4. Consumer’s behavior: the cardinal utility theory

Cardinal utility theory, also known as marginal utility theory is used to analyze behavior of rational consumer. By rational consumer we mean the one who attempts to get the best value for money from his or her purchases.

People buy goods and services to get satisfaction from them. This satisfaction is called utility.

An important distinction must be made between total utility and marginal utility.

Total utility is the total satisfaction a person gains from all those units of a commodity consumed within a given time period.

Marginal utility is the additional satisfaction gained from consuming one extra unit within a given period of time.

Utility is subjective as we never know that people experience the same utility from the same goods. However, the utility in this theory is measured in utils.

Diminishing marginal utility

The more of a commodity is consumed in a period, the less is satisfaction, or utility, we get out of each additional, or marginal, unit. When satisfaction grows each additional unit of a commodity brings less and less satisfaction. This is the principle of diminishing marginal utility.

Total and marginal utility curves

The MU curve slopes downwards. This is the illustration of the diminishing marginal utility.

The TU curve starts at the origin. Zero consumption yields zero utility.

TU reaches its peak when MU is zero, there is no addition to total utility.

Marginal Utility can be derived from the TU curve. It is the slope of the line joining 2 adjacent quantities on the curve.

The slope of the line is given by the formula:

Consumer choice is rational when TU is maximized, or MU=0, all else equal.

The Ceteris Paribus Assumption

The graph above is driven under assumption that other things do not change. In fact they do change.

The choice of consumption depends on the availability of substitutes and compliments to the goods consumed.

If the consumption of other goods – whether substitutes or compliments – change, a new utility schedule will have to be drawn up. The curve would shift. Utility is not a property of the good, it is in the mind of the consumer, and consumers change their minds.

The optimum level of consumption

The optimum level of consumption is the amount of goods that a person should consume to make the best of their limited income. This problem needs to measure the utility. To do this we may use money. This means that utility becomes the value that people place on their consumption. The marginal utility is the amount of money a person is prepared to spend to obtain one more unit – the extra worth of a unit.

To denote the optimum level of consumption we should introduce a notion of consumer surplus.

Marginal consumer surplus

Marginal consumer surplus is the difference between what one is willing to pay for one more unit of a good and what it really costs him.

MCS = MU – P

Total Consumer Surplus

Total Consumer Surplus is the sum of all marginal consumer surpluses that one have obtained from all the units of a good one have consumed. It is the difference between the total utility and from all the units and the expenditures on them.

TSC = TU – TE

Marginal utility and the demand curve

An individual demand curve for any good will be the same as their marginal utility curve for that good, where utility is measured in money.

The market demand curve. The price elasticity of demand will reflect the rate at which MU diminishes. If there are close substitutes for a good, it is likely to have an elastic demand, and MU will diminish slowly as consumption increases.

Rational consumer behavior

The rational consumer behavior is known as equi-marginal principle. This states that a consumer will get the highest utility from a given level of income when the ratio of the marginal utilities equals the ratio of the prices.

This is when for any pair of goods A and B, that are consumed:

This equation would satisfy multi-commodity model too. This equation would be fair for all other goods (C, D, E, etc).

If the price of A falls, such that:

, the one would buy more of A and less of any other good, until the point when the equation will be satisfied.

Budget constraint-shows what an individual can afford and is determined by the individual’s income and prices of goods.