Amity School of Business Dr.
Shruti Aggarwal
Microeconomics
Module II: The Cardinal and Ordinal
Utility Theories of Consumption
Marginal utility theory: Law of diminishing marginal utility,
law of equi-marginal utility, Indifference curve theory:
properties of indifference curves,
marginal rate of substitution, budget line,
and consumer’s equilibrium.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Module II
Cardinal Utility: Given by Marshall
Assumptions:
Utility can be measurable and quantifiable entity.
According to Marshall, "Marginal utility is actually measurable in terms of
money”.
Independent utilities: Utility from the consumption of one good doesn’t depend
on the consumption of one other good.
This makes utility as “Additive”. i.e., separate utilities of different goods can
be added to obtain total sum of utilities of all goods purchased.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Cardinal Utility: Given by Marshall
Assumptions:
Constant Marginal utility of money: Utility a person gets from additional
amount of money remains same.
Law of diminishing marginal utility:
“The additional benefit which a person derives from a given ↑ in
consumption diminish”.
This law is based on 2 important facts:
While total wants are unlimited, each single want is satiable (can
be fully satisfied).
Different goods are not perfect substitutes for each other in the
satisfaction of various wants.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
TU
TU
Q TU MU (Δ TU/ΔQ) (TUn - TUn-1)
1 12 12
2 22 10
3 30 8 When TU ↑→ ↓MU but (+ve)
MU
Q
4 36 6 When TU is maximum MU is zero
5 40 4 When TU ↓→ ↓MU but (-ve)
6 41 1
7 39 -2
8 34 -5
Q
MU
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Law of Equi-Marginal Utility:
Suppose consumer spend money on only 2 goods X and Y, and the income is
given.
Consumer behavior depends on 2 factors:
MU of the goods
Prices of two goods
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 spent on each good is equal.
Consumer is in equilibrium when MU of money on each good is same.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
MUx MUx
MUx MUx Q MUxMUy
MUm = x Px Py
Px Py 1 20 24 10 8
MUx MUx 2 18 21 9 7
If > or consume more of x 3 16 18
Px Py 8 6
4 14 15 7 5
MUx MUx 5 12 9 6 3
> consume more of y
Px Py 6 10 3 5 1
Now Px = 2, Py = 3, M=24
MUx MUx
= When consume 6 units of X and 4 units of y.
Px Py
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Limitations of Law of Equi-Marginal Utility:
For applying this law in real-life, consumer must weigh the marginal utility of
different commodities, consumers are governed by habits and customs and
not so rational and calculating.
Consumers must be able to measure the marginal utility of different
commodities in cardinal terms. It is not possible for consumer to measure
utility in cardinal terms.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Limitations of Law of Equi-Marginal Utility:
Few of the goods are indivisible, it is not possible to equate their marginal
utility of money spent on them.
For Example: Car cost 10 lakh and is indivisible +, while food grains can
be [Link] utility of money spent on car can’t be equalized with
marginal utility of money spent on food grain.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Critics of Cardinal utility:
[Link] measurability of utility is unrealistic.
[Link] of independent utilities is wrong.
[Link] of constant MU of money is not valid.
[Link] doesn't distinguish between income effect and substitution effect of a
price change.
[Link] analysis assumes too much and explains too little.
[Link]’t explain the exceptions of law of demand.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Ordinal Utility: It implies that consumer can compare different levels of satisfaction.
Consumer give rank on the basis of their preferences and utility.
To explain consumer behavior economist assume that consumer have a set of
preferences which guide them in choosing among goods for their preferences.
Assumptions about consumer preferences:
[Link]: Consumer is capable of ranking alternative bundles of goods of
his consumption.
[Link]: Consumer is able to rank all available bundles of goods in a
consistent manner.
[Link] A>B and B>C then A>C
[Link] is better.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Indifference Curve (IC) Approach:
Indifference Curve represents all those combinations of Y
goods which give some satisfaction to the consumer. A
Assumptions:
[Link] Curve is convex to origin. B
[Link] the Indifference Curve, more the satisfaction. C
IC
[Link] preferences.
[Link] Curve don’t intersect. X
[Link] marginal rate of substitution.
Same level of satisfaction
at all the points (A,B&C)
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Marginal rate of substitution:
It is the rate at which consumer is willing to give up
(substitute) one good for an additional unit of other good.
Keeping overall utility constant.
MUx
MRSxy =
MUy
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Y
Indifference Curve (IC) of perfect substitutes and perfect complements:
Perfect Substitute:
MRS in this case will be constant. Consumer equally prefers the two IC3
IC2
goods and is willing to exchange one good for the other at constant IC1
rate. Y
X
Perfect Complements: These goods are consumed together in a fixed
ratio, So the MRS of perfect complement is zero. As the substitution
of one good is not possible for other.
IC3
U(x,y) = min (x,y) IC2
IC1
X
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Some non-normal cases of Indifference Curve:
When one commodity is good and one is bad.
X is bad and Y is good commodity.
That is why IC3 gives more
satisfaction, will consume less of X.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Some non-normal cases of Indifference Curve:
When X is neutral good: When Y is neutral good:
Y Y IC1 IC2 IC3
IC3
IC2
IC1
X X
IC3 gives max satisfaction. IC3 gives max satisfaction.
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Budget line or Budget constraint:
Budget line shows all those combinations of two goods which all
consumers can buy by spending his given money income on 2
goods at their given prices.
To attain max satisfaction and reach to the highest IC, he has to Y
M/Py
work under two constraints:
[Link] has to pay prices of goods.
[Link] has limited money income.
Px .X + Py .Y = M
M/Px X
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Changes in prices and shift in Budget line:
If Px changes: If Py changes: Changes in Income:
Y A Y Y
B’ A’
B A
B’’ A’’
A A
B’’ B B’ X X B’’ B B’ X
Px
Slope of Budget line:
Py
Amity School of Business Dr. Shruti Aggarwal
Microeconomics
Consumer’s Equilibrium:
A consumer is said to in equilibrium when he is buying such a combination of
goods as leaves him with no tendency to rearrange his purchase of goods.
Condition of consumer Equilibrium:
1.A given budget line must be tangent to an IC or MRS must be equal to the
price ratio of two goods.
[Link] must be convex to the origin at the point of tangency.
Px MUx
MRSxy = =
Py MUy
Amity School of Business Dr. Shruti Aggarwal
Thank You