Amity School of Business
Module 2: Cardinal Utility
Analysis
By: Gaurav Shreekant
1
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Two basic questions in Demand Analysis:
• How does consumer allocate his given income
among different goods and services he buys in
order to get maximum possible satisfaction?
• How does an individual consumer react to
change in price of a commodity and why?
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These two questions are dealt in three different
analysis, which are:
• Marginal utility (or cardinal utility) analysis
attributed to Alfred Marshall (1890)
• Indifference curve analysis (ordinal concept)
attributed to J.R. Hicks and R.G.D. Allen
(1934)
• Revealed preference hypothesis attributed to
Paul A. Samuelson (1947)
Concept of Utility & Marginal Utility
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Utility: Anticipated satisfaction from the commodity.
(distinction between ‘anticipated’ and ‘actual’
satisfaction).
Utility is a subjective, and ethically neutral concept.
Marginal utility: the addition made to the total utility by
acquiring one more unit of a commodity.
MUn = TUn – TUn-1
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Assumptions of Cardinal Utility Analysis
• The cardinal measurability of Utility (Utils are an
artificial construct used to “measure” utility).
• The hypothesis of Independent utilities
• Constancy of the Marginal Utility of money
• Introspective method
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Law of diminishing marginal utility: as a consumer
consumes more and more units of a specific
commodity (without break), utility from successive
units goes on diminishing.
Assumptions behind the law
1. All units of good are homogeneous.
2. No change in consumer’s tastes during consumption
process.
3. There is no time gap between consumption of different
units.
g
m Amity School of Business
a
r Units Total Utility Marginal Utility
g 1st glass 20 20
i
n 2nd glass 32 12
a
3rd glass 40 8
l
4th glass 42 2
u
t 5th glass 42 0
i 6th glass 39 –3
l
i
t
y
g
r
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a
p
h
i
c
a
l
l
y
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Exceptions to the Law of Diminishing Marginal
Utility:
• Rare collection
• Drunkards
• Misers
• Music, Poetry, and Reading
Consumer’s Equilibrium (Marginal Utility
Analysis): One commodity case Amity School of Business
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Applications of the Law of Diminishing Marginal
Utility:
1. Explains the paradox of value (Diamond-Water Paradox)
2. Explains the derivation of the Law of demand
3. Explains the rationality behind redistribution of
income
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The Solution to the Diamond-Water Paradox
• Goods have both Total
Utility and Marginal Utility
• The Total Utility of water is
high while the Total Utility
of Diamonds is low.
• The Marginal Utility of
water is low while the
Marginal Utility of
Diamonds is high
Consumer’s Equilibrium (Marginal Utility
Analysis): multi commodity case Amity School of Business
The Law of Equi-marginal Utility: that the
consumer will distribute his money income
between goods in such a way that the utility
derived from the last rupee spent on each good
is equal.
Consumer’s Equilibrium (Marginal Utility
Analysis): multi commodity case Amity School of Business
The Law of Equi-marginal Utility:
Hence consumer’s equilibrium will be indicated by the
following equation:
MUx MUy MUz
MUm
Px Py Pz
The Law of Equi-marginal Utility:
explained through an example Amity School of Business
Let our consumer has to allocate his given money income Rs. 24 on two goods: X &
Y. Let prices of goods X & Y be Rs. 2 and Rs. 3 resp; Further, let marginal utility of
money be 5 utils per rupee.
Units MUx (Utils) MUx/Px MUy (Utils) MUy/Py
(Utils/Re) (Utils/Re)
1 20 10 24 8
2 18 9 21 7
3 16 8 18 6
4 14 7 15 5
5 12 6 9 3
6 10 5 3 1
The Law of Equi-marginal Utility
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Therefore, the consumer in the given example would be in
equilibrium when:
MUx MUy
MUm
Px Py
10 15
5
2 3
That is when he would buy 6 units of good X and 4 units
of good Y
The Law of Equi-marginal Utility
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The Law of Equi-marginal Utility
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Practical Importance of the Law:
1. It applies to consumption.
2. It applies to production.
3. It applies to distribution.
4. It applies to Public Finance.
The Law of Equi-marginal Utility
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Limitations of this law:
Consumer is not so calculative while spending.
Consumer may not be aware of other more useful
alternatives.
Consumers are most of the times slaves of their
habits, customs or fashion.
Goods are not divisible into small bits to enable
consumers to equalize marginal utilities.
Marginal utility of money does not remain
constant.
