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Here is a compilation of essays on the ‘Cardinal Utility Theory’ for class 11 and 12. Find paragraphs, long and short essays on the ‘Cardinal Utility Theory’ especially written for school and college students.
Essay on the Cardinal Utility Theory
Essay Contents:
- Essay on the Introduction to the Cardinal Utility Theory
- Essay on the Applications of Cardinal Utility Theory
- Essay on the Income Effect
- Essay on the Limitations of Cardinal Utility Theory
- Essay on the Replacement by the Ordinal Utility Theory
Essay # 1. Introduction to the Cardinal Utility Theory:
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The cardinal utility theory explains the different aspects of consumer demand on the assumption that the consumer maximizes his satisfaction in the given market situation. The consumer’s satisfaction is represented by an additive utility function.
The analysis is based on three crucial assumptions:
1. Marginal utilities are independent (ensured by the additive utility function),
2. The marginal utility of a good decreases as its consumption increases,
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3. The marginal utility of money is constant, given the consumer’s wealth.
The theory is simply presented in terms of marginal utilities.
The Additive Utility Function:
The total utility of the consumer is the sum of the individual utilities of the goods he consumes. These goods can be many, but for convenience, we assume that there are only two goods – apples (q1) and nuts (q2). The consumer derives utility from the consumption of apples and nuts as well as from the money balance at his disposal (m). His total utility function is –
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UT = U(q1) + V(q2) + μ(m) …[1]
Why apples and nuts yield satisfaction, is no mystery. But why should the amount of money at one’s disposal yield satisfaction? Although Marshall is silent on this question, it seems evident that m represents the consumer’s command over ready purchasing power. Ready purchasing power may be valued for the advantages it offers in face of contingencies, speculative opportunities, as well as in carrying out transactions over a period of time.
Money Balances with the Consumer (m):
The amount of money at the disposal of the consumer m is the difference between the amount of money he would have had had he spent nothing, M, and his consumption expenditure. Thus,
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m = M – p1 q1 – p2q2 …[2]
M reflects the consumer’s access to resources or his wealth. If his wealth is constant, so is M. On the other hand, m may be positive or negative. If it is negative, it shows that the consumer is dissaving.
Essay # 2. Applications of Cardinal Utility Theory:
1. The Diamond-Water Paradox:
The Cardinal utility theory throws light on the diamond-water paradox. This paradox points out that water, the most useful good, has a lower market value than diamonds which are less useful. Thus the paradox contrasts the ratio of the total utilities of water and diamonds to their price ratio.
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Cardinal utility resolves this paradox by pointing out that total utility has no bearing on the market price of any good. The market price of any good cannot exceed its demand price, which is the marginal worth of the quantity purchased. Thus the marginal worth of the good sets the ceiling to the price that can be charged for any quantity sold.
A lower price for water than for diamonds, suggests that the marginal worth of water is less than diamonds. This is merely saying that the marginal utility of water is less than that of diamonds. The marginal utility of water is lower because it is plentiful when compared to diamonds, whereas the marginal utility of diamonds is high because their availability is low.
This follows from the law of diminishing marginal utility. By this law, if the availability of water were also to become low, like diamonds, its marginal utility would also be high. This would raise its marginal worth and hence its market value. The chain of causation proposed by some early utility theorists to explain the diamond-water paradox runs as follows – scarcity determines marginal utility, marginal utility determines value.
2. Consumer’s Surplus and Consumers’ Surplus:
The consumer purchases goods only because his purchases generate a net surplus in his satisfaction. An economic measure of this surplus satisfaction is the consumer’s surplus.
Surplus Satisfaction:
Marshall explains surplus satisfaction as follows:
… the satisfaction which …[the consumer]… gets from its purchase generally exceeds that which he gives up in paying away its price, and he thus derives from the purchase a surplus of satisfaction (1920).
Thus the surplus satisfaction comes from the difference between the satisfaction gained and satisfaction lost from purchases.
For every extra unit purchased, surplus satisfaction is the difference between its marginal utility and the product of its price with the marginal utility of money [MUX – px μm]. The latter measures the satisfaction lost, and the former, the satisfaction gained from the extra unit purchased. By totalling up the surplus satisfaction for every extra unit purchased, beginning from zero, we get the total surplus satisfaction [∑(MUX – pxμm)].
Consumer’s Surplus:
Surplus satisfaction can be expressed in rupees, by measuring it in terms of the marginal utility of money. This is an economic measure of surplus satisfaction, which Marshall calls the consumer’s surplus. Thus, according to Marshall –
Consumer’s Surplus = Surplus Satisfaction/μm
Marshall defines consumer’s surplus as follows:
The excess of price which he would be willing to pay over that which he actually does pay … may be called consumer’s surplus.
Every point of the marginal worth curve shows the worth in rupees of an extra unit purchased at that quantity. Thus, it shows the price that the consumer would be willing to pay for that marginal purchase. Hence, the difference between the marginal worth curve and the price shows the consumer’s surplus for each marginal purchase.
In Fig. 4.4 we estimate the consumer’s surplus by summing up this difference from zero till q1. This is given by A-B. This is the consumer’s surplus when he purchases q1 at the price p1.
Unfortunately, the marginal worth curve can only be measured in a laboratory and cannot be observed in economic activity. Hence we need an operational measure of the consumer’s surplus. That is to say, we need a procedure by which we can measure the consumer’s surplus from observable economic behaviour.
An Operational Procedure to Measure Consumers’ Surplus:
Market responses to different prices reveal the market demand curve which is the lateral sum of individual demand curves. Individual demand curves are only the downward sloping portions of the marginal worth curves. Hence, each point on the individual demand curve shows the price that the consumer is willing to pay for the marginal unit. It follows that the difference between them and the price line will give an estimate of the consumer’s surplus.
However there is a hitch. Individual demand curves are rarely observed. What is usually encountered is their lateral sum—the market demand curve. Hence we can take the area between the market demand curve (Dm) and the price line. This is shown as the area A in Fig. 4.5. This area may be called the consumers’ surplus. This is the sum of the consumer’s surplus of all the individual consumers in the market.
Consumers’ Surplus and its Applications:
The use of market demand curves to measure the consumers’ surplus opens up attractive possibilities. Marshall used this to analyse the effects of taxes and bounties on the consumers’ surplus in different situations. Even in very recent times, the method of measuring the consumers’ surplus through market demand curves has stimulated some empirical research. It has led to studies on the effects of monopolisation on welfare, broadly on lines suggested by Harberger (1954). Thus, because of its simplicity, the concept of consumers’ surplus continues to have some appeal even in modern times.
However, the use of demand curves to measure the consumers’ surplus suffers from some limitations. In fact, even the concept of consumer’s surplus as an economic measure of the individual consumer’s surplus satisfaction has limitations.
Limitations:
Changes in the Marginal Utility of Money – Consumer’s surplus measures surplus satisfaction using the marginal utility of money as a standard. Only if this standard is itself constant, can the measurement be unambiguous.
Unfortunately the marginal utility of money does not stay constant when the consumer’s expenditure on a good changes. What this means is that the satisfaction lost in paying the same price is different according to whether we have more or less money at our disposal. As a result, the precision with which consumer’s surplus measures surplus satisfaction is misleading.
However, if the consumer’s outlay on the good is very small, we may assume that the change in the marginal utility of money is negligible. This is because the money at the disposal of the consumer is not likely to change by much if the outlay on the said good changes. Thus the concept of consumer’s surplus is best applied to ‘marginal commodities’, which account for a small part of the budget.
Limited Knowledge of Demand Curves – Even when this is done, the measurement of the consumer’s surplus from an individual demand curve has some defects. This is due to two reasons. Firstly, our knowledge of the individual demand curve is limited mainly to the price situations close to the current price. What happens at distant situations can only be construed. For instance, for the first few drops of water, the consumer may ‘offer the sky’.
Since water is reasonably priced in normal market situations, the consumer’s surplus is likely to be infinitely large. This is true for all absolute necessities. But this large size of the consumer’s surplus may not be reflected by the individual demand curve, which is estimated in more normal price situations.
Neglect of the Rising Part of the Marginal Worth Curves – Secondly, individual demand only represents the downward sloping portion of the marginal worth curve. Hence, from the individual demand curve, no estimates can be made about the consumer’s surplus in the rising portion.
This problem is illustrated in Fig. 4.6. The individual demand curve is the segment to the right of D. Hence, the consumer’s surplus will be estimated from the demand curve as A. However, this measurement ignores B – C which is also a part of the consumer’s surplus, and which may not be equal to zero.
Variation of Marginal Utility of Money between Persons – Finally, the sum of all individual consumer’s surpluses which is labelled as the consumers’ surplus, suffers from greater ambiguities. This is because the marginal utility of money varies from person to person and across social classes. Thus, what a poor man means by a hundred rupees worth of surplus satisfaction may be very different from what a rich man understands it to mean.
Although the amount of money is the same, it represents very different quantities of surplus satisfaction to the two people. Hence, their ‘total surplus satisfaction’ cannot be measured by totalling the two amounts of money. This is why consumers’ surplus cannot adequately measure the total surplus satisfaction.
Difficulties of Interpersonal Comparison of Utilities – Some economists even doubt the meaning of a total surplus satisfaction. In this view, the satisfaction of one individual cannot be compared with that of another. They represent different subjective qualities which cannot be reduced to a common denominator. If inter-subjective comparisons are impossible, it makes no sense to speak of a ‘total surplus satisfaction’, let alone measure it by consumers’ surplus.
Essay # 3. The Income Effect:
A change in the wealth of the consumer changes M, the amount of money he would have had, had he spent nothing. Let us call M, the money income of the consumer. Suppose, the consumer’s money income increases. The likely effects on consumer demand may be reasoned out as follows.
We recall that the declining segment of the marginal worth curve (U1/μm) is the individual’s demand curve. The marginal utility of the good is independent of changes in the consumer’s income. Hence, if a higher income affects the marginal utility of money, it will also affect the demand for the good at any price p1 but not otherwise.
Marshall assumes that at a higher income, the marginal utility of money will be lower. Hence, the marginal worth curve will be higher at a higher money income. This is illustrated in Fig. 4.7. The consequence is obvious. Since the last good purchased is now worth more, the consumer will purchase more at the same price. Thus the demand for the good is higher, when the consumer’s income is higher. This is true for all goods. Hence all goods are non-inferior in the Marshallian world.
There can be no inferior goods in the cardinal utility theory. To allow for inferiority, we have to let the marginal utility of money be higher at a higher income. But if we assume this to be so, all the goods become inferior, which is just as bad. This seems to be a serious deficiency in the cardinal utility theory. In fact the theory has several other limitations as well.
Essay # 4. Limitations of Cardinal Utility Theory:
1. There are no inferior goods (or alternatively all are inferior goods) in the cardinal utility theory.
2. There are no Giffen goods. Since Giffen goods are a class of inferior goods, they are automatically excluded when there are no inferior goods. But even if we manipulate assumptions in order to let all goods become inferior, by assuming ∂μm /∂M > 0, there would still be no Giffen goods.
The reason is simple. If the consumer is to be in equilibrium, the marginal utility of each good must diminish as its availability increases. But if marginal utility diminishes, marginal worth declines and the demand curve slopes down to the right. Hence there can be no Giffen goods.
3. There are no gross substitutes or complements in the model. The change in the price of one good does not affect the demand for any other good.
To understand this, recall that the demand for any good is determined by its marginal worth curve—described by MUx/μm. We can show that both the numerator and the denominator do not change when the price of another good changes. Firstly, the change in the price of another good does not change the denominator — μm (marginal utility of money) which is constant by assumption.
Secondly, the change in price of another good changes the consumption of that good only, without affecting the marginal utility of any other good because marginal utilities are independent. Hence the numerator MUx, is unaffected by a change in the price of another good. Since both the numerator and the denominator are unaffected, the marginal worth curve remains constant and the demand for any good is not affected by the change in price of another good. Thus constancy of the marginal utility of money, and the independence of marginal utilities of goods ensure that all cross price effects are zero.
4. The marginal utility of money is not necessarily constant in reality. If marginal utility of money is variable, diminishing marginal utility is not sufficient for equilibrium. Moreover with a variable μm, the concept of consumer’s surplus becomes ambiguous.
5. The strongly additive form of the utility function is not justified. Usually, the utilities of goods are not independent. The consumption level of one good affects the satisfaction obtained from the other. On the same logic, marginal utilities are not independent either. But if these criticisms are granted, and the additive utility function is dropped, diminishing marginal utility no longer suffices to ensure the consumer’s equilibrium.
6. The amount of money at the disposal of the consumer m depends less on his consumption expenditure and more on his investment expenditure. This is because money is an asset like other investment goods and durables. Hence the satisfaction from holding money is better introduced in a theory of asset portfolios, rather than in a theory of consumption.
7. Diminishing marginal utility may indeed be obtained for every good beyond some critical level of availability. But the moot question is whether consumers have indeed crossed this critical level. If not, they may still experience increasing marginal utility.
For instance, it is not implausible to find a consumer reporting that an extra unit of consumption gives greater extra satisfaction, but still refraining from purchasing it pleading a ‘budget constraint’. Thus we may frequently observe increasing marginal utility in consumer equilibrium. Is such a consumer irrational, or is our theory over-restrictive?
8. The law of diminishing marginal utility rests on a strong cet. par. clause. The assumptions involved may be justified by examples from the dining table, but not from the situation in the market place. But it is the consumer’s market behaviour that needs to be explained.
9. The marginal utility of money may not decline as income rises. In fact, the desire for money not spent, may rise with income, since it depends upon the value of transactions that one has to carry out (Keynes), and these may be expected to grow with incomes.
10. Utility cannot be measured ‘cardinally’. That is, it is not possible to say that the extra utility from the consumption of two apples is exactly n times the extra utility from consuming one apple.
Essay # 5. Replacement by the Ordinal Utility Theory:
To overcome these limitations, Hicks and Allen (1934), revived and developed the use of generalized utility functions to analyse consumer behaviour. Their theory of consumer behaviour was able to accommodate cross price effects, some inferior goods, and even Giffen goods.
The Hicks-Allen theory abandoned the cramping dependence on diminishing marginal utility and the constancy of marginal utility of money. The former was no longer necessary or sufficient for the consumer’s equilibrium. This was now characterized by the convexity of ‘indifference curves’. The crucial role played by indifference curves in the theory also earned the theory the name indifference curve analysis.
The cardinal measurability of utility disappeared with the abandonment of constancy of marginal utility of money. It was no longer maintained that the consumer could meaningfully answer the question: ‘How much more satisfaction?’. Instead, it was asserted that it was sufficient if the consumer could rank his satisfaction. Thus the ability of the consumer to rationally rank his satisfaction in an ordering of more than, less than, or equal to, was now the basis of the new theory. Hence its other name, ‘Ordinal Utility theory’.
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