Cardinal Utility Analysis,

Consumer Surplus

Managerial Economics
Sem I
 Explaining Utility

 The value that a consumer places on a good or service

depends on the satisfaction derived from its use

 The satisfaction that a product yields is termed utility

 Utility is defined as the want satisfying power of a good or

service
 Cardinal & Ordinal Utility
Measuring Utility in Utils (Cardinal Approach)
 Utility is quantified – there is numerical measurement of
utility
 Mr. X derives 15 utils of utility from watching sports and
12 utils from watching a movie

Utility explained through comparison (Ordinal

Approach)

 Mr. X prefers watching sports to watching a movie

 Cardinal Utility & Money
• Cardinal approach was developed by Alfred Marshall
• Marshall used ‘utils’ as unit of measurement
• As money is used for transactions, money can also be
used for measuring and comparing utility of goods
• Ms. B is willing to pay Rs. 25 for a bar of chocolate
and Rs. 50 for a milk shake
• Utility of a chocolate bar = Rs.25
• Utility of milk shake = Rs.50
 Law of Diminishing Marginal Utility
• As a person consumes more and more units of a
good, the intensity of want for that good keeps on
falling

• Marginal Utility or the additional utility derived

from each additional unit consumed falls as more
units are consumed

• When saturation point is reached, marginal utility

becomes zero and thereafter negative
Total Utility & Marginal Utility
 Total utility is the total satisfaction derived from the
consumption of all units of a good over a given
consumption period
 Marginal Utility is the additional satisfaction or utility
gained from the use of an additional unit of a good

Total Utility (TU) = Sum of Marginal Utilities

Marginal Utility of the nth unit consumed MU(n)
= TU(n) – TU(n-1)
MU =
Total Utility & Marginal Utility
No. of cups of Total Utility (TU) Marginal Utility
tea per day MU =

1 12 12
2 22 10
3 30 8
4 36 6
5 40 4
6 40 0
7 39 -1
8 34 -5
Relationship between TU & MU

 TU rises, but at a
diminishing rate
 MU is the rate at which TU
rises
 MU diminishes as the
number of units consumed
increases
 MU is the slope of the TU
curve
 When TU is maximum
(quantity Q4), MU is zero
 When TU falls, MU is
negative
 Utility Maximizing Rule
• Consumers have a budget constraint, hence choices have to be made
• In purchasing a basket of goods, total utility (satisfaction) is
maximized when the budget is fully spent and the marginal utility per
unit of money spent is equal across all goods.
• If the entire budget of a consumer is spent on buying two goods X &
Y, the optimum combination of goods will be when

& - the marginal utility of the last unit of money spent on goods X & Y respectively
The marginal utility obtained from the expenditure on X equals MU on expenditure on Y
 Law of Equi-Marginal Utility
Utility is maximised when the consumer equates the ratio of MU of a
good to its price for all goods purchased
If

 it means that the marginal utility of last unit of money spent on X is

greater than that of Y

 will decrease when more units of X are bought (Law of

DMU)

 Consumer should increase the purchase of X and reduce that of Y such

that
 Optimal Purchase – Pop Corn & Ice
Cream
Quantity MU Price MU/P MU Price MU/P
(ice cream) (ice cream) (ice cream) (pop corn) (pop corn) (pop corn)
1 45 10 4.5 48 6 8
2 40 10 4 36 6 6
3 32 10 3.2 20 6 3.3
4 20 10 2 15 6 2.5
5 10 10 1 10 6 1.7
6 7 10 0.7 6 6 1
7 3 10 0.3 3 6 0.5
8 0 10 0 0 6 0

At equilibrium, 5 units of ice cream and 6 units of pop corn are purchased
 Consumer Surplus
• Consumer surplus is a measure of the welfare that people
gain from consuming goods & services
• It is the difference between what the consumer is willing to
pay (indicated by demand curve) and what the consumer
actually pays i.e. the market price of the product
• Willingness to pay (WTP) is the maximum amount that a
consumer is prepared to pay for a good and is based on
marginal utility for that product
Consumer Surplus = Willingness to pay Price – Market Price
 Measurement of CS for an Individual
Consumer
No. of Marginal Price Consumer
units utility - (₹) Surplus
WTP (₹)

1 20 12 8

2 18 12 6

3 16 12 4

4 14 12 2

5 12 12 0

6 10 12 -2

Total CS from 5 units = 20

Market Measurement of CS

Consumer 5 who has

no CS is the marginal
consumer
 Measuring CS on the Demand Curve
Consumer surplus is the area below the demand curve and
above price
Price = OP1; Quantity =
OQ1
Area below the demand
curve is Total Utility
TU for OQ1 units = area of
OACQ1
Total Payment for OQ1 =
area of □ OBCQ1
Consumer surplus = area
of ∆ABC

Demand curve is based on marginal utility. The area under the demand
curve is ∑MU = TU
The market demand function for a product is given by Q d=300-2P. How
much consumer surplus do they receive when:
P=45
P=30

When P= 45, Qd = 210, CS = ½*210*105= 11025

When P=30, Qd = 240, CS = ½*240*120= 14400
Paradox of Value
 Diamond – Water Paradox

• Paradox of Value – Essential goods like water have a

low market value while market value of non-
essential goods like diamond is high

• High value in use does not always mean high value in

exchange

• Early economists were unable to explain divergence

between value in use and value in exchange
 Resolving Diamond-Water Paradox
• Key to resolving paradox – distinction between Total Utility &
Marginal Utility
• Area under demand curve measures the total utility that
consumers get from consuming a given quantity of a product.
Total utility (value in use) for water is high
• Market price (value in exchange) is determined not by TU, but
marginal utility – the value that a consumer places on the last
unit consumed
• As more units consumed, MU diminishes. Hence consumers are
willing to pay only a lower price
• Hence it is possible for a good to have high utility and a low
price
• Demand and supply together determines market value
Resolving Diamond – Water Paradox

• The market value of a good (price or value in exchange) depends on supply and
demand taken together
• Water is abundant in supply, hence market price is low. Price depends on
marginal utility, not total utility. Total utility of water is ODEW QW
• Supply of diamonds is limited, so market price is high. Total Utility is ODEdQd
• Consumer surplus of water is high and that of diamond is low
Resolving Diamond – Water Paradox
 Asha , Lata . Jeevan and Ashok go for a trek and stop at a
motel. The willingness to pay of each trekker is given below
which reflects their marginal utility. The price of the motel
room is Rs 3000. What would be the consumer surplus for each
of them? What would be the dilemma for the group?
Suppose price of motel room is reduced to Rs 2500 How
would the decision change?

Name WTP(MU in Rs)

Asha 7000
Lata 6000
Jeevan 4000
Ashok 2500