Download Cardinal-Utility-Analysis

CARDINAL UTILITY
ANALYSIS
Amandeep Verma
Economics
CONSUMPTION
Meaning and importance, the utility
concept, marginal and total utility, the
law of diminishing utility and the law of
equi-marginal utility
Consumption
• The act of satisfying human wants is the simplest form of
consumption. When we consume something, it gets us some
satisfaction. The power of a good or service to satisfy human wants is
referred to as utility. It however does not necessarily mean
usefulness. In the case of some wants, like smoking and drinking, the
act of consumption may actually be harmful to human health. But
since the consumer gets some utility from such consumption, he is
ready to pay for it. Consumption is defined as an act of destroying or
reducing the utility of the good with the object of satisfying human
wants. A house destroyed by fire also destroys its utility but it is not
consumption. Consumption happens only with the satisfaction of a
human want. Consumption in in its broadest sense means the use of
economic goods and personal services in the satisfaction of human
wants.
Types of consumption
• The consumer by nature is a bundle of wants.
• All of these can not be satisfied because of their
scarcity and consumers limited income.
• Currently, another dimension has assumed
significance. It relates to concerns of high mass
consumption and the global warming debate.
• A consumer therefore has to optimize his
consumption under the constraints of limited
income and his preferences. This involves a
study of his satisfaction/utility and the budget
constraints
Understanding consumer’s behavior
• The process of consumers decision making
involves the following factors:
• 1.His/her set of preferences
• 2.His constraints set in terms of income and
market prices
• 3. His/her optimal decision set from the feasible
set.
• There are two approaches available for this
optimization, namely,
• 1. Cardinal and, 2. Ordinal
Types of consumption
• 1. Perishable goods like tea, coffee, ice cream
vegetables, fruit, cigarettes, chocolates …
• 2. Consumers durables like TVs, washing machines,
automobiles, houses
Cardinal approach: the law of diminishing
marginal utility
• In economics we prefer the term ‘utility’ over
satisfaction/benefits as a measure of what a consumer
wants to optimize.
• The term was coined by Jeremy Bentham, a British
philosopher.
• The term ‘utility, refers to ranking order of preferences.
• Utility can be understood as synonymous to satisfaction.
The law of diminishing utility
• The law simply states that as our stock of something
scarce and capable of satisfying a human want increases
its liking begins to diminish.
• In other words, the utility derived by the consumption of a
good or service diminishes as we consume more and
more of it. It reaches even zero and can become negative
also.
The law of diminishing marginal
utility……..
• The law is subject to the following assumptions:
• 1. The consumer is a rational person.
• 2. The unit of consumption is of specific standard.
• 3. Consumption is simultaneous.
• 4. Utility is measurable objectively.
Exceptions to the law
• The law does not appear to apply in the following cases:
• 1.Money
• 2.Adictions like drinking alcohol
• 3. Some hobbies like stamp and coin collection
Utility maximization: the law of equimarginal utility
• Under cardinal utility analysis a consumer maximizes his
total utility by equalizing his marginal utility in relation to
price in all the directions of his consumption or on each
good and service purchased by him.
• The principle of such maximization is popularly referred to
as the Law of equi-marginal utility.
Utility maximization principles
• Optimization Rule 1:
When only one good is consumed and is available for
free, consume till
MUx = 0
Utility maximization contd…
• Optimization Rule 2:
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
The law of equi-marginal utility
• Stated simply the law is as follows:
• MU of apples/price of apples = Mu of cups of tea/price of a tea cup =
Mu of an auto-mobile/price of the automobile = ……= Mu of good
‘n’/price of good ‘n’.
• This implies a comparison of marginal utilities (Mu) worth rupee one
of each of the goods a consumer is purchasing from his limited
income. This makes the comparison easy and meaningful.
• If mu is not equalized on all goods and services consumed, the
consumer is not maximizing his total utility. So he must reshuffle his
expenditure till the marginal utility of each rupee spent by a consumer
on all the goods and services purchased by him is equal. Now the
consumer has no incentive to reshuffle his expenditure as he has
attained maximum total utility from his expenditure.
• The above summary of the law has to be supported by tables and
diagrams presented during the course of class lectures.
Criticism of the laws
The laws of diminishing and equi marginal utility
suffer from the criticism that utility is subjective in
nature and can not therefore be measured
objectively.
Since it can not be measured objectively, it
becomes difficult to work-out the marginal utilities
of goods and services consumed by a consumer,
especially of their successive units of
consumption. However, the essence of the law
remains quite valid.
This is why we need to resort to ordinal utility
analysis to prove the validity of these laws.