Utility Analysis

CARDINAL AND ORDINAL UTILITY

Cardinal Utility
• The numbers 1, 2, 3, 4 are cardinal numbers. For example the number 2 is twice
the size of 1. In the same way, the number 4 is four times the size of number 1.
• Alfred Marshall developed cardinal utility analysis.
• According to cardinal approach, utility can be measured.

Ordinal utility
• The numbers 1st, 2nd, 3rd, and 4th, are ordinal numbers. These ordinal numbers
are ranked or ordered. This ranking does not explain the actual size relation of
the numbers. The second one might or might not be twice as big as the first one.
• Hicks and Allen used ordinal utility approach for analyzing the consumer
behavior.
• This analysis is known as indifference curve analysis.
TYPES OF UTILITY.
• The want satisfying power contained in a good is said to be its utility.
• In economics the term utility is used to denote the satisfaction or
welfare.
• Utility derived from a good are of different form such as 1) Form
utility, 2) Place utility, 3) Time utility, and 4) Service utility.
The Law of Diminishing Marginal Utility

• It is a psychological fact that when a person acquires more and more

units of the same commodity during a particular time, the utility he
derives from the successive units will diminish. In other words, the
additional satisfaction derived from the additional units of a
commodity goes on decreasing.
• H.H Gossen was the first economist to explain the law of diminishing
marginal utility, and the law of equi marginal utility in 1854. W.S
Jevons named them as Gossen first and second laws of consumption
(1871). In 1890 Marshall in his “Principle of Economics” developed
this analysis in a refined manner
Assumptions of the Law:
• The law of diminishing marginal utility is based on the cardinal measurement of
utility.
• Utility is measured in terms of money. The law assumes that the marginal utility
of money is constant.
• There should not be any time gap between the consumption of one unit and the
other unit.
• The units of the commodity are homogeneous.
• The consumer is assumed to be a rational economic man. He has the knowledge
about the market.
Total Utility
• Total utility means the total satisfaction attained by the consumer from all the units of a
commodity taken together in the consumption of a certain thing at a time.
• For example, if the 1st ice-cream gives you a satisfaction of 20 utils and 2nd one gives 16
utils, then TU from 2 ice-creams is 20 + 16 = 36 utils. If the 3rd ice-cream generates
satisfaction of 10 utils, then TU from 3 ice-creams will be 20+ 16 + 10 = 46 utils.
• TU can be calculated as:
TUn = U1 + U2 + U3 +……………………. + Un
Where: TUn = Total utility from n units of a given commodity
U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit
n = Number of units consumed
Marginal Utility
• Marginal utility is the additional utility obtains from an additional unit of any commodity
consumed or acquired.
• It is measured the difference between the utility of the total units of stock of
consumption of a given commodity and that of consuming one unit less in the stock
considered.
• In symbolic terms:
MUn = Tun - TUn-1
Here: MUn = Marginal utility from nth unit; TUn = Total utility from n units;
TUn-1 = Total utility from n – 1 units; n = Number of units of consumption
MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils

• One More way to Calculate MU. MU is the change in TU when one more unit is
consumed. However, when change in units consumed is more than one, then MU can
also be calculated as:
MU = Change in Total Utility/ Change in number of units = ∆TU/∆Q
• In Fig. 2.1, units of ice-cream, are shown along the X-axis and TU and
MU are measured along the Y-axis. MU is positive and TU is
increasing till the 4th ice-cream. After consuming the 5th ice-cream,
MU is zero and TU is maximum.
• This point is known as the point of satiety or the stage of maximum
satisfaction. After consuming the 6th ice-cream, MU is negative
(known as disutility) and total utility starts diminishing. Disutility is
the opposite of utility. It refers to loss of satisfaction due to
consumption of too much of a thing.
Definition of the Law
• Alfred Marshall defines the ‘Law of Diminishing Marginal Utility’ as
“The additional benefit which a person derives from a given increase
of his stock of a thing diminishes with every increase in the stock that
he already has.”
• In the words of K.E Boulding “As a consumer increases the
consumption of any one commodity, keeping constant the
consumption of all other commodities the marginal utility of the
variable commodity must eventually decline”
Explanation of the Law of Diminishing Marginal Utility

• We can explain the law with the help of the table. In the table a consumer goes
on increasing ‘X’ goods, the additional utility derived from an additional ‘X’ goods
declining. The law is clear from the following table.
• We can observe that as the units of the commodity ‘X’ is increase, the marginal
utility derived from each success units tends to diminish. The total utility
increases at diminishing rate till the 6th ‘X’. At that level total utility becomes
maximum, and marginal utility is zero.
• After this level total utility declines and marginal utility becomes negative. Zero
marginal utility implies the point of satiety which indicates the complete
satisfaction of a given want. The law of diminishing marginal utility can also be
represented diagrammatically through the marginal and total utility curves.
• Consider Table 2 in which we have presented the total and
marginal utilities derived by a person from cups of tea
consumed per day. When one cup of tea is taken per day, the
total utility derived by the person is 12 units. And because this
is the first cup its marginal utility is also 12.
• With the consumption of 2nd cup per day, the total utility rises
to 22 but marginal utility falls to 10. It will be seen from the
table that as the consumption of tea increases to six cups per
day, marginal utility from the additional cups goes on
diminishing (i.e., the total utility goes on increasing at a
diminishing rate).
• However, when the cups of tea consumed per day increase to
seven, then instead of giving positive marginal utility, the
seventh cup gives negative marginal utility equal to -2. This is
because too many cups of tea consumed per day (say more
than six for a particular individual) may cause him acidity and
gas trouble. Thus, the extra cups of tea beyond six to the
individual in question give him disutility rather than positive
satisfaction.
Relationship Between Total Utility And Marginal
Utility
1. When total utility increases at diminishes
rate, marginal utility diminishes.
2. When total utility is maximum, marginal
utility becomes zero.
3. When total utility decreases, marginal utility
becomes negative.
Equilibrium under the Law of Diminishing MU
• Let us consider the money income of the consumer and price of the
commodity. In a given, price-income situation, the consumer is in
equilibrium when the MU of commodity X is equated to the utility
foregone by paying the price of one unit. Because paying money for a
commodity will involve a sacrifice in terms of money but a gain in
terms of utility from a commodity.
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Consumer’s Equilibrium in case of Single
Commodity
A consumer purchasing a single commodity will be at equilibrium,
when he is buying such a quantity of that commodity, which gives him
maximum satisfaction. The number of units to be consumed of the
given commodity by a consumer depends on 2 factors:
1. Price of the given commodity
2. Expected utility (Marginal utility) from each successive unit.
• To determine the equilibrium point, consumer compares the price (or
cost) of the given commodity with its utility (satisfaction or benefit).
Being a rational consumer, he will be at equilibrium when marginal
utility is equal to price paid for the commodity.
• We know, marginal utility is expressed in utils and price is expressed
in terms of money However, marginal utility and price can be
effectively compared only when both are stated in the same units.
Therefore, marginal utility in utils is expressed in terms of money.
Marginal Utility in terms of Money = Marginal Utility in utils/ Marginal
Utility of one rupee (MUM)
• MU of one rupee is the extra utility obtained when an additional
rupee is spent on other goods. As utility is a subjective concept and
differs from person to person, it is assumed that a consumer himself
defines the MU of one rupee, in terms of satisfaction from bundle of
goods.
Equilibrium Condition
Consumer in consumption of single commodity (say, x) will be at
equilibrium when:
Marginal Utility (MUx) is equal to Price (Px) paid for the commodity; i.e.
MU = Price
1. If MUX > Px, then consumer is not at equilibrium and he goes on
buying because benefit is greater than cost. As he buys more, MU
falls because of operation of the law of diminishing marginal utility.
When MU becomes equal to price, consumer gets the maximum
benefits and is in equilibrium.
2. Similarly, when MUX < Px, then also consumer is not at equilibrium
as he will have to reduce consumption of commodity x to raise his
total satisfaction till MU becomes equal to price.
The Law of Equi Marginal Utility:
• The law of equi-marginal utility explains as to how a consumer distributes his
limited income among various commodities
• He will spend his income in such away that the last rupee spent on each of the
commodity gives him the same marginal utility.
• Therefore, this law is known as the Law of Equi-Marginal Utility.
• In order to get maximum satisfaction out of his limited income, the consumer
carefully weighs the satisfaction obtained from each rupee that he spends. If he
thinks that a rupee spent on one commodity has greater utility than spending it
on another commodity, he will go on spend his money on the former till the
satisfaction derived from the last rupee spent in the two cases equal
Assumptions of the Law:
1. The utility is cardinally measurable.
2. The marginal utility of money remains constant.
3. Consumer has a limited amount of income and he spends the entire amount.
4. The wants and habits of the consumer remain constant.
5. The consumer is rational. He tries to get maximum satisfaction.
6. The consumer spends his income in small quantities while purchasing the
commodities.
Illustration of the Law
• The law of equi-marginal utility has been stated by Marshall as follows “If a
person has a thing which can be put to several uses, he will distribute it among
the uses in such a way that it has the same marginal utility in all”.

• The law can be explained with the help of a numerical example suppose a
consumer has Rs 5/- which he wants to spend on two types of commodities
namely X and Y so that he obtains maximum utility. The following table shows
the marginal utilities of successive rupees of income when spends on X and Y.
• Figures in the brackets shows as to how
the consumer spent his Rs 5/- on two types
of commodities.
• Let us assume that the price of each Units Mux Muy
commodity is one rupee. The consumer
starts spending his first rupee on X because 1 10(1) 8 (2)
the highest marginal utility on X is 10 utils.
In the same way he spends his 2nd, 3rd, 4th 2 8 (3) 6 (4)
and 5th rupee on the commodities which
gives highest utility. Thus the total utility 3 6 (5) 4
obtain from X and Y will be 38, i.e. from X
(10+8+6=24) and from Y (8+6=14). 4 4 2
• In this way the consumer spends his entire 5 2 0
income on X and Y in such way that the last
rupee spent on X and Y gives the same Total 30 20
marginal utility. Thus the consumer gets
maximum satisfaction
• Money expenditure and quantity of
demand is shown on X axis and the Equi-Marginal Utility
marginal utility derived from the
12
commodities X and Y is shown on Y axis.
Marginal utility of X is shown by the 10

Marginal Utility
curve MUx, and marginal utility of Y is 8

shown by the curve MUy. Marginal 6

utilities of both the commodities are 4
equal at 6 utils. The consumer is in
2
equilibrium by purchasing the
combination of 3 units of X and 2 units of 0 mux
1 2 3 4 5
Y as he obtains the maximum total utility
Quantity of commoditiesmuy
at that purchase.
Importance of the Law:
1. The law explains as to how a consumer maximizes his satisfaction
from his limited recourses.
2. Optimum allocation of the recourses can be possible by applying this
principle.
3. While imposing taxes, the government is cautious that the marginal
sacrifice of all the taxpayers is the same.
4. The law guides an individual in the allocation of his time between
‘work’ and ‘leisure’.
Equilibrium under Law of Equi-Marginal Utility
• Now, the question is how one would allocate his money income
among various goods that is to say, what would be his equilibrium
position in respect of the purchases of the various goods.
• Suppose there are only two goods X and Y on which a consumer has
to spend a given income.
• The consumer’s behaviour will be governed by two factors: first, the
marginal utilities of the goods and secondly, the prices of two goods.
Suppose the prices of the goods are given for the consumer.
• The law of equi-marginal utility states that the consumer will
distribute his money income between the goods in such a way that
the utility derived from the last rupee spend on each good is equal.
• In other words, consumer is in equilibrium position when marginal
utility of money expenditure on each goods is the same.
• Now, the marginal utility of money expenditure on a good is equal to
the marginal utility of goods divided by the price of the goods.
• In symbols:
MUe=MUZ/PZ
• Now, if MUx / Px and MUy/ Py are not equal and MUx / Px -is greater
than MUy / Py then the consumer will substitute goods X for goods Y.
• As a result of this substitution the marginal utility of goods Y will rise.
The consumer will continue Substituting goods X for goods Y till MUy/
PZ becomes equal to MUy / Py consumer will be in equilibrium.
• Now, the question is how far a consumer goes on purchasing the
goods he wants. This is determined by the size of his money
expenditure. With a given expenditure a rupee has a certain utility for
him: this utility is the marginal utility of money by him.
• Since the law of diminishing marginal utility applies to money also,
the greater his money expenditure the consumer will go on
purchasing goods till the marginal utility of expenditure on each good
becomes equal to the marginal utility of money to him.
• Thus, the consumer will be in equilibrium when the following
equation holds good:
MUx/Px= MUY/Py = Mum
• If there are more than two goods on which the consumer is spending
his income, the above equation must hold good for all of them.
• Suppose apples and oranges are the two commodities to be
purchased. Suppose further that we have got seven rupees to spend.
Let us spend three rupees on oranges and four rupees on apples.
What is the result?
• The utility of the 3rd unit of oranges is 6 and that of the 4th unit of
apples is 2. As the marginal utility of oranges is higher, we should buy
more of oranges and less of apples.
• Let us substitute one orange for one apple so that we buy four
oranges and three apples.
• Now the marginal utility of both oranges and apples is the same, i.e.,
4. This arrangement yields maximum satisfaction. The total utility of 4
oranges would be 10 + 8 + 6 + 4 = 28 and of three apples 8 + 6 + 4= 18
which gives us a total utility of 46. The satisfaction given by 4 oranges
and 3 apples at one rupee each is greater than could be obtained by
any other combination of apples and oranges. In no other case does
this utility amount to 46. We may take some other combinations and
see.
• We thus come to the conclusion that we obtain maximum satisfaction
when we equalize marginal utilities by substituting some units of the
more useful for the less useful commodity.
In the two figures given below, OX and OY are the two axes. On X-axis OX are
represented the units of money and on the Y-axis marginal utilities. Suppose a
person has 7 rupees to spend on apples and oranges whose diminishing marginal
utilities are shown by the two curves AP and OR respectively.
The consumer will gain maximum
satisfaction if he spends OM money (3
rupees) on apples and OM’ money (4
rupees) on oranges because in this
situation the marginal utilities of the two
are equal (PM = P’M’). Any other
combination will give less total
satisfaction.
Let the purchase spend MN money (one rupee) more on apples and the same amount of
money, N’M'( = MN) less on oranges. The diagram shows a loss of utility represented by
the shaded area LN’M’P’ and a gain of PMNE utility. As MN = N’M’ and PM=P’M’, it is
proved that the area LN’M’P’ (loss of utility from reduced consumption of oranges) is
bigger than PMNE (gain of utility from increased consumption of apples). Hence the total
utility of this new combination is less.

We then, conclude that no other

combination of apples and oranges
gives as great a satisfaction to the
consumer as when PM = P’M’, i.e.,
where the marginal utilities of apples
and oranges purchased are equal, with
given amour, of money at our disposal.
Thus, conditions for the equilibrium of the consumer can be stated as:
• A consumer is in equilibrium when he equalizes weighted marginal utilities
of all goods, that is, when the marginal utility of each good weighted by its
price is equal. In other words, when
MUx/ Px = MUY/Py = MUN /PN = MUm
• A consumer is in equilibrium when he equalises the ratios of marginal
utilities of goods with the ratio of corresponding prices for each pair of
goods consumed, that is, when
MUx/Px = PZ/ Py
and MUY/MUx =Py /Px and so forth
• Since MUZ/PZ measures the marginal utility of a rupee’s worth of each good
consumed at the given prices, consumer can be said to be in equilibrium
when the marginal utility of a rupee spent on each good purchased in
equal. Marginal utility of a rupee spent on a good means the marginal
utility of a rupee’s worth of the good.
Criticisms of Cardinal Approach
Consumer surplus
• The price which a consumer pays for a commodity is always less than what he is willing pay
for it, so that the satisfaction which he gets from its purchase is more than the price paid for
it and thus he derives a surplus satisfaction which Marshall calls Consumer’s Surplus.
Instances of commodities from which we derive consumer’s surplus in our daily life are salt,
news papers, postcard, matches, etc.
• consumer’s surplus can be defined as the difference between what a consumer is willing to
pay for a commodity and what he actually does pay for it.
• The amount of money which a person is willing to pay for a good indicates the
amount of utility he derives from that good; the greater the amount of money he
is willing to pay, the greater the utility he obtains from it.
• Therefore, the marginal utility of a unit of a good determines the
price a consumer will be prepared to pay for that unit. The total utility
which a person gets from a good is given by the sum of marginal
utilities (MU) of the units of a good purchased and the total price
which he actually pays is equal to the price per unit of the good
multiplied by the number of units of it purchased.
• Thus: Consumer’s surplus = What a consumer is willing to pay minus
what he actually pays.
= ∑ Marginal utility – (Price x Number of units of a commodity
purchased)
• The concept of consumer surplus is derived from the law of diminishing
marginal utility. As we purchase more units of a good, its marginal utility
goes on diminishing. It is because of the diminishing marginal utility that
consumer’s willingness to pay for additional units of a commodity declines
as he has more units of the commodity.
• The consumer is in equilibrium when marginal utility from a commodity
becomes equal to its given price. In other words, consumer purchases the
number of units of a commodity at which marginal utility is equal to price.
This means that at the margin what a consumer will be willing to pay (i.e.,
marginal utility) is equal to the price he actually pays.
• But for the previous units which he purchases, his willingness to pay (or the
marginal utility he derives from the commodity) is greater than the price
he actually pays for them. This is because the price of the commodity is
given and constant for him and therefore price of all the units is the same.
Marshall’s Measure of Consumer Surplus
• It is due to the occurrence of diminishing marginal utility that a
consumer gets total utility from the consumption of a commodity
greater than its market value. Marshall tried to obtain the monetary
measure of this surplus, that is, how many rupees this surplus of
utility is worth to the consumer.
• It is the monetary value of this surplus that Marshall called consumer
surplus. To determine this monetary measure of consumer surplus we
are required to measure two things. First, the total utility in terms of
money that a consumer expects to get from the consumption of a
certain amount of a commodity. Second, the total market value of the
amount of commodity consumed by him.
• It is quite easy to measure the total market value as it is equal to
market price of a commodity multiplied by its quantity purchased
(i.e., P.Q.). An important contribution of Marshall has been the way
he devised to determine the monetary measure of the total utility a
consumer obtained from the commodity. Consider Table 14.1 which
has been graphically shown in Fig. 14.1.
Table 14.1: Marginal Utility and Consumer Surplus:
Table 14.1: Marginal Utility and Consumer Surplus • Suppose for the first unit of the
commodity the consumer is
prepared to pay Rs. 20. This means
that the first unit of the commodity
is at least worth Rs. 20 to him. In
other words, he derives marginal
utility equal to Rs. 20 from the first
unit.
• For the second unit of the
commodity, he is willing to pay Rs.
18, that is, the second unit is at
least worth Rs. 18 to him. This is in
accordance with the law of
diminishing marginal utility.
Similarly, the marginal utility of the
third, fourth, fifth and sixth units of
the commodity fall to Rs. 16, 14, 12
and 10 respectively.
• However, actually the consumer has not to pay the sum of money equal to
the marginal utility or marginal valuation he places on them. For all the
units of the commodity he has to pay the current market price of the
commodity.
• Suppose the current market price of the commodity is Rs. 12. It will be
seen from the Table 14.1 and Fig. 14.1 that the consumer will buy 5 units of
the commodity at this price because his marginal utility of the fifth unit just
equals the market price of Rs. 12.
• This shows that his marginal utility of the first four units is greater than the
market price which he actually pays for them. He will therefore obtain
surplus or net marginal benefit of Rs. 8 (Rs. 20 – 12) from the first unit, Rs.
6 (= Rs. 18-12) from the second unit, Rs. 4 from the third unit and Rs. 2
from the fourth unit and zero from the fifth unit. He thus obtains total
consumer surplus or total net benefit equal to Rs. 20.
Criticisms of Concept of Consumer Surplus