Introduces Cardinal and Ordinal Analysis

1. ECONOMIC ANALYSIS (PART-II)
Compiled by
Dr.S.Vigneswaran.,M.A.,Ph.D.,(NET, SET)
Assistant Professor of Economics,
Mannar Thirumalai Naicker College, Madurai-04.

2. TOPICS COVERED
 Cardinal and Ordinal Utility Analysis.
Law of Diminishing Marginal Utility – Law of Equi-
Marginal Utility – Consumer’s Surplus – Law of
Demand – Why demand curve slopes downward? –
Law of supply.
Indifference Curve Analysis – Meaning – Properties –
Price Effect – Income Effect – Substitution Effect.

3.  Utility: Power of a commodity to satisfy a human want.
 Marginal Utility: Addition made to the total utility by
consuming one more unit of the commodity.
 Total Utility: Utility derived from the consumption of all units
of the commodity taken together at a time. (Sum of the
marginal utilities.)

4. LAW DIMINISHING MARGINAL UTILITY
 H.H Gossen was formulated this law in 1854.
 So it is known as ‘Gossen’s First Law of
Consumption’
 Marshall perfected this law on the basis of Cardinal
Analysis.

5. Assumptions:
1. Cardinal Utility.
2. Constant Marginal Utility of Money.
3. Rational Consumer.
4. Reasonable Units.
5. Homogeneity.
6. Period of Consumption.
7. No change in character of the consumer

6. THE LAW
The Law:
If a consumer continues to consume more and more
units of the same commodity, its marginal utility
diminishes.
Illustration:
No. of Guava Marginal Utility Total Utility
1 + 30 30
2 + 20 (50-30) 50
3 + 10 (60-50) 60
4 0 (60-60) 60
5 - 10 (50-60) 50
6 - 20 (30-50) 30

7. Diagram

8. CRITICISMS OF THE LAW
1. This law assumes utility can be measured, but
utility is subjective.
2. This law is based on the unrealistic assumption.
3. Not suitable for indivisible commodities.

9. EXEMPTIONS TO THE LAW
Following are the exceptions of Law of Diminishing
Marginal Utility:
The marginal utility tends to increase in case of Hobbies,
Drunkards, Misers, Reading, Music and Poetry. So the law of
diminishing marginal utility is not applicable.

10. THE LAW OF EQUI-MARGINAL UTILITY
Also called as
The Law of Substitution
Gossen’s Second Law of Consumption
The Law of Maximum Satisfaction
The Law of Consumer’s Equilibrium

11. Assumptions:
1. Cardinal Utility.
2. Constant Marginal Utility of Money.
3. Rational Consumer.
4. Reasonable Units.
5. Homogeneity.
6. Period of Consumption.
7. Consumer’s income is fixed and limited.
8. No change in the price of the goods.

12. THE LAW
The law states that how a consumer can get
maximum satisfaction out of given expenditure on
different goods.
MUA / PA = MUB / PB = M
MU = Marginal Utility
P = Price
A = Commodity A
B = Commodity B
M = Maximum Satisfaction

13. ILLUSTRATION
Units of
Commodity
Apple Orange
MU TU MUA / PA MU TU MUB / PB
1 25 25 25 / 2 =12.5 20 20 20 / 1 = 20
2 20 45 20 / 2 = 10 11 31 11 / 1 = 11
3 18 63 18 / 2 = 9 8 39 8 / 1 = 8
4 15 78 15 / 2 = 7.5 5 44 5 / 1 = 5
5 10 88 10 / 2 = 5 4 48 4 / 1 = 4
6 4 92 4 / 2 = 2 3 51 3 / 1 = 3
GIVEN INCOME = RS.14
PRICE OF COMMODITY A = RS.2
PRICE OF COMMODITY B = RS.1
If the consumer spends Rs.10 on Apple and Rs.4 on
Orange, he gets maximum satisfaction (88 + 44 =
132 Utils)

14. DIAGRAM
MN and PQ are the Marginal Utility Curves.
If consumer consumes OA units of apple and OB units or orange, the
MU of both are equal and the satisfaction is maximum.

15. CRITICISMS OF THE LAW
1. This law assumes utility can be measured, but
utility is subjective.
2. This law is based on the unrealistic assumptions.
3. Prices of goods may change.

16. CONSUMER’S SURPLUS
Introduction:
Alfred Marshall developed this concept in 1879.
Based on Law of Diminishing Marginal Utility.
Meaning and Definition:
“Consumer’s Surplus is the difference between the potential
price and actual price” – Taussig
Consumer’s Surplus = TU – (P x Q)
Potential Price = Price that the consumer willing to pay.
Actual Price = What he actually pays.

17. ILLUSTRATION
Units Potential Price
(PP)
Actual Price
(AP)
Consumer’s Surplus
(PP –AP)
1 6 2 6 – 2 = 4
2 5 2 5 – 2 = 3
3 4 2 4 – 2 = 2
4 3 2 3 – 2 = 1
5 2 2 2 – 2 = 0
Total (Q) 20 (TU) 10 (P) 10 (CS)
Consumer’s Surplus = TU – ( P x Q)
= 20 – (2 x 5)
= 20 – 10
= 10

18. DIAGRAM

19. ASSUMPTIONS
1. Cardinal Utility.
2. Constant Marginal Utility of Money.
3. No Substitutes.
4. Independency of utility.
5. Based on Law of Diminishing Marginal Utility.

20. CRITICISMS OF CONSUMER’S SURPLUS
1. This law assumes utility can be measured, but
utility is subjective.
2. This law is based on the unrealistic assumptions.
3. Not applicable to necessary goods.
4. In real life utilities are inter-dependent.

21. DEMAND
 Meaning: Demand is a combo of ability and
willingness to buy the commodity.
Types of Demand:
1. Price Demand
Change in demand due to change in price.
2. Income Demand:
Change in demand due to change in income of the consumer.
3.Cross Demand:
Change in demand of ‘X’ due to change in price of ‘Y’

22. LAW OF DEMAND
 Formulated by Augustin Cournot in 1838.
 Refined by Alfred Marshall.
Explanation:
Law demand states that there is a inverse
relationship between the price and demand of a
commodity.

23. ILLUSTRATION
Price (in Rs) Quantity Demanded (in Kg)
10 10
8 20
6 30
4 40
2 50
From the above table it is evident that, when price decreased
from Rs. 10 to Rs.2; the quantity demanded is increased from
10 units to 50 units.

24. DIAGRAM
DD1 is the demand curve. The downward sloping demand curve
indicates the inverse relationship between price and demand.

25. ASSUMPTIONS
1.Consumer’s income, taste, habit and preference
remain constant.
2. No change in quality of the commodity.
3. Demand must be continuous.

26. WHY DOES DEMAND CURVE SLOPE
DOWNWARDS?
1. Law of Diminishing Marginal Utility:
The law demand is based on DMU, so the demand curve
slopes downward.
2. Income Effect:
When the price falls, the real income increases and vice
versa. So the demand change according to price.
3. Substitution Effect
If the price of substitutes remaining same, the demand for
cheaper goods increases.

27. 4. Principle of Different Uses:
Different uses of certain commodities may be restricted due to
rise in price and vice versa.
5. Price Effect:
A fall in price may attract new consumers in the market. So
demand may increase.
6. Psychological Effect:
Psychologically people buy more when price falls even the
commodity has less utility.

28. SUPPLY
Meaning of Supply:
The quantity of output that a seller is willing and able to sell at
different prices.
Law of Supply:
Denotes the ‘direct relationship between price and supply’

29. ILLUSTRATION
Price (in Rs) Quantity Supplied (in Kg)
1 10
2 20
3 30
4 40
5 50
From the above table it is evident that, when price increased
from Rs. 1 to Rs.5; the quantity supplied is increased from 10
units to 50 units.

30. DIAGRAM
SS is the supply curve. The upward sloping supply curve
indicates the direct relationship between price and
supply.

31. ASSUMPTION
1.Consumer’s income, taste, habit, preference and other things
remain constant.
Exceptions
1. Anticipation of price.
2.Need of cash.
3. Cost of production.
4. Closing of business.
5.Consumer Behaviour.
6. Agricultural Products

32. INDIFFERENCE CURVE ANALYSIS
 Developed by J.R.Hicks published in his book ‘Value and
Capital’ in 1939.
 Also known as ‘Ordinal Analysis’ or ‘Hicksian Approach’
Scale of Preference
Arrangement of combinations of goods in the order of level of
satisfaction.

33. ASSUMPTIONS
1. Rational Consumer.
2. Utility can be ordered by ordinal numbers such as I, II, III …
3. Based on the ‘Diminishing Marginal Rate of Substitution’
4.Consumer purchases two goods only.
5. Consumer’s income, taste, habit, preference and other things
remain constant.

34. Indifference Schedule:
Combination of two commodities which will give same level of
satisfaction.
Combinations Apple Orange
I 1 3
II 2 2
III 3 1

35. INDIFFERENCE CURVE

36. INDIFFERENCE MAP
Collection of indifference curves corresponding to different levels
of satisfaction.

37. MARGINAL RATE OF SUBSTITUTION
 Willingness to surrender quantity of ‘x’ to get one
more unit of ‘Y’ for maintaining same level of
satisfaction.
Diminishing Marginal Rate of Substitution
Combinations Wheat Rice MRSWR
I 10 5 --
II 7 6 1 Unit Rice = 3 Units Wheat
III 5 7 1 Unit Rice = 2 Units Wheat
IV 4 8 1 Unit Rice = 1 Unit Wheat

38. DIAGRAM
The slope of Indifference Curve represents the Marginal Rate of
Substitution. It is always downward slopping.

39. 1. Indifference Curves Slope downward from Left to Right:
If the quantity of A increased in a combo, quantity of B reduced to
maintain same level of satisfaction.
Indifference curves can not be slope Upward, Horizontal or Vertical
like given in the diagrams A, B, C.
PROPERTIES OF INDIFFERENCE CURVES

40. 2. Indifference Curves are convex to the origin:
ICs are convex due to the principle of Diminishing Marginal Rate of
Substitution. Not like in diagrams A and B.

41. 3.Indifference curves are neither touch nor intersect each
other.
ICs represent different levels of utility, so they neither touch nor intersect
each other.

42. 4. Higher Indifference curves represent a higher level of
satisfaction:
IC that lies above to the right of the another curve represents a
greater satisfaction than that of the left.

43. 5. Indifference curves need not be parallel to each other:
MRS between the two commodities need not be the same in all
the Indifference Curves.

44. INCOME EFFECT
 If the income of the consumer changes, the effect it
will have on his purchases is known as the income
Effect.
The ICC curve has a positive slope throughout its
range. Here the income effect is also positive and
both X and Y are normal goods.

45. SUBSTITUTION EFFECT
 The substitution of one product for another when
there's a change in their relative pricing is known as
substitution effect.
 The relation between price and quantity demanded
being inverse, the substitution effect is negative.

46. PRICE EFFECT
 The price effect indicates the way the consumer’s
purchases of good X change, when its price
changes, while no change in price of Y.
 The above figure showing that the consumer will
buy more X than before as X has become cheaper.

47.  Reference: https://www.economicsdiscussion.net