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.
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Units Total Utility Marginal Utility

1st glass 20 20
2nd glass 32 12
3rd glass 40 8
4th glass 42 2
5th glass 42 0
6th glass 39 –3
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Exceptions to the Law of Diminishing Marginal

Utility:
• Rare collection
• Drunkards
• Misers
• Music, Poetry, and Reading
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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
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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.
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Hence consumer’s equilibrium will be indicated by the

following equation:

MUx MUy MUz

   MUm
Px Py Pz
 Marginal Utilities of Goods X & Y
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Let prices of goods X & Y be Rs. 2 and Rs. 3 resp; Let Rs. 24
be the consumer’s money income to be spent on two goods.
Further, let marginal utility of money be 5 utils per rupee.
Units MUx (Utils) MUx/Px MUy (Utils) MUy/Py

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
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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
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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.
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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.
 Consumer’s 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.