Lecture 08

Unit No.2- Demand Analysis Lesson No.-8 Utility Approaches to the Theory of Demand

Learning Outcomes

After reading this lesson you shouldUnderstand various approaches to the theory of demand. Understand the chief characteristics of ordinal and cardinal approach. Distinguish between ordinal and cardinal approach. Analyze the demand structure based on Cardinal approach. Prepare a schedule to indicate the Law of Diminishing Marginal Utility. Derive demand curve by Cardinal Approach.

Introduction Students, in the last lesson we has seen the Law of Demand. ‘What does it state?’ It states the inverse relation between the price of a commodity and its quantity added. This Law of Demand was been explained by various economist in their own ways. These explanations are known as the approaches to explain the Law of Demand . Approaches

Cardinal (by Marshall)

Ordinal (by Hicks)

Pragmatic App. to DD analysis

Both these approaches states that the demand for any product is based on the utility of that commodity. However, there are certain fundamental differences. Before going into the differences let’s understand both the approaches first.

Cardinal Approach This is a traditional approach and examines the consumer behaviour solely on the utility consideration. (For basic terms read appendix) Law of Diminishing Marginal Utility : It states that “Other things remaining the same, as a consumer increases his consumption of goods, the Marginal Utility eventually starts declining”. Suppose, you are extremely thirsty, a glass of water certainly will have a high Marginal Utility. However, after 2 or 3 glasses of water the Marginal Utility inevitably starts falling and Marginal Utility of 5 or 6 glasses of water at a time may prove to be negative. Utility schedule : Quantity

T.U.

M.U.

2

8

---

3

18

10

4

26

8

5

31

5

6

33

2

7

33

0

8

32

-1

Activity:Draw T.U. and M.U. curves taking quantity on x-axis.

Derivation of DD curve Demand curve can be derived TU from MU curve. According to the diagram given below , MU curve starts at point A and becomes negative at point D. The lower panel suggests that for 2 units the buyer is ready to buy at Rs.

10/-. However, as the MU falls the buyer’s willingness reduces to buy the commodity reduces resulting into decline in the price. Diagram (P.T.O.) TU, MU TU A B C D MU

Qty

D Price

D Qty

Demand curve can be derived TU from MU curve. According to the diagram MU curve starts at point A and becomes negative at point D. The lower panel suggests that for 2 units the buyer is ready to buy at Rs. 10/-. However, as the MU falls the buyer’s willingness reduces to buy the commodity reduces resulting into decline in the price. Limitations •

It is based on the unrealistic assumption of cardinal measurement of utility. Utility is a psychological term which can not be measured in terms of numbers and units.

•

It is applicable only for one commodity.

•

It does not explain the impact of the complementary and substitute goods on the demand.

•

It can not explain the impact of changes in the income on demand.

Activity: Analyse and list some more limitations of this approach.

Ordinal Utility Approach In order to overcome the limitations of the cardinal utility approach Hick gave a new treatment to the theory of demand. According to this approach instead of measuring the utility in terms of the number, given a choice from the “basket of commodities” a consumer can rank the commodities according to their preferences. The higher order of preference is given to the commodity which will give a higher utility. Thus this theory is also know as the ‘revealed preference theory’. This approach is explained with the help of “indifference curve analyis”. 1) Indifference curve Indifference curve is the focus of points at which the combination of goods gives the same amount of utility (level of satisfaction). For e.g. – if I am consuming two commodities, viz. mangoes and oranges. Schedule: Combination

Mangoes

Oranges

1

10

2

2

8

3

3

6

4

4

4

5

5

2

6

Diagram:

Com Y

IC

Com X

All the above combinations will give me same level of utility. Whether I consume 10 mangoes and 2 oranges or 6 mangoes and 4 oranges, my level of satisfaction is the same. Naturally the consumer is different in any of these combinations. That is why the above downward sloping curve is known as the “indifference curve”.

2) Budget Line The amount of goods a consumer can buy is constrained by the income. This budgetary constraint can be shown by the budget line. Suppose, I have Rs. 100/- to spend on buying fruits. I may buy mangoes or oranges. Pm = Price of mangoes = Rs. 20/Po = Price of oranges = Rs. 10/(Pm x Qm)

+

(Po x Qo)

=

Total Income

20

x5

10 x 0

100

20

x4

10 x 2

100

20

x3

10 x 4

100

20

x2

10 x 6

100

20

x1

10 x 8

100

Diagram According to the above Table we can buy any of the combinations. 4 mangoes and 2 oranges or 2 mangoes and 6 oranges will result into complete utilization of my budge

Qty of O

Qty of M

According to the above Table I can buy any of the combinations. 4 mangoes and 2 oranges or 2 mangoes and 6 oranges will result into complete utilisation of my budget. Consumer equilibrium Diagram The consumer is in the equilibrium where the indifference curve is tangent to the budget line. According to the diagram given below, the equilibrium is at point E.

Qty of O

C

F E IC 3 IC 2 D IC 1 Qty of M

Activity:Analyse why C, D or F point are not the point of equilibrium.

Points to pointer Slide 1

___________________________________

Why do you need a commodity

___________________________________ ___________________________________

A commodity is needed because of the following reasons: to satisfy our want To have happiness To have pleasure

___________________________________ ___________________________________ ___________________________________ ___________________________________

___________________________________

Slide 2 Meaning of utility

___________________________________

it’s a want satisfying capacity of a commodity

___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________

___________________________________

Slide 3 Utility approaches

___________________________________

two types of utility approaches: Cardinal approach Ordinal approach

___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________

Slide 4

___________________________________ Cardinal approach its based on the assumption of the cardinal measurement of utility. Its coined by neo-classical economist “Marshall”.

___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________

___________________________________

Slide 5 ordinal approach Its coined by modern economist “J.R HICKS” Based on the assumption of ranking of utility according to the preferences. Example: more than, less than, equals to, etc.

___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________

___________________________________

Slide 6 Difference between cardinal and ordinal approaches Difference between cardinal approach and ordinal is that “according to cardinal approach utility can be measurable in numeric terms and according to the ordinal utility can’t be measurable in numeric terms .

___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________ ___________________________________