Cardinal Utility Analysis

1. Cardinal Utility Analysis Amandeep Verma Economics

2. Consumption Meaning and importance, the utility concept, marginal and total utility, the law of diminishing utility and the law of equi-marginal utility

3. 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.

4. 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

5. 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

6. Types of consumption • 1. Perishable goods like tea, coffee, ice cream vegetables, fruit, cigarettes, chocolates … • 2. Consumers durables like TVs, washing machines, automobiles, houses

7. 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.

8. 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.

9. 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.

10. 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

11. Utility maximization: the law of equi-marginal 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.

12. Utility maximization principles • Optimization Rule 1: When only one good is consumed and is available for free, consume till MUx = 0

13. 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

14. 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.

15. 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.