Cardinal Utility Approach

THE CARDINAL UTILITY APPROACH
 ASSUMPTIONS:
a) The consumer behaves rationally i.e. each consumer tries to

maximize his own utility. Each consumer must possess a
utility function, which reflects the tastes & preference of the
consumer.
b) Utility is a cardinal concept: i.e. one can measure it

quantitatively on numerical scale.
c) If money is the measuring rod in terms of which utility is

measurable, then we have to assume that the measuring rod
itself remains constant, i.e. the MARGINAL UTILITY OF
MONEY remains constant.
a) Utility is independent : This implies the utility derived from the

consumption of commodity x depends only on the amount of
x consumed & not on the quantities of other commodities
consumed
i.e. U = U x + Uy + U z
b) The consumer Behaviour is subject to law of diminishing

Marginal utility:
After sufficient units of a commodity have been consumed, a

consumer experiences diminishing marginal utility for the
additional units consumed.
- When total utility is increasing at an increasing rate, Marginal utility is

increasing
- When TU is increasing at a decreasing rate, MU is falling.
- When Marginal Utility is zero the consumer is completely satiated with

the goods. The law of diminishing Marginal Utility holds when Marginal
Utility is positive but declining.
 EQUILIBRIUM CONDITION:
- The consumer is said to be in equilibrium when he maximizes his utility

subject to his money income & market prices.
- For a single commodity, this will happen when marginal utility of x is
equal to its market price i.e. Mux = Px
- If Mux were greater than Px it would be possible for the consumer to
increase his consumption of x. As more units of good x are consumed,
the MU of x will keep increasing till Mux = Px & TU is maximum. Any
further consumption of x will cause TU to fall as MU would become –
ve.
- Similarly, if Mux were less than Px the consumer can ↑se his total
satisfaction by cutting down the quantity of X and switching expenditure
from good x to other commodities.
- If there is more than one commodity, the condition for the equilibrium of
the consumer is when the consumer allocates his income in such a
way, that the ratios of the Mu’s of the individual commodities are equal
to their price. I.e.
MUX MUY MUn

------ = ------ =--------------------- -----
Px PY Pn
This is called the PRINCIPE OF EQUIMARGINAL UTILITY.
- Take the case of MUx = MUy

Px Py
If the price of X were now to fall so that,
MUX MUY
------  ------
Px PY
The consumer can ↑se TU by consuming more units of good X. This will have
the effect of ing the MU of X & he will continue ↑ing his expenditure on X till
equality is restored.
Thus, a fall in the price of goods will, cateris paribus, give rise to an ↑se in a
consumers’ demand for it.
Each point on the MU curve corresponds to a particular quantity level.
 The demand curve is identical to the MU curve when measured in monetary

units.
 Suppose the consumer’s utility function is
U = µ ( x)
and his total income spent (expenditure )on x would be :

B = x. Px, where his income B ( Budget) is given
Presumably, the C wants to maximize the diff. between his utility

(satisfaction) & Exp. (Sacrifice)
Exercise A consumer consumes two goods x & y. The TU

schedules are given. Money income of the consumer is Rs. 55. The
prices ( per unit ) are Rs. 5 for x & Rs. 8 for y. Find the optimal choice
of x & y.
MUx MU
Unit of x TU of x Unit of y TU of y MUx Px Muy Py
1 35 1 72 35 7 72 9
2 65 2 136 30 6 64 8
(3) 90 3 192 25 (5) 56 7
4 110 4 240 20 4 48 6
5 125 5 280 15 3 40 (5)
6 135 6 312 10 2 32 4
7 140 7 336 5 1 24 3
8 135 8 352 -5 -1 16 2
9 125 9 360 -10 -2 8 1
10 110 10 340 -15 -3 -20 -20/8
INDIFFERENCE CURVE ANALYSIS
Defn An I-curve is defined as the locus of all those combinations of two

goods x & y which are equally preferred by the consumer. The
consumer gets the same level of satisfaction or utility from the
consumption bundles lying on a given I – curve. The consumption
bundles lying on higher I – curve will give higher level of satisfaction
or utility and therefore, would be preferred.
 Assumptions:
a) Transitivity Suppose there are three combinations of two goods :

A,B,& C. If the consumer is indifferent between A & B and also
between B & C, it is then assumed that he will be indifferent between
A & C too. This is consistency of choice.
b) Ordinal Utility Utility is only ordinally measurable. I.e. the

consumer is able to tell only the order of his preferences.
c) Nonsatiety : The consumer is not over-supplied with goods in

question i.e. he has not reached the point of saturation in case of any
commodity. Therefore, a consumer always prefers a larger quantity of
all the goods.
d) Diminishing Marginal Rate of substitution
MRS of x for y may be defined as the amount of y whose loss can just
be compensated by a unit gain in x. i.e. it represents the amount of y
which the consumer has to give up for the gain of one additional unit
of x so that his level of satisfaction remains the same.
Indifference schedule
Combination Good x Good y MRS xy
A 1 12
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
- Why MRS of x for y diminishes:
a) If a rational Cr were to maintain the same level of satisfaction, after

sacrificing some of good y he must be compensated by additional
units of good x.
b) However, as the Cr sacrifices more & more of good y for an

additional unit of good x, the relative desirability of good y ↑es and
he becomes more & more reluctant to sacrifice good y for good x.
c) Thus, the amount of good y that he is willing to sacrifice for an

additional unit of good x becomes less & less or diminishes. Thus
MRS x, y which is defined as the amount of good y sacrificed for an
additional unit of good x diminishes.
d) Geometrical Analysis : The slope of an IC is equal to the MRS x, y .

But the slope of an IC is given by the slope of the tangent to the
curve at that point. Since as the slope of the tangent gets flatter &
flatter, its slope  es & hence, the MRS  es.
 The relationship between MRS & MUs:
In moving down the I – curve from A to B, the Cr gives up ∆ y for the

gain in x by ∆ x & remains on the same level of satisfaction. i.e. the
total loss in utility to him by giving up ∆ y is equal to the total gain in
utility to him owing to the ↑se in x by ∆ x.
∆ y x MU of y = ∆ x x MU of x
∆y MU of x
---- = ----------- = MRS x, y
∆x MU of y
 PROPERTIES OF I - CURVES
(i) I – curve slope downward to the right :
It means that when the amount of one good in the combination is

⁭increased, the amount of the other good is reduced. This can also
be proved by contradiction.
(ii ) IC’s never intersect
(iii ) Higher IC’s denote higher utility
(iv ) Diminishing marginal rate of substitution:

As the consumer would move down an IC he would get less &
less of good y and more and more of good x. As the
consumer has less & less of good y, the consumer becomes
more reluctant to give up good y for good x. Hence the MRS
of x for y keeps diminishing. Its on this count that IC’s are
convex to the origin.
PRICE LINE / BUDGET LINE
- The budget line shows all the possible combinations of two goods that can
just be bought by a consumer given his income and the prices of the two
commodities.
- Slope of the Price line is equal to the ratio of the prices of two goods. The
slope of the price line PL is OP .
OL
The quantity of good x purchased if whole of the given income M is spent

on it is OL. OL x Px = M i.e OL = M
Px
Similarly OP x Py = M  OP = M
Py
OP = M/Py = Px
OL M/Px Py
 CONSUMER EQUILIBRIUM:
A rational consumer is said to be in equilibrium when he maximizes

his satisfaction given his money income and the prices of
commodities. A consumer will reach his equilibrium when his budget
line is tangent to his highest possible Indifference curve.
- The budget line shows what the consumer is able to do.

- The I – curve show what the consumer would like to do.
- At Equilibrium,
MRS x,y = Px / Py = MUx / MUy
 Analysis without using IC:
- The price effect is defined as the total change in quantity demanded,

due to a change in price, cateris paribus. The PE is – ve for normal
goods since for normal goods, price &quantity demanded have an
inverse relationship.
- If the price of good x falls, cateris paribus, two effects take place
simultaneously:
a) There is a change in the relative prices of all goods. Since good
x is now relatively cheaper to all other goods, it is now
substituted for other goods. This change in quantity demanded
due to a change in relative prices (alone) is called the
substitution effect.
The SE is – ve whether x is a normal good or an inferior good or

Giffen good since when the price of x decreases the quantity
demanded of x as a result of the SE ⁭ increases.
b) The real income (purchasing power) of the consumer ⁭ increases

even though his (actual) money income has remained the same.
If x is a normal good, an ⁭ increase in real income will mean that
more of good x will be demanded. If x is an inferior good, an ⁭
increase in real income will mean that less of good x will be
demanded. Since all Giffen goods are inferior, it follows that for
Giffen goods too, an ⁭increase in income will mean a reduction in
quantity demanded. This change in quantity demanded of good
x due a change in real income is called the income effect.
The IE is – ve for normal goods, since, when price ↓es the

quantity demanded as a result of the income effect increases.
The IE is + ve for inferior & Gifen goods, since, when price ↓es
the quantity demanded as a result of the income effect ↓es.
- PE = IE + SE
a) For normal goods, the – ve income effect is reinforced by the – ve

substitution effect, so that the PE is – ve i.e. for normal goods price &
quantity are inversely related, Cateris paribus.
b) For inferior goods, the + ve income effect & the – ve substitution effect,
work in opposite directions. However, the – ve substitution effect is
stronger than the + ve income effect so that the price effect is –ve. i.e.
for inferior goods, price & quantity are inversely related, Cateris
Paribus.
c) For Giffen goods, too, the + ve income effect & the – ve substn. effect,
work in opposite directions. But the + ve Income effect is stronger than
the –ve susbstn. effect so that the price effect is + ve. Effectively, this
means that for Giffen goods price & quantity are directly related, Cateris
Paribus.

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THE CARDINAL UTILITY APPROACH

a) The consumer behaves rationally i.e. each consumer tries to

b) Utility is a cardinal concept: i.e. one can measure it

c) If money is the measuring rod in terms of which utility is

a) Utility is independent : This implies the utility derived from the

b) The consumer Behaviour is subject to law of diminishing

After sufficient units of a commodity have been consumed, a

- When total utility is increasing at an increasing rate, Marginal utility is

- When TU is increasing at a decreasing rate, MU is falling.

- When Marginal Utility is zero the consumer is completely satiated with

- The consumer is said to be in equilibrium when he maximizes his utility

MUX MUY MUn

This is called the PRINCIPE OF EQUIMARGINAL UTILITY.

- Take the case of MUx = MUy

If the price of X were now to fall so that,

Each point on the MU curve corresponds to a particular quantity level.

 The demand curve is identical to the MU curve when measured in monetary

 Suppose the consumer’s utility function is

and his total income spent (expenditure )on x would be :

Presumably, the C wants to maximize the diff. between his utility

Exercise A consumer consumes two goods x & y. The TU

Defn An I-curve is defined as the locus of all those combinations of two

a) Transitivity Suppose there are three combinations of two goods :

b) Ordinal Utility Utility is only ordinally measurable. I.e. the

c) Nonsatiety : The consumer is not over-supplied with goods in

d) Diminishing Marginal Rate of substitution

Combination Good x Good y MRS xy

a) If a rational Cr were to maintain the same level of satisfaction, after

b) However, as the Cr sacrifices more & more of good y for an

c) Thus, the amount of good y that he is willing to sacrifice for an

d) Geometrical Analysis : The slope of an IC is equal to the MRS x, y .

 The relationship between MRS & MUs:

In moving down the I – curve from A to B, the Cr gives up ∆ y for the

(i) I – curve slope downward to the right :

It means that when the amount of one good in the combination is

(ii ) IC’s never intersect

(iii ) Higher IC’s denote higher utility

(iv ) Diminishing marginal rate of substitution:

PRICE LINE / BUDGET LINE

The quantity of good x purchased if whole of the given income M is spent

A rational consumer is said to be in equilibrium when he maximizes

- The budget line shows what the consumer is able to do.

MRS x,y = Px / Py = MUx / MUy

 Analysis without using IC:

- The price effect is defined as the total change in quantity demanded,

The SE is – ve whether x is a normal good or an inferior good or

b) The real income (purchasing power) of the consumer ⁭ increases

The IE is – ve for normal goods, since, when price ↓es the

a) For normal goods, the – ve income effect is reinforced by the – ve

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