THE CARDINAL UTILITY THEORY Introduction Assumptions Equilibrium of the Consumer Derivation of the demand curve Limitations

Introduction Demand refers to a desire for a good backed by ability and willingness to pay. It refers to the quantity demanded for goods and services at different prices in given period. In other words, it is the quantity of a commodity that a person is willing to buy at a given price in a specified period of time Demand is a multivariate relationship. It is determined by many factors simultaneously: its own price, consumers income, price of other commodities, tastes, income distribution, total population , consumers wealth, credit availability, Govt. policy, past levels of demand & fast levels of income, advertisement, etc. The traditional theory of demand has concentrated on four of the above determinants (price, income, price of other goods and taste

Approaches to behavior of consumer A) The Cardinalist approach ; B) Ordinalist approach A). The cardinalist school postulated that utility can be measured. Some economists suggested that utility can be measured in monetary units by the amount of money the consumer is willing to sacrifice for another unit of commodity Others suggested the measurement of utility in subjective units called utils by Walras B).The ordinalist school postulated that utility is not measurable; it is on ordinal magnitudes. The consumer need not know utility of various commodities in specific units to make his choice. It is sufficient for him if he is able to rank the various baskets of goods according to the satisfaction that each bundle gives him.

Assumptions Rationality: The consumer is assumed to be rational. Cardinal utility: The utility of each commodity is measurable in terms of money. The utility is measured by the monetary units that the consumer is prepared to pay for another unit of the commodity. Constant marginal utility of money : If the marginal utility of money changes as income increases or decreases, the measuring rod for utility becomes like an elastic ruler; then it becomes in appropriate for measurement of utility. Diminishing marginal utility: The utility obtained from successive units of a commodity diminishes. Hermann Heinrich Gossen was the first to formulate this law in 1854 it is known as the “Gossen’s first law”.

5) Additivity:The total utility of a basket of goods depends on the quantities of the individual commodity. If there are ‘n’ commodities in the bundle with quantities X1, X2…….Xn, U=f (X1, X2………..Xn) In the early version of the demand theory or theory of consumer behavior it was assumed that the total utility is additive. U= U1 (X1) +U2 (X2)…..+Un (Xn) But the additivity assumption was dropped in the later version of the cardinalist approach Additivity implies that independent utilities of the various commodities in the bundle, an assumption clearly unrealistic and not necessary for the cardinal theory.

Equilibrium of the Consumer Condition for the equilibrium MUx = Px If MUx > Px, the consumer can increase welfare by purchasing more of x commodities If MUx < Px, the consumer can increase his total satisfaction by cutting down his purchase of x commodities If MUx = Px, the consumer will be in equilibrium If there are two commodities MUx/Px = MUy/Py The utility that can be derived from spending an additional unit of money must be the same for all commodities he consumes. This is known as the “Law of Equi-margina Utility”, termed it as Gossen’s second law.

Derivation of Demand Curve according to Cardinal approach Fig:1 Derivation of Demand Curve MUx Ux TU X O X O X X Quantity of X MUx Quantity of X

Fig: Marginal Utility Curve and Derivation of Demand Curve MUX Px P1 MU1 MU2 P2 MU3 P3 O X 1 O X2 X3 X1 X2 X3 MUX Quantity of X

Why does demand curve slopes downward? Income effect of price change Substitution effect Price effect Diminishing marginal utiltity

Weakness of Cardinal approach The assumption of cardinal utility is extremely doubtful. The satisfaction derived from the consumption of various goods cannot be measured objectively. The attempts by Walras to use subjective units (utils) for the measurement of utility does not provide any solution. The assumption of constant marginal utility is unrealistic. As income increases, the marginal utility of money changes. The law of diminishing marginal utility has been established from introspection. It is a psychological law which must be taken for granted,

Exception to the law of demand Bandwagon effect: People sometimes demand a commodity because other are purchasing, either to be fashionable or to keep up with others. Demand curve will be flatter or more elastic Snob effect: As the price of a commodity falls, more people buy it; but some people stop buying it in order to stand out to be different. Veblen effect: In order to impress others,some individuals demand more of certain commodities such as diamond, mink coats which are more expensive.

Table 1: Marginal Utility of Good X and Y Units MUx (Units) MUy MUx/Px MUy/Py 1 20 24 10 8 2 18 21 9 7 3 16 6 4 14 15 5 12 Income Rs 24 Price of x Rs.2 Price of y Rs.3 6 units of X 4 units of Y MUx/Px = MUy/Py= 10/2 = 15/3=5