tries to equalize MU of acommodity with its price so that his satisfaction ismaximized and he will reach equilibrium point. MUx=Px

When P falls, MU > than P-----No equilibrium , no max ofTU.

Hence hell decrease MU till = reduced Price.

Increase in stock MU decreases. Consumer buys morewhen P falls.


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Marginal Utility ofChocolates and Ice Cream

Total Income limitedto Rs. 60 per week.

Chocolate and Icecream both cost Rs. 10.

To buy morechocolates, he has togive up ice cream andvice versa.

MU goes of chocolatesgoes on diminishing ashe consumes more andmore units.

Chocolates perWeek

(Rs. 10)

Icecreamper

Week(Rs. 10)

MU perRs onChocol

ates

MU perRs onIce

Cream

1 5 10 2

2 4 8 4

3 3 6 6

4 2 4 8

5 1 2 10


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Assumptions

The wants of a consumer remain unchanged.

He has a fixed income. The prices of all goods are given and known to a

consumer.

He is one of the many buyers in the sense that he

is powerless to alter the market price. He can spend his income in small amounts.

He acts rationally in the sense that he wantmaximum satisfaction

Utility is measured cardinally. This means thatutility, or use of a good, can be expressed in termsof units or utils. This utility is not only comparablebut also quantifiable.


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The Law of Equi-Marginal Utility

This law states that the consumer maximizing his total utilitywill allocate his income among various commodities in such

a way that his marginal utility of the last rupee spent oneach commodity is equal.

The consumer will spend his money income on differentgoods in such a way that marginal utility of each good isproportional to its price.

This law states that how a consumer allocates his moneyincome between various goods so as to obtain maximum

satisfaction . An extension to the law of DMU.

The rationale is that as long as the marginal utility of anytwo or more goods are different, a consumer will try toconsume the good with a higher marginal utility.


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MARGINAL UTILITY THEORY


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Quantity Good A Good B POSSIBILITIES

T U M U T U M U QA QB T U of A & B

0 0 / 0 / 0 7 0 + 110 = 110

1 10 10 24 24 2 6 19 + 104 = 123

2 19 9 45 21 4 5 34 + 94 = 128

3 27 8 64 19 6 4 45 + 80 = 125

4 34 7 80 16 8 3 52 + 64 = 116

5 40 6 94 14

6 45 5 104 010

7 49 4 110 6

8 52 3 114 4

Result :M U of A / Price of A =

M U of B / Price of B =

7 units of utility / $ 1Given : Income = $14 ;

Price of A = $1 ; Price of B = $2.


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Explanation

Consumer will be at equilibrium when,MUx/Px=MUy/Py i.e when the ratio of marginalutilities and price are equalized in purchasing thevarious commodities.

If P of X falls, then might be MUx/Px > MUy/Py.

To attain equilibrium, consumer will reduce MUxand increase MUy till both ratios are equal.

Will purchase more units of X and less of Y.

Will substitute of X for Y till both MU and Price of Xand Y are equal i.e. MUx/Px = MUy/Py.

This Price change is expressed by Marshall asSubstitution Effect and Income Effect.


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Concept of Utility and its Cardinal

Condition of Consumer Optimum : Utility Maximization

From the example above, the consumer will consume adifferent quantity of good X and Y.

The MU ( obtained by the last Rs. spent ) derived fromthe good X & Y will equal so that a state of equilibriumcould be reached.

MUx / Px = MUy / Py = MUz / Pz .....( A state of consumer optimum )

If the equation is re-written into another form :

MUx / MUy = Px / Py .....

( The ratio of MU of any two goods =Theirrelative price )


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Substitution Effect

When P decreased of a commodity,consumer is induced to substitute more ofthe relatively cheaper commodity for thedearer one (no change in price).

To increase his total satisfaction hepurchased of the cheaper commodity.

Most common psychological attitude of

every consumer. Since SE is always +ve, will buy large Qt. at

lower price.


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Income Effect

Refers to changes in real income of the consumer due to

changes in price. When P decreases , purchasing power of the real income

increases, can purchase more with the same money.

IE can be +ve, -ve or Zero.

When a commodity has relatively high MU, the IE will be

+ve such that the surplus amount realized due to Pdecrease may be spent on the same commodity.

IE= 0 , if entire surplus income is spent on some othercomm.

IE= -ve, if Qt. purchased is less than before ( inferior good).

If both SE and IE are +ve, consumer will increase purchasewith fall in price.

Even if IE is -ve, SE is relatively so forceful that it outweighs-ve IE, the consumer will demand more at reduced prices.

Therefore when Price decreases, D increases and vice

versa.


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Limitations of Law of Equi-Marginal Utility

It is difficult for the consumer to know the marginalutilities from different commodities because utility cannot

be measured.

Consumer are ignorant and therefore are not in aposition to arrive at an equilibrium.

It does not apply to indivisible and inexpensive

commodity. Ex: TV sets, Houses, etc.

Alfred Marshall accepts the cardinal approach.He further believes that the MU of money is constant.

This is a highly controversial assertion but it makes the analysis simpler.


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Limitations of Marshallian Approach

Untenable Cardinal measurement of Utility

Wrong conception of +ve Utility

Homogeneity Assumption isUnrealistic

Separate measurement of Utility Constancy of MU of Money

Inapplicability in case of Indivisible or bulkygoods.

Incomplete Analysis of Price Effect Inadequate Explanation of Giffen Goods

Limited Scope

No empirical Test

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Cardinal Approach

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