Name: Akshat Gupta
Course: Bcom Prog.
Section: C
Subject: Business Economics
CARDINAL AND
ORDINAL UTILITY
INTRO
DUCTION
Utility can be measured in two alternative ways:
1) Cardinal measurement of utility
2) Ordinal measurement of utility
Alfred Marshal assumed that utility can be measured and added,i.e., in terms of
money, in terms of price paid for the commodity.
Hicks and Allen advocated that utility can be measured in terms of preferences.
The consumer ranks their consumption bundle in the order of their preferences.
Geater the preference for the commodity greater the satisfaction derived from
the commodity.
ASSUMPTIONS
OF CARDINAL
UTILITY
1. Utility is Measurable in Utils
2. Additivity Of Utility
3. Constant Marginal Utility Of Money
4. Diminishing Marginal Utility
5. Independent Utilities
01
UTILITY IS
MEASURABLE IN UTILS
02
ADDITIVITY OF
UTILITY
Cardinal utility theory assumes
that satisfaction or utility can be
quantified in units called "utils."
Total utility is the sum of the
utility from each unit of a good
consumed.
For 01
example, consuming an apple
might yield 10 utils, while a
banana might yield 8 utils. This
allows for an absolute
comparison of satisfaction across
goods.
This means if a consumer eats
three apples, the total utility is
the sum of the utils derived
from each apple (e.g.,
U=U1+U2+U3U = U_1 + U_2 +
U_3U=U1​+U2​+U3​).
03
INDEPENDENT
UTILITIES
The utility derived from one good
is assumed to be independent of
the utility derived from another.
For example, the utility gained
from consuming bread does
not depend on the
consumption of milk or any
other goods.
04
CONSTANT MARGINAL
UTILITY OF MONEY
Marshall assumed that the measurement of utility in terms of money is
possible only when the marginal utility
of money remains constant. This was
01
because money is used as a
measuring rod and if the marginal
utility of money varies, it will become
a defective measure inappropriate for
measurement. Thus, MU of money will
not change with the change in price
05
DIMINISHING
MARGINAL UTILITY
The basic assumption of utility
theory is DMU. It is also known as
Gossen's First basic law of
consumption.
In other words, as a person goes
on increasing the consumption of
the com- modity, the additional
satisfaction derived from each
additional unit goes on
decreasing.
RELATIONSHIP BETWEEN TU AND MU AND
LAW OF DMU
1) When TU increases at a decreasing rate,
MU decreases but is positive
2) When TU is maximum, MU = 0
3) When TU falls, MU is negative.
ASSUMPTIONS OF LAW OF DMU
1) MU of money is constant.
2) There should be no time gap in units
consumed of a commodity, that is
consumption has to be in succession.
3) A standard unit of good has to be
consume
LIMITATIONS OF
CARDINAL UTILITY
Cardinal measurement
is doubtful
Constant MU of money
is unrealistic
Lack of interdepedence
between goods
According to Hicks and Allen,
utility cannot be measured
cardinally as it is a subjective
phenomenon. In fact, utility is
measured on the scale of
preferences. Greater the
preference, greater is the
utility derived from the
commodity.
MU of money cannot remain
constant. It varies from
person to person. As the
income of the person
increases, MU of money
decreases. This is because
more money a person has,
less is the marginal utility of
money for him.
Utility is not additive because
it is not independent. In
reality, utility derived from
one commodity depends on
the utility from other
commodities. MU depends on
the change in consumption of
its substitute and
complementary goods.
Two british economists John Hicks and RGD Allen tries to solve the
various restrictive assumptions from cardinal utility suffered.
According to Hicks and Allen, utility is measured ordinally,ie., in
terms of preferences. Consumer rank their preferences according
to the utility derived form it. That is utility is not measured in terms
of money, i.e., price paid for the commodity. This is because utility
derived is a subjective phenomenon.
Y
T
I
L
I
T
U
L
A
N
I
D
OR
Indifference curve is a geometrical device
used to replace the neo - classical cardinal
utility analysis.
Ans Indifference curve is a curve showing
different combinations of the commodities
which gives the same level of satisfaction to
the consumer so that he is indifferent in his
approach.
INDIFFERENCE
CURVE
ASSUMPTIONS OF ORDINAL UTILITY
APPROACH ( OR INDIFFERENCE CURVE )
Rationality
Consumer tries to maximise his
utility with the given income
and the given prices of the
commodities.
Utility is Ordinal
Transitivity
According to ordinal theory utility
is a psychological feeling, it is not
quantifiable, i.e., it cannot be
measured in quantitative
(cardinal) terms. Instead, Utility is
measured on the basis of
preferences according to the
satisfaction derived. Greater the
preference, greater is the utility
derived from the commodity.
Thus, consumers ranks all the
commodities he consumes in the
order of his preferences.
Preferences of consumers are
transitive.
This implies: A combination of
goods may give him more or less
satisfaction compared to other
combination (This is known as
scale of presents there are 3
combinations of goods A, B, C
and if combination A is preferred
to combination B, and
combination B is preferred to
combination C; it implies that
combination A is preferred to
combination C.
More is Preferred to Less
Non-Satiety - Other things being equal, the consumer always prefers
more of any good to less of that same good, that is, a consumer will
always prefer a greater combination of two goods compared to lesser
combination but he never reaches the point of satiety.
More is always better than less except in case of Bad where less is pre
ferred to more. (Bad are those goods which give negative utility, e.g.,
pollution, garbage etc.)
Bundle A, B, C is superior to bundle D
Reason: Bundle D has less of both goods and therefore is inferior to all
bundles having more of both goods.
However, Bundle A, B, C is inferior to bundle E.
Reason: Bundle E has more of both goods than bundle A, B and C.
Thus given a choice between combinations A, B, C and D consumer will
prefer A or B or C.
However, given a choice between combinations A, B, C and E, consumer
will prefer combination E because bundle E has more of both the goods
than bundle A, B and C.
Diminishing Marginal Rate Of Substitution ( DMRS )
Marginal Rate of Substitution between commodity X and (MR*S_{n}) refers
to the rate at which the consumer is willing to sacrifice (i.e. give
consumption of commodity Y for each additional unit of commodity X, so
that he remains on the same IC (Indifference curve), that is, total utility
remains constant.
As an individual moves down on an IC, MRS diminishes. This is because as
he increases the consumption of commodity and decreases the
consumption of commodity Y, the marginal significance (importance) of
commodity X decreases while that of commodity Y increases as he
decreased the consumption of commodity Y. Therefore, he is willing to
sacrifice the consumption of commodity Y but in a decreasing manner (Fig.
9.3). Thus MRS diminishes
PROPERTIES OF
INDIFFERENCE
CURVE
IC are always sloping downwards
IC are always convex to the origin
Each IC represents different levels of
satisfaction
IC will never touch or intersect each
other
IC are always sloping downwards
An IC has a negative slope because if the consumer decides to have more
units of one good (X) he will have to reduce the consumption (units) of good
Y, if his level of satisfaction is to remain unchanged, that is, if he has to
remain on the same IC.
As consumer moves from point A to B (Fig. 9.5) he has more of commodity X
and less of commodity Y.
Similarly when he moves from point C to B, he has more of commodity Y
and less of commodity X.
This implies that there is a negative relationship between two commodities.
Therefore, IC are negatively sloped.
IC are always convex to the origin
IC must be convex to the origin - (that is concave upwards and not downwards or
gets flatter to the right and steeper to the left).
This is based on the principle of Diminishing Marginal Rate of Substitution (DMRS).
In order to increase the consumption of goods (X) by an additional unit, consumer
will have to forego (i.e., sacrifice) the consumption of Y but in a decreasing manner.
This can be explained with help of an e.g.
Assume:
Initial stock of X (pen) with consumer = 1
Stock of Y (pencil) = 16
As Stock of X < stock of Y
:: Marginal significance (valuation) of X > marginal significance of Y But, as the
consumer increases the consumption of X and decreases the consumption of Y,
Stock of X > stock of Y
:. Marginal significance of X decreases, while marginal significance of Y increases. As
marginal significance of Y is increasing, consumer is willing to sacrifice the
consumption of Y for each additional unit of X but in a decreasing manner.
Therefore, IC are always sloping downwards towards the right and are convex to the
origin
Each IC represents different levels of satisfaction
Higher the IC, higher is the level of satisfaction, lower the IC, lower is the
level of satisfaction.
Satisfaction derived on i1 > satisfaction derived on i0 (Fig. 9.10)
Reason: i1 represents greater combination of the 2 goods than i0
According to the assumption: more is preferred to less; combination lying
i1 will be preferred to combinations lying on i0 Similarly satisfaction
derived on i2 < satisfaction derived on i0.
Because i2 represents lesser combination of 2 goods as compared to i0.
Therefore combination on i0 will be preferred to the combinations lying
on i2.
IC will never touch or intersect each other
IC will never touch or intersect each other - Two IC cannot intersect each
other because each IC represents different level of satisfaction. If they
intersect then both IC will represent same level of satisfaction which is not
possible. Thus, it will violate the assumption of transitivity and the notion of
more is preferred to less.
IC 1 and IC 2 intersect each other at point A.
It means both combinations are equally preferred. This is inconsistent
because combination Blies on lower IC therefore will give lower satisfaction
as compared to combination C which lies on higher IC. Thus, two levels of
satisfaction at B and C which are unequal have succeeded in becoming equal
at point A which is not acceptable.
Thus IC representing a particular level of satisfaction should not touch or
intersect each other.
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