A.

THE CARDINAL UTILITY THEORY

Assumptions
1. Rationality. The consumer is rational. He aims at the
subject to the constraint imposed by his given income. maximisation of his utility
2. Cardinal
utility. The utility of each commodity is measurable.
concept. The most convenient measure is the
Utility is a cardinal
units that the consumer is money: utility is measured by the monetary
prepared pay for another unit of the
to
3.
commodity.
Constant
is used as the marginal utility of money. This assumption is necessary if the
measure
is that it be constant. Ifof utility. The essential feature of a standard unit ofmonetary
unit

decreases) the
the marginal
utility of money changes as income measurement
measurement.
measuring-rod for utility becomes like an elastic ruler, increases (or
inappropriate for
4.
Diminishing marginal utility, The utility
diminishes. In other gained
words, the marginal utility
from successive units of a
sumer acquires larger quantities of it. This is the commodity diminishes commodity
of a
as the con-
axiom of
The concept of diminishing marginal utility.
and Walras subjective, measurable utility is attributed to
(1874). Marshall (1890) also assumed Gossen (1854), Jevons
f1871)
position on utility is not clear in independent and additive
several
aspects. utilities, but his
Theory of Demand
5
The total utility of a 'basket of goods' depends the quantities of the individual
on
ommodities.
co If there are
n commodities in the bundle with quantities
the total utility is XX2 X

In very early versions of the theory of consumer behaviour it was assumed that the
total utility is additire,

U=U,x,)+ Ux)+ Ux)

The additivity assumption was dropped in later versions of the cardinal utility theory.
Additivity implies independent utilities of the various commodities in the bundle, an
assumption clearly unrealistic, and unnecessary for the cardinal theory.

Equilibrium of the consumer

We begin with the simple model of a single commodity x. The consumer can either
buy x or retain his money income Y. Under these conditions the consumer is in equili-
brium when the marginal utility ofx is equated to its market price (P,). Symbolically we
have

MU, = P

If the marginal utility of x is greater than its price, the consumer can increase his wel-
fare by purchasing more units of x. Similarly if the marginal utility of x is less than its
price the consumer can increase his total satisfaction by cutting down the quantity of
x and keeping more of his income unspent. Therefore, he attains the maximisation of his
utility when MU, = P
If there are more commodities, the condition for the equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their
prices

MU. MU,= = MU.

P P, P
Mathematical derivation of the equilibrium of the consumer

The utility function is

U = fle
his expenditure is q, Py-
where is measured in monetary units. If the consumer buys q,
utility
the difference between his utility and his expendi-
Presumably the consumer seeks to maximise
ture
U - P4

with respect
he necessary condition for a maximum
is that the partial derivative ofthe function
to 9, be equal to zero. Thus

UP,9_0
Rearranging we obtain
= P or MU, = P
 Basic Tools of
16
Analysis
The utility derived from spending an additional unit of money must be the same f
commodities. If the consumer derives greater utility from any one commodity. he all
increase his welfare by spending more on that commodity and less on the others can
until
the above equilibrium condition is fulfilled.

Derivation of the demand of the consumer

The derivation of demand is based on the axiom of diminishing marginal utilitu

The marginal utility of commodity x may be depicted by a line with a negative slone
(fgure 2.2). Geometrically the marginal utility of x is the slope of the total utility
function U = fq.). The total utility increases, but at a decreasing rate, up to quantity

MU,

TU

MU,
Figure 2.1 Figure 2.2

x, and then starts declining (figure 2.1). Accordingly the

continuously, and becomes negative beyond quantity marginal
ofx
x. If the utility declines
marginal utility is
measured in monetary units the demand curve for x
is identical to the
segment of the marginal utility curve. At x1 the positive
This is equal to Pi, by definition. Hence at marginal utility is MU, (figure 2.3)
P, the consumer demands x^ quantity
(figure 2.4). Similarly at x2 the marginal utility is MU2, which is
buy X2, and so on. The negative sectionequal
at P2 the consumer will to P2. Hence
does not form part of the demand of the MU curve
curve, since negative quantitiesdo not make
in economics. sense

MU,

MU

MUg
MUs

MU,
Figure 2.3
Figure 2.4
Theory of Demand

Critique of the cardinal approach 17

There are three basic

cardinal utility is extremelyweaknesses
doubtful.
in the cardinalist
approach. The
cannot be measured objectively. The satisfaction derived from variousassumption
The of
commodities
for the measurement of attempt by Walras to use subjective units (utils)
utility does not provide any
tion of constant utility of
money is also unrealistic. satisfactory solution. The
As income increases the assump-
utility of money changes. Thus marginal
utility changes. Finally, the axiommoney cannot be used as a
of diminishing measuring-rod since its own
from introspection, it is a marginal utility has been 'established'
psychological law which must be taken for granted.
B. THE
INDIFFERENCE-CURVEs THEORY
Assumptions

1. Rationality. The consumer is assumed to be rational- he aims at the maximisation

of his utility, given his income and market
(certainty) of all relevant information. prices. It is assumed he has full knowledge

2. Utility is ordinal. It is taken as

axiomatically true that the
preferences (order the various 'baskets of goods') according to consumer can rank
the satisfaction his
of each
basket. He need not know precisely the amount of satisfaction. It suffices that he ex-
presses his preference for the various bundles of commodities. It is not necessary to
assume that utility is cardinally measurable. Only ordinal measurement iarequired.
3. Diminishing_marginal rate of substitution. Preferences are ranked în terms of in-
difference curves, which are assumed to be convex to the origin. This implies that the
slope of the indifference curves increases.The slope of the indifference curve is called the
marginal rate of substitution of the commodities. The indifference-curve theory is based,
thus, on the axiom of diminishing marginal rate of substitution (see below).

4.The total utility of the consumer depends on the quantities of the commodities

consumed
U = f41 92 4 4y, 4

It is assumed that the consumer is consistent

. Consistency and transitivity of choice. will not choose
in his choice, that is, if in one period he chooses bundle A over B, he
A in another period if both bundles are available to him. The consistency assump-
Bover
tion may be symbolically written as follows:

IfA> B, then B > A

it
consumer's choices are
characterised by transitivity:
ailarly, it is assumed that to C, then bundle A, is preferred to C.
undle A is preferred to B, and B is preferred
assumption as follows:
ymbolically we may write the transitivity
then A>C
IfA>B, and B> C,
Economica (1934).
Reconsideration of the Theory
of Value',
Hicks and R. J. Allen, 'A
SeeJ. University Press, 1939).
See also Hicks, Value and Capital (Oxford
18 Basic Tools of
Analysi
Equilibriurm of the consumer
To define the equilibrium of the consumer (that is, his choice of the bundle that maxi
his utility) we must introduce the concept of indifterence curves and of their. aximises
of the budget line. These ape
(the marginal rate of substitution), and the concept the
basic tools of the indifference curves approach.

Indifference curves. An indifference curve is the locus of points particular combinaticne

or bundles of goods-which yield the same utility (level of satisfaction) tq the consume
umer,
so that he is indifferent as to the particular combination heconsumes."
An indifference map shows all the indifference curves which rank the preferences a
the consumer.(Combinations of goods situated on an inditference curve yield the same
utility. Combinations of goods lying on a higher inditterence curve yield higher level of
satisfaction and are preferred. Combinations of goods on a lower indifference curve
yield a lower utiity.
An indifference curve is shown in figure 2.5 and a partial indiference map is depicted
in figure 2.6. It is assumed that the commodities y and x can substitute one another to a

-I
I

Figure 2.5 Figure 2.6

certain extent but are not perfect substitutes (see footnote, p. 20). The negative of the
slopeof an indiference curve at any one point is called themarginal rate of substitu-
tionof the twocommodities, x and y, and is given by the slope of the tangentat that
point
slope of
indifference
curve
dyMRS,,y
The marginal rate of substitution of x for y is defined as the numberof units of commodity
y that must be given up in exchange for an extraunit of commodity x sothatthe con-
sumermaintains the same level of satisfaction With this definition the proponents of
theindifference-curves approach thought that they could avoid the non-operational
concept of marginal utility. In fact, what they avoid is the assumption of diminishing

Symbolically an indifference curve is given by the equation

U =
f%, X2 ..,X,)=k
where k is a constant.
An indifference map may be derived by assigning to k every possible value.
 Theory of Demand
19
individual marginal utilities and the need
marginal utility 1s implicit in the definition of for their measurement.
the MRS, since it can be
The concept of
marginal rate of substitution (the slope of the indifference proved that the
the marginal utilities of the commodities curve) is equal to the ratio of
involved in the utility function:
MRS MU, or
MRS,
MU,
MU,
MU,
Furthermore, the indifference-curves theorists substitute the assumption of
marginal utility with another which may also be questioned, namely the diminishing
assumption
that the indifterence curves are convex to the origin, which implies diminishing MRS)
of the commodities.

Praperties of the indifference curves. 1. An indifference curve has a negative slope,

which denotes that if the quantity of one commodity (y) decreases, the quantity of the
other (x) must increase, if the consumer is to stay on the same level of satisfaction.
2. The further away from the origin an indifference curve lies,
the higher the level
ofutility it denotes: bundles of goods on a higher indiflerence curveare preferred by
therational consumer.
3. Indifference curves do not intersect. If they did, the point of their intersection
would imply two different levels of satisfaction, which /s impossible.

Pro
Proof: The slope of a curve at any one point is measured by the slope ofthe tangent at that
point. Theequation ofatangent is given by the total derivative or total diferential, which shows
t h e total change of the function as all its determinants change.
The total utility function in the case of two commodities x and y is

The equation of an indifference curve is

U =
fx,) =k
where k is a constant. The total differential of the utility function is

OU
dU =dy +dx = (MU,) dy + (MU) dx
y ôx
total
shows the total change in utility as the quantities
of both commodities change. The
t to the change in y multiplied
in U caused by changes in y and x is (approximately) equal
Cnange its marginal utility.
by its marginal utility, plus the change in x multiplied by to zero.
the total differential is by definition equal
indifference curve
Along any particular
Thus for any indifference curve

(MU,) dx 0
(MU,) dy + =

dU =

Rearranging we obtain
dx M MRSy,x
either dy MU MRS - or
dy MU.
dx MU,
 20 Basic Tools of Analysis
This implies that the slone
indifference curves are convex the origin.
to
4.he absolute terms) as we move along
the curve fro
an indifference curve decreases (in ofsubstitution of the commodit
downwards the right: the marginal rate
the left to ike the "law of diminishino
from introspection,
Isdiminishing. This axiom is derived
school. The axiom of decreasing marginal ráte o
marginal utility' of the cardinalist behavioural rule that the number of units of xthe
Substitution expresses the observed additional unit ofy increases ac
consumer is willing to sacrifice
in order to obtain an
difficult to substitute x for y as wWe
becomes increasingly
the quantity of y decreases. It
curve. In figure 2.9
the fifth unit of y can be substituted
move along the indifference second unit of y and
for x by the consumer giving up xj X2
ofx; but to substitute the
a much greater quantitv
satisfaction the consumer must give upP
still retain the same

of x, namely X3 X4

has a given income which sets

of the consumer. The
consumer
The budget constraint
in the attempt for
maximising behaviour. Income acts as a constraint
hmits to his in the case of two commodities, may be
maximising utility. The income constraint,
written
Y= P4x + P,4 (2.1)
We may present the income constraint graphically by the budget line, whose equation
is derived from expression 2.1, by solving for q,:

P 1
4,pY-4
Assigning successive values to q« (given the income, Y and the commodity prices, Pr
Py, we may find the corresponding values of qy. Thus, if q, = 0 (that is, if the con-
sumer spends all his income on y) the consumer can buy Y/P, units of y. Similarly. it
q,=0 (that is, if the consumer spends all his income on x) the consumer can buy Y/P
units ofx. In figure 2.10 these results are shown by points A and B. If we join these points

This assumption implies that the commodities can substitute one another, but are not
perfect substitutes. If the commodities are perfect substitutes the indiference curve becomes a
straight line with negative slope (figure 2.7). If the commodities are complements the indifference
curve takes the shape of a right angle (figure 2.8).

Figure 2.7 Perfect substitutes Figure 2.8 Complementary goods

In the first case the equilibrium of the consumer may be a corner solution, that is, a situation
in which the consumer spends all his income on one commodity. This is sometimes called
'monomania'. Situations of 'monomania' are not observed in the real world and are usually
ruled out from the analysis of the behaviour of the consumer. In the case of complementary
goods, indiference-curves analysis breaks down, since there is no possibility of substitution
between the commodities.
Theory of Demand
21

Figure 2.9

with a line we obtain the

budget line, whose slope is the ratio of the prices of the two
commodities. Geometrically the slope of the budget line is
OA
OB Y/P
Mathematically the slope of the budget line is the derivative

Figure 2.100

is in equilibrium when he
Derivation of the equilibrium of the consumer. The consumer
and the market prices. Two conditions must
naximises his utility, given his income
be fulfilled for the consumer to be in equilibrium. of
of substitution be equal to th ratio
The
first condition is that the marginal rate
commodity prices
MU
MRS.MU, P, condition
equilibrium. The _econd
not sufficient condition for
s a necessary but to the origin. This condition Is fulilled by
the
curves be convex
nat the indifference
22 Basic Tools of Analysis
axiom of diminishing MRS, , which states that the slope of the indifference curve
decreases (in absolute terms) as we move along the curve from the left downwards to
the right.

raphical presentation of the equilibrium of the consumer. Given the indifference man
line, the is defined the
of the consumer and his budget equilibrium by point of tangency
of the budget line with the highest possible indifference curve (point e in igure 2.11)

x B

Figure 2.11

At the point of tangency the slopes of the budget line (P/P,) and of the indifference
curve (MRS, =
MU,/MU,) are
equal
MU,
MU, Py
Thus the first-order condition is denoted
two relevant curves. The second-order
graphically by the point of tangency ot the
condition is implied by the convex shape of the
indifference curves. The consumer maximises his
Commodities.
utility by buyingx* and y* of the two
 Ila

Derivation of the demand curve using the indifference-curves approach

Graphical derivation of the demand curve. As the price of a commodity, for example of
falls, the budget line of the consumer shifts to the right, from its initial position (A
to a new position (AB'), due to the increase in the purchasing power of the given mOna
income of the consumer. With more purchasing power in his possession the consumer
ney
ner
can buy more of x (and more of y). The new budget line is tangent toa higher indifferenee
curve (e.g. curve II). The new equilibrium occurs to the right of the original equilibrium

(for
normal that as price falls more of the commodity will be bought
goods) showing
If we allow the price of x to fall continuously and wejoin the points of tangency ofsucces
sive budget lines and higher indiflerencecurves wetorm theso-called price-consumpton
x. At point e.
line (figure 2.12), from which we derive the demand curve lor commodity
the consumer buys quantity X at price y1. At point e2 the price, y2, is lower than y,.
and the quantity demanded has increased to X2, and so on. We may plot the price-
quantity pairs definedthe points of equilibrium
by (on the price-consumption line)
to obtain a demand curve, as shown in figure 2.13.
The demand curve for normal commodities will always have a negative slope,
denotingthe law of demand, (the quantity bought increases as the price falls).
In the indifference-curves approach the 'law of demand' is derived from what is known
as Slutsky's thorem, which states that the substitution effect of a price change is always
negative (relative to the price: if the price increases, the quantity demanded decreases
involves sophisticated math-
and vice versa). The formal proof of Slutsky's theorem
ematics. However, we may show graphically the implications of this theorem.
We saw that a fall in the price of x from P to P2 resulted in an increase in the quanuty
demanded from x, to x,. This is the totalprice efjeet which may be split into two separate

A
price-consumption line
-

2 B X3 8
Figure 2.12

A commodity is defined as 'normal' when its demand changes in the same direction as
income. If the demand ol a commodity decreases when income increases, the commodity Is

called 'inferior'
Theory of Demand
25
P

2 3
Figure 2.13
as enschs
effects, a substitution effect and an income effect. The substitution effect is the increase
inthe quantitybought as the price ofthe commodity falls, after adjusting incomesoas
to keep the real purchasing power of the consumer the same as before. This adjustment
inincome is called compensating variation and isshown graphically by parallel shift
ofthe new budget line until it becomestangent to the initial indifference curve (fgure
a

2.14). The purpose ofthe compensating variation isto allow the consumer toremain
on the same level of satisfaction as before the price change. The 'compensated-budget
line' will be tangent to the original indifference curve (I) at a point (e'1) to the right
of
line whichis
the original tangency (e1), because this line is parallefto the new budget
less steep than the original one when the price of x falls. The movement from point e
to e shows the substitution effect of
the price change: the consumer buys more of x
now that it is cheaper, substituting y for x. However, the compensating variationis a
device which enables the isolation of the substitution effect, but does not show the
e2 on the higher
indiffer-
newequilibrium of the consumer.
This is
defined by point
has in fact a power, and, if the
higher purchasing
ence curve II. The consumer
some of his increased real
income on x, thus
commodity is normal, he will spend
income effect of the price change. Theincome effect
moving from x'1 to x2. This is the
goods and it reinforces the negative substitu
ofa price change is negative for normal inferior, theineome effect of,
(1on effect (figure 2.14). If, however, the commodity is
increases, less of x will be
will be positive: as the purchasing power
theprice change

eA
income
effect
compensoted
budget line
substitution
effect

Figure 2.14

income increases,
more
ol
for normal goods: as relate the change
in
1 se is positive because we
income effect per is negative
d at the the income effect
state here that of x.
emanded. We in the price
income to the change
Purchasing power of money
 Basic Tools of Analysis
26
will effect
inferior goods the negative substitution
mo.

Still for most of the total price effect will be negati

bought. income effect, so that the
than offset the positive cases adequate for establishing the
effect is in most
Thus the negative substitution
and very strong that the "law of demand
law of demand.
the income effect is positive
(It is when which are inferior and their
case of the Giffen goods,
r
does not hold. This is the
Gillen goods are very rare in practice.)
demand curve has a positive slope. be proved mathematicallu
theorem can
It should be noted that although Slutsky's
its proof is based on the axiomatic
assumption of the convexity of the indifferenc
curves.

demand curve. The demand curve may be derived from the

Mathematical derivation of the
equilibrium condition

MU._MU, =
MU.
P

and the budget constraint

Y 2Pai=1

For example, assume that there are only two commodities and that the total utility function is
multiplicative of the form
U = 299,
The marginal utilities of x and y are

MU. oU
and

OU
MU, a
Substituting the marginal utilities in the equilibrium condition we obtain

P Py

4,Py9Px
(Note that the equality of expenditures of the two commodities is not a general rule; the
turesdepend on the specific form of the utility function.) expendi-
We may derive the demand for
commodity x by substituting q,p, in the budget constraint:
4,P, + 9 P , = Y

24P,=Y

Y 2P
'For a discussion of other cases
of 'irregular demand patterns see H. Leibenstein, "Band
wagon, Snob and Veblen Effects in the
Economics (1950) pp. 183-207. Theory of Consumers' Demand', Quarterly Journal of
 Theory of Demand
21
Thus the demand for x is negatively related to its own price p, and positively to income Y.
Similarly the demand for y is obtained by substituting q, P, in the budget constraint:

4y Y
2p.
In our particular example the demand curves are symmetric due to the particular multiplicative
form of the consumer s utility function which we assumed.

VCritique of the indifference-curves approach

The indifierence-curves analysis has been a major advance in the field of consumer's
demand. The assumptions of this theory are less stringent than for the cardinal utility
approach. Only ordinality of preferences is required, and the assumption of constant
utility of money has been dropped.
The methodology of indifference curves has provided a framework for the measure-
ment of the 'consumer's surplus', which is important in welfare economics and in design-
ing government policy. The measurement of the consumers' surplus is discussed in
section D below (p. 32).
Perhaps the most important theoretical contribution of this approach is the establish-
ment of a better criterion for the classification of
goods into substitutes and comple
ments. Earlier theorists were using the total effect of a
price change for this purpose,
without compensating for the change in real income. The classification was based on the
sign of the cross-elasticity of demand

eyx
04 P
where the total change in the quantity of y was considered as a result of a change in the
price of x. A positive sign of the cross-elasticity implies that x and y are substitutes;
a negative sign
implies that the commodities are complements. This approach may easily
lead to absurd classifications if the change in the price of x is substantial. For
example,
if the price of beef is halved it is almost certain that both the consumption of beef and
of pork will be increased, due to the increase of the real income of the consumer. This
Would imply a negative cross-elasticity for pork, and hence pork would be classified as
a
complementary commodity to beef!
Hicks' suggested measuring the cross-elasticity after compensating for changes in
real income. Thus, according to Hicks, goods x and y are substitutes if, after com-
pensating for the change in real income (arising from the change in the price of x) a
decrease in the price of x leads to a decrease in the
quantity demanded of y.
Although this criterion is theoretically more correct than the usual approach based
on the total change in the quantity of y as a result of a change in the price of x, in practice
ts application is impossible because it requires knowledge of the individual preference
Tunctions, which cannot be statistically estimated. On the other hand, the usual approach
OI the total price effect is feasible because it requires knowledge of the market demand
functions which can be empirically estimated.
Although the advantages of the indifference-curves approach are important, the
neory has indeed its own severe limitations. The main weakness of thistheory isits axio-
aie assumption of the existence and the convexity of the indifference curves. The
neorydoes not establish either the ex1stence or the shape of the indiference curYes
SUmes that they exist and have the required shape of convexity. Furthermore, it Iis
Hicks, Value and Capital (Oxford Universiy Press, 1946) 2nd edn, pp. 42-52.
28
Basic Tools of
Analysis
questionable whether the consumer is able to order his
rationally as the theory implies. Also the preferences of preferences as
the consumers
precisely and
tinuóusly under the influence of various factors, so that change con-
even if possible, should be any ordering of these preferences,
considered as valid for the very short nin.
has retained most of the weaknesses of
the cardinalist school with the
Finally,this theory
of rationality and the
concept of the marginal utility implicit in thestrong assumption
definition of the
marginal rate of substitution.
Another defect of the indifference
curves approach is that it does not
effects of advertising, of past behaviour
(habit
analyse the
dependence of the preferences of the consumers, persistence), of stocks, of the inter
which lead to behaviour that would
be considered as irrational, and
hence ruled out by the theory.' Furthermore
tive demand and random behaviour are
is
ruled out. Yet these
specula-
for the pricing and output decisions factors are very
important
of the firm.2