Questions

1. Evaluate the Alfrade Marshall’s Cardinal Marginal Utility analysis.

2. Explain the difference between Hicksian substitution effect and Slutsky substitution
effect through the concept of consumption variation and cost different with the help
of draft.
3. Evaluate critical appraisal of Revealed Preference Theory.
Answer: 1

The Cardinal Utility Theory was developed by classical economists, viz., Gossen of Germany,
William Stanley Jevons of England, Leon Walras of France, Karl Menger of Austria.

Neo-Classical Economists, particularly Alfred Marshall made significant refinements in the

Cardinal Utility Theory. This led to the Cardinal Utility Theory being known as Neo-
Classical Utility Theory or ‘Marshallian Utility Theory.’

Meaning of Utility in Economics

Utility is the capacity to satisfy a human desire or serve a human purpose. In the words of
S.C. Maurice, “utility is a consumer’s perception of his or her own happiness or satisfaction.”

Moreover, ‘utility’ and ‘usefulness’ are not synonymous. A commodity may be regarded by
society as useless or even positively undesirable. It may be frivolous, injurious or even
pernicious, but if it satisfies an economic want, it possesses utility. For example, a cigarette
will yield tremendous utility to a smoker, but zero or negative utility to a non-smoker.
Therefore, utility has no moral, legal, or ethical connotation.

Since utility is ‘subjective’ and not ‘objective’, it is not susceptible to precise quantitative
measurement. Utility is a relative phenomenon, which varies from person to person, from
time to time and from place to place depending upon the intensity of people’s respective
needs. It also depends to a large extent on culture and civilization.

Likewise, the term utility should not be confused with satisfaction. Utility implies ‘expected
satisfaction’ whereas ‘satisfaction’ stands for realized satisfaction. A consumer thinks of
utility when he is contemplating the purchase of a commodity, though he obtains
satisfaction only after the consumption of the commodity.

Cardinal and Ordinal Utility

The controversy between cardinalist and ordinalist approaches to utility theory is not of
recent origin. There are some theories of utility that attach significance to the magnitude of
utility. These are known as cardinal utility theories. The numbers 1,2,3 and so on are
cardinal numbers. The cardinal utility theory states that it is measurable just as weight,
temperature, and length. Utility is assumed to be measurable in subjective units called utils.

This mythical unit of satisfaction is merely a convenient pedagogical device which will
allow us to quantify thinking about human behavior. Marshall assumed that utility is
measurable in monetary units. The money price, which we are willing to pay for an extra
unit of a commodity is supposed to measure its utility. Thus, according to the concept of
Cardinal Utility, utility can be measured and compared in terms of the number of units. For
example, an apple possesses 10 utils and an orange possesses 5 utils. Here the utility of an
apple is twice that of an orange.

The numbers 1st, 2nd, 3rd and so on are ordinal numbers. J.R. Hicks and R.G.D. Allen assumed
that utility cannot be measured but can only be ranked. Utility in this case denotes rank
ordering of preferences. That is, we can say whether the utility of an orange is less than,
equal to, or greater than the utility of an apple.

Since, ordinal utility theory requires fewer assumptions and has as much predictive power
as the cardinal utility theory, economists have preferred the former to the latter following
the law of parsimony. The law of parsimony, often called Occam’s Razor is that if two
theories have equal predictive power then the theory with fewer assumptions should be
preferred.

Assumptions of the Cardinal Utility Approach

The Cardinal Utility approach is based on the following explicit assumptions.

1. Rationality

The consumer is rational in the sense that he aims at maximizing his utility subject to
income constraint.

2. Cardinal Utility

Marginal utility analysis assumes utility as a quantifiable entity. According to Marshall, the
amount of money, which a person is willing to pay for a thing, instead of going without it, is
the money measurement of utility.

3. Constancy of Marginal Utility of Money

Since money is the measuring rod of utility, the marginal utility of money must remain
constant. If the marginal utility of money changes as income increases or decreases the
measuring rod may behave like an elastic ruler. Then, it becomes inappropriate to
measurement.

4. Utilities are independent

The marginal utility approach assumes that the satisfaction derived from the consumption
of one good is the function of that good alone and not of another. In other words, the
commodities, which are supposed to enter the consumer’s budget are neither substitutes nor
complements.
5. Diminishing marginal utility

The marginal utility of a commodity diminishes as a consumer possesses larger quantities of

it.

MUx = f(Qx)

Marginal utility of a commodity X is a function of the quantity of X. The greater the

quantity, the lesser is its marginal utility. There are two approaches to explain consumer’s
behavior in terms of cardinal utility: (a) diminishing marginal utility and (b) equi-marginal
utility.

Total Utility (TU) and Marginal Utility (MU)

Total Utility is the sum utility derived from consumption of bundle of commodity

Marginal Utility is the rate of change from one more unit of extra consumption

MUn = TUn – TUn-1

MU =∆TU/∆Q
Law of diminishing marginal utility

According to Alfred Marshall ‘the additional utility which a person derive from the
consumption a commodity diminishes, that is Total Utility increase at an diminishing rate ‘

TU
Unit of Total Marginal
Saturation point
Mango Utility Utility
1 10 10
2 20 10
3 29 9 TU
4 37 8
5 43 6
6 48 5 No of Mango
7 51 3
MU
8 52 1
9 52 0
10 50 -2

MU

No of Mango

Law of Equal-Marginal utility

Consumer’s equilibrium under Marshellian analysis

It explains how consumer is maximizing his satisfaction by allocating his income with
different commodity at various prices.

Condition for consumer equilibrium two commodities

MUx/Px=MUy/Py=MUmoney
Condition for consumer equilibrium more commodities

MUx/Px=MUy/Py=…………………………….MUn/Pn=MUmoney

Apple (A) MUA MUA/PA Banana(B) MUB MUB/PB

1 60 20 1 60 12
2 48 16 2 55 11
3 42 14 3 50 10
4 36 12 4 45 9
5 30 10 5 40 8
6 24 8 6 35 7
7 18 6 7 20 4
Price of A=3 Price of B=5

MU of Money=10 (constant)

Expenditure=5*Price of A+3*price of B

=(5*3)+(3*5)

=Rs.30

So he has to purchase 5 units of apple and 3 units of banana in order to maximize his
utility.

Critical evaluation of Cardinal Utility analysis

 Utility is not cardinally measurable

 Marginal Utility of money is not constant
 Inadequacy of methods of introspection
 Utilities are n interdependence
 Failure to explain Giffen Paradox
 Failure to distinguish income effect and substitution effect
Answer: 2
A substitution effect shows change in consumer's optimal consumption combination as a
result of change in the relative price alone, real income of the consumer remaining
unchanged. Substitution effect is shown in the figure. It starts with the initial optimal
consumption combination attained at point e at which OX units of good X and OY units of
good Y are purchased.

Figure: 1
When the price of good X decreases, the budget constraint then becomes flatter, as the
lower end point moves rightward. This is shown by budget constraint PL1. The real income
of the consumer also increases. This increase in real income will be neutralized through
Compensatory Variation in Money Income so that the real income of the consumer remains
unchanged. In other words we need to reduce consumer's money income to bring her/him
at initial real income level. This adjustment in money income shifts the budget constraint
backwards and it is a parallel shift as shown by the price line AB.

The relative prices of goods X and Y are different on budget constraint AB than on the
budget constraint PL. Good X is relatively cheaper to good Y on budget constraint PL1 than
budget constraint PL. This is because budget constraint PL1 is obtained when the price of
good X (Px) decreases, price of good Y (P y) remaining unchanged. Similarly, good X is
relatively cheaper to good Y on budget constraint AB, as it is parallel to PL1.

Thus, good X is relatively cheaper to good Y on budget constraint AB than on budget

constraint PL. However, Consumer's real income on budget constraint AB is same as her/his
real income on budget constraint PL, as budget constraint AB is obtained through
compensatory variation in consumer's money income.

Figure.1 shows that on the new budget constraint AB, obtained after compensatory

variation in money income, the consumer attains optimal consumption combination at
point e1 which is on the same indifference curve U and purchases OX1 units of good X
and OY1 units of good Y.

Thus, consumer's movement from optimal consumption combination e to e1 shows

substitution effect. Similarly, increase in her/his consumption of good X by XX1 and
decrease in consumption of good Y by YY1 is on account of change in the relative price
alone, real income of the consumer remaining unchanged.

Thus a substitution effect shows consumers preference for relatively cheaper goods. In that
sense the substitution effect works in opposite direction. It is always negative. A consumer
buys more units of a good whose price is relatively lower. Further, the consumer remains on
the same indifference curve. Chart 1 presents a summary of Figure.1.

Chart: 1

Slutsky’s Substitution effect

Slutsky's substituion effect approach differs from the Hicksian approach in terms of
compensatory variation in money income. In Hicksian approach the compensatory
variation in money income is to the extent that would bring the consumer back at initial
income level (utility level) or on the original indifference curve. On the other hand, in
Slutsky's substitution effect approach the compensatory variation in money income is to the
extent to bring the consumer back to the original optimal consumption combination. This is
shown in Figure 2. It starts with the initial optimal consumption combination attained at
point e at which OX units of good X and OY units of good Y are purchased.

Figure:2

When the price of good X decreases, the budget constraint becomes flatter, as shown by
budget constraint PL1 . The real income of the consumer also increases. This increase in real
income is neutralized through Compensatory Variation in Money Income so that the
consumer is able to buy the initial optimal consumption combination e. This adjustment in
money income shifts the budget constraint backwards and it is a parallel shift as shown by
the budget constraint AB which passes through point e.

The relative prices of goods X and Y are different on budget constraint AB than on the
budget constraint PL. Good X is relatively cheaper to good Y on budget constraint PL 1 than
budget constraint PL. This is because budget constraint PL 1 is obtained when the price of
good X (Px) decreases, price of good Y (Py) remaining unchanged. Similarly, good X is
relatively cheaper to good Y on budget constraint AB, as it is paralle to PL 1.

Thus, good X is relatively cheaper to good Y on budget constraint AB than on budget

constraint PL. Figure.2 shows that on the new budget constraint AB, the consumer attains
optimal consumption combination at point e1 which is on a higher indifference curve
U1 and purchases OX1 units of good X and OY1 units of good Y.

Thus, consumer's movement from optimal consumption combination e to e1 shows

substitution effect. Similarly, increase in her/his consumption of good X by XX1 and
decrease in consumption of good Y by YY1 is on account of change in the relative price
alone, real income of the consumer remaining unchanged. However, unlike in Hicksian
approach, the consumer is now at higher utility levels as combination e 1 is on a higher
indifference curve U1.

Comparison of Hicksian and Slutsky's Substitution Effect approach

The above discussion shows that the basic difference between the two approaches arises in
terms of how much money income variation is essential for real income to remain
unchanged. There is no general reason to prefer one approach over the other. The two
approaches are dealing with different set of questions. In the Hicksian approach, income
compensation is to the extent to bring the consumer back on the original level of utility or
well-being. The consumer is neighter better off nor worse off. This concept of money
compensation is useful for welfare comparisons.

In Slutsky's approach the compensatory variation in money income is to the extent to bring
the consumer back to the initial optimal consumption combination. The variables such as
income, price changes and initial consumption combination are observable and therefore
easy to calculate

Answer: 3
 The course of development of the pure theory of demand would describe revealed
preference theory as a move from psychological to behaviouristic explanation of
consumer’s behaviour in market. The utility theory was purely subjective. It sought to
explain observed consumer behaviour in terms of motivation and psychological
valuation.
 The indifference curve analysis released the theory of consumer’s choice from
psychological implications to some extent, but it did not explain the observed behaviour
of the consumer. The indifference curves continued to remain a sort of psychological
postulate.
 The revealed preference theory as the third root of the logical theory of demand enun-
ciated the demand theory from observed consumer behaviour. It was the first attempt to
formalise consumer’s behaviour from market observations alone.
 This theory has gained some advantages over the two alternative formulations. It frees
the consumer theory of the vestiges of psychological and introspective analysis. It also
drops ‘utility maximisation’ and ‘continuity’ assumptions making rationalisation of
consumer behaviour less difficult than in the other two models. It is based on simpler
and more realistic assumptions.
 Commenting on the earlier two theories of demand, Samuelson remarks, “for just as we
do not claim to know by introspection the behaviour of utility, many will argue we
cannot, know the behaviour of ratios of marginal utilities or of indifference directions”.
 Further, “The introduction and meaning of the marginal rate of substitution as an entity
independent of any psychological, introspective implications would be, to say the least,
ambiguous, and would seem an artificial convention in the explanation of price
behaviour”.
 The propagator of the indifference curve analysis J.R. Hicks himself admitted in his later
work, ‘A Revision of Demand Theory’ that “the most awkward of the assumptions into
which the older theory (i.e., the indifference curve theory) appeared to be impelled by
its geometrical analogy was the notion that the consumer is capable of ordering all
conceivable alternatives that might possibly be presented to him, all the positions which
might be represented by points on his indifference map. This assumption is so
unrealistic that it was bound to be stumbling block”.
 The revealed preference theory based on behaviourist approach is no doubt an advance
over the utility and the indifference curve approaches of studying demand. It gives a
direct way to the derivation of the demand curve, which does not require the use of the
subjective concept of utility or indifference curves.
 The theory can prove the existence and convexity of the indifference curves under
weaker assumptions than earlier theories. It also provides the basis for the construction
 of index numbers of the cost of living and their use of noticing changes in the consumer
welfare, when prices change.

Reference:

 http://sundaramponnusamy.hubpages.com/hub/Introduction-to-the-Cardinal-
Utility-Theory
 http://www.slideshare.net/siasdeeconomica/utility-and-cardinal-utility-analysis.
 http://wikieducator.org/SUBSTITUTION_EFFECT/Next
 http://www.shareyouressays.com/115679/notes-on-the-critical-appraisal-of-the-
revealed-preference-theory