Consumers are assumed to be rational. Given his money income and the market prices of various commodities, he plans the spending of his income so as to attain the highest possible satisfaction. It is possible to measure the amount or level of satisfaction that individuals get from consuming a commodity or a bundle of goods using the concept of utility. Two approaches to the concept of utility (Cardinalists and Ordinalists approach) describe how utility can be gauged. The analysis of how consumers make choices can be done using the budget constraint and indifference curves. An indifference curve shows various bundles of commodities that make the consumer equally happy, or give him the same level of satisfaction.
Utility is a measure of the satisfaction that a consumer gets from consuming a commodity or a bundle of goods. The marginal utility of a good is the increase in utility that the consumer gets from consuming an additional unit of the good. Most goods are assumed to exhibit diminishing marginal utility ie. the more of a good a consumer already has, the lower the marginal utility derived from the consumption of an additional unit of the commodity. The table below illustrates diminishing marginal utility.
Quantity of x Total utility Marginal Consumed per week (units per week) (utility units) 0 0 0
The Cardinalist vs Ordinalists’ Approach
The cardinalist approach considers utility as being measurable in monetary terms by the amount of money the consumer is willing to sacrifice for another unit of the commodity or in subjective units called utils and can be assigned a value eg. 10, 20, 30. The ordinalists say that utility is not measurable, but is an ordinal magnitude. The consumer need not know in specific units the utility of various commodities to make his choice. It is enough for him to be able to rank the various ‘baskets of goods’ according to the satisfaction that each bundle gives him. He must be able to determine his order of preference among the different bundles of goods. The main ordinal theories are the indifference curves approach and the revealed preference hypothesis.
Assumptions of the Cardinal Utility Theory
1. Rationality: The consumer is rational and aims at maximizing his utility subject to the constraint imposed by his given income. 2. Cardinal utility: The utility of each commodity is measurable. The most convenient measure is money-the utility is measured by the monetary units that the consumer is willing to pay for another unit of the commodity. 3. Constant marginal utility of money: This assumption is necessary if the monetary unit is to be used as a measure of utility. 4. Diminishing marginal utility: The utility gained from successive units of a commodity diminishes as a consumer acquires more of it. 5. The total utility of a ‘basket of goods’ depends on the quantities of the individual commodities in the basket. The more the goods, the higher the utility.
Assumptions of the Ordinalist Utility Theory (Indifference Curves Approach) 1. Rationality: The consumer is assumed to be rational - he aims at the maximization of his utility, given his income and market prices and has full knowledge of market conditions. 2. Utility is ordinal: Consumers can rank their preferences according to the satisfaction of each basket. He need not know precisely the amount of satisfaction. 3. Diminishing marginal rate of substitution: Preferences are ranked in terms of indifference curves, which are assumed to be convex to the origin. 4. The total utility of the consumer depends on the quantities consumed. 5. Consistency and transitivity of...