Consumer Behavior: Cardinal and Ordinal Utility Theories

Introduction to Utility

Utility Defined: Utility refers to the satisfaction or pleasure a consumer derives from consuming goods and services.
Measuring Utility: There are two main approaches to measuring utility:
- Cardinal Utility Theory: Assumes utility can be measured numerically using a scale (utils).
- Ordinal Utility Theory: Assumes utility cannot be measured numerically, but can be ordered or ranked.
Cardinal vs. Ordinal: Cardinal approach involves assigning numerical values to utility, while ordinal approach involves ranking preferences.

Cardinal and Ordinal Approaches

Cardinal Approach: Utility is measurable using numbers (utils).
Ordinal Approach: Utility can be ordered, but not measured numerically.

Consumer Choice and Utility

Consumer Choices: Consumers aim to maximize their utility (satisfaction) when consuming goods/services.
Constraints: Consumer choices are limited by their income.
Optimization: Consumers try to optimize or maximize their utility given their income level.
Evaluation: Consumers evaluate and compare goods based on their utilities within their income limits.

Measuring Utility: Utils

Utils: Units of measurement for utility in the cardinal approach.
Example*: Jack derives 10 utils from a slice of pizza, but only 5 utils from a burger.
Comparison: In the ordinal approach, utility is measured by comparison, not numerically.

Ordinal Approach: Preferences

Preference Ordering: Consumers express preferences by ordering them (e.g., Jill prefers a burger to pizza, and pizza to a hotdog).
Trade-offs: Consumers are willing to make trade-offs, implying relative utility (e.g., Jill trades a burger for four hotdogs, but only two hotdogs for pizza).

Cardinal vs. Ordinal: Why Two Approaches?

Two Approaches: There are two approaches because some economists believe utility can be measured numerically (cardinal), while others believe it can only be ordered (ordinal).

Cardinal Utility in Detail

Total Utility (TU): The total satisfaction from consuming all units of a good.
Marginal Utility (MU): The additional satisfaction from consuming one more unit of a good.

Total and Marginal Utility

*Assuming consumption of a good over a given time period:
*Total Utility Increase**: As consumption increases, total utility increases.

Marginal Utility: The contribution of each additional unit to the total utility.
Example*: Eating an apple yields 10 utils. Eating a second apple increases total utility to 17 utils. Therefore, the marginal utility of the second apple is 7 utils.
Behavior of TU and MU: Understanding the behavior of total and marginal utility is crucial.
Marginal Utility Defined: The utility derived from the last unit of a good consumed.
Total Utility and Marginal Utility Connection*: Total utility is the sum of all marginal utilities.

Deriving the Demand Curve

Cardinal Utility and Demand: The cardinal utility approach can be used to derive the demand curve.
Inverse Relationship: The demand curve shows an inverse relationship between price and quantity demanded.
Cardinal Utility Analysis: The oldest theory of demand, explaining consumers' demand for products and services.
Law of Demand: States the inverse relationship between price and quantity demanded, represented by the demand curve, schedule, or equation.

Marshallian Cardinal Utility Analysis of Demand

Marshall's Contribution: The derivation of the demand curve using cardinal utility theory is known as Marshallian cardinal utility analysis of demand.
Theory Assumptions*: All theories, including this one, rely on assumptions.

Assumptions of Cardinal Utility Approach

Assumption 1: Cardinal Measurability of Utility: Utility can be measured using utils, allowing quantification of satisfaction.
Example*: A person derives 10 utils from good A and 20 utils from good B.
Assumption 2: Marginal Utility Measured in Terms of Money: The marginal utility can be represented using money.
Money as Purchasing Power: Money represents general purchasing power over utility-yielding goods.
Marshall's Argument: Money is the measurable part of utility.

Marginal Utility and Money

Marginal Utility Representation*: If consuming an additional unit yields five utils, it can be represented as 5 rupees.

Assumption 3: Hypothesis of Independent Utilities: The utility from a good depends only on the quantity of that good, not on other goods.
Independent Utility: Utility from consuming Good A is independent of Good B.
Assumption 4: Constancy of the Marginal Utility of Money*: The satisfaction from receiving money remains constant.

Constancy of Marginal Utility of Money

*Marginal Utility of Money: Unlike goods, the marginal utility of money does not diminish. *Maintaining Money Value: The utility of money remains constant to serve as a reliable measure. If the utility of money changes, then money cannot be used as a measure.
Four Assumptions*: Deriving the demand curve using Marshall's approach requires these four assumptions.

Law of Diminishing Marginal Utility

Diminishing Marginal Utility: As more of a good is consumed, the additional satisfaction from each unit decreases.
*Total Utility Behavior: Total utility increases but at a decreasing rate due to diminishing marginal utility. *Marginal behavior: As more tacos are consumed per meal, the total utility increases, but the marginal utility decreases, eventually reaching zero and then becoming negative.
Maximum Total Utility**: Maximum T.U. is where M.U. is equal to zero.

Connection Between Demand and Utility

Marginal Utility and Willingness to Pay: The marginal utility reflects the amount a consumer is willing to pay for a good.
*When the purchase of one unit of a good gives you 10 worth of satisfaction. In other words, we can say the marginal utility of that first unit of the good is what? 10 or 10 rupees.
Demand Curve and Marginal Utility: The demand curve is derived from how much people are willing to pay, based on marginal utility.

Marginal Utility and Price

Price Sensitivity*: As marginal utility decreases with consumption, consumers are willing to pay less for additional units.

Demand Schedule: A table showing the quantity of goods consumers are willing to purchase at various prices, aligning marginal utility with willingness to pay.
Quantity Vs Price*: This is an inverse relationship and produces a negative slope demand curve.
Total Utility Calculation: By summing the marginal utility values, the total utility at different consumption levels can be determined.

Ordinal Approach Introduction

Ordinal Approach: Utility cannot be expressed using numbers like 10 rupees or 20 rupees or 10 new deals, 20 deals.

Ordinal Approach: Key Concepts

Consumption Possibilities: Explained using the budget line.
Budget Line: A tool for understanding consumption possibilities, dependent on consumer's budget and prices of goods and services.
Budget Considerations*: A budget line describes the limits to consumption choices and depend on the consumer's budget and the price of goods and services.

Budget Line

Budget Line Derivation: Each consumer has their own budget line, dependent on income and prices of goods.
Two-Good Assumption: Budget line analysis typically considers only two goods (X and Y) for simplicity.
Let's look at Tina's budget line. For example, Tina has 4 a day to spend on two goods, bottled water and gum.
Bottled water and twin gum. Those are the two items consumed by Tina. Why do you take only two items? The reason, if you take a graph, we can represent only two units. That means x and y. That is why here we have taken only bottled water and gum, and the budget is given. Tina is having 4. But one information is missing. What is that price of bottled water and the price of gum?

Consumption Possibilities and Budget

*The price of water is 1 a bottle and the price of gum is what? 50¢ per pack. Consumption Possibilities graph is shown.

Maximum Consumption: To generate budget line assume all 4 spent on one good (either water or gum) to find maximums.
Drawing the Line*: The line you take on this curve, you will get what? You will get 4.
Areas on Budget Line: Areas left of the budget line are affordable any area right of the budget line is unaffordable.

Changes to the Budget Line

Budget Vs Consumption*: When a consumer's budget increases, consumption possibilities expand. When a consumer's budget decreases, consumption possibilities shrink.

Budget Shifts: Budget is 4 and then what will happen if the budget is 2 it is what shifted to the left side. And if you assume that budget is 6 now you can see the budget line has shifted to the right side. But in this case, we assume that the amount of money or the budget has increased, but the price of the goods are not changing.
Changes in budget only shift entire line.

Prices and Spending

Price Change Vs Budget*: No change in budget, but instead changing the price of the goods and services. So then let's see what will happen.

Price Increase/Decrease Consideration: Price of one good changes when the price of the other goods and the budget remains the same. So therefore price of one good increasing, no change in the price of the other good and no change in the budget. Then what will happen? If you look at the graph that you can see clearly.
Budget change only changes shifts parts specific to the good who's price changed.
Recall that slope equals rise over run.