Merchant of Venice

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ONSUMER EQUILIBRIUM CARDINAL AND ORDINAL
UNIT 5 CONSUMER EQUILIBRIUM:
CARDINAL AND ORDINAL
APPROACHES
Structure
5.0 Objectives
5.1 Introduction
5.2 Cardinal utility approach to consumer behaviour
5.3 The law of eventual diminishing marginal utility
5.4 Consumer’s equilibrium
5.5 Basis of law of demand in the cardinal approach
5.6 Consumer’s surplus
5.7 The ordinal utility approach to consumer behaviour: the indifference curve approach
5.8 Consumer’s budget constraint
5.9 Consumer’s equilibrium in the ordinal utility approach 5.10 Special cases
5.11 Price-consumption curve
5.12 Income-consumption curve
5.13 Price, substitution, and income effects
5.14 Derivation of the demand curve for a good
5.15 Inferior goods and Giffen goods
5.16 Let us sum up
5.17 Some key words
5.18 Some useful books
5.19 Answers or Hints to Check Your Progress Exercises
5.0 OBJECTIVES
This unit will enable you to:
l understand and analyse how a consumer attains equilibrium; l use cardinal utility theory to explain consumer behaviour; l describe the law of diminishing marginal utility;
l explain consumer’s equilibrium in terms of the Marshallian law of equi-marginal utility. Also use this law to explain the law of demand;
l explain the concept of consumer’s surplus;
l explain consumer’s behaviour in terms of ordinal utility theory, the Hicks-Allen approach
l describe consumer’s equilibrium condition in terms of ordinal utility theory; l decompose price effect into substitution effect and income effect; l graphically derive price consumption curve and income consumption curve, and demand curve for a good;

l understand the difference between normal, inferior, and Giffen goods; l provide a comparative evaluation of the two competing theories. 5.1 INTRODUCTION
In the previous unit we have introduced the concept of demand function, various determinants of demand and its elasticity. In this unit, we continue the discussion on demand and focus our attention on consumer’s behaviour in order to explain the law of demand. The law of demand says that when price of a commodity is lowered a larger quantity is demanded, and when price rises a smaller quantity is demanded, other things remaining the same. In other words, the law states that price and quantity demanded are inversely related. In this unit we will introduce you two contending theories - Alfred Marshall’s cardinal utility theory of demand, and J.R. Hick’s and R.G.D. Allen’s preference approach (or the indifference curve theory, or the ordinal utility theory) of consumer behaviour.

In Hicks-Allen approach some of the restrictive assumptions of the Marshallian approach are dropped. Particularly, that utility is a cardinal concept and is measurable on a numerical scale with an absolute zero and that marginal utility of money is constant are relaxed. Marshallian theory is also based on the law of diminishing marginal utility as well as on inter-personal comparisons of utility. In the preference approach these limitations are overcome with the help of Hicks-Allen formulation, which is based on the indifference curve technique. We will first develop the properties of indifference curves. Using the indifference curves and in conjunction with prices of goods and the consumer’s money income (or budget) we will be showing how a rational consumer attains equilibrium.

Since consumer’s choice depends on prices and money income, and as prices change or money income changes, the consumer’s equilibrium choice will also change. We explain how to derive the price-consumption curve and the income-consumption curve. We will then show how the demand curve for a good can be derived from the price consumption curve. This part of the discussion ends by pointing out the difference among normal good, inferior good and Giffen good. It is only in the case of Giffen good that the law of demand is violated and the demand curve for a good is upward sloping rather than downward sloping. The law of...
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