FACULTY OF BUSINESS & MANAGEMENT

SEPTEMBER 2015

BBEK1103

PRINCIPLES OF MICROECONOMICS

NAME : SARPRIT KAUR D/O PARITAM

SINGH

MATRICULATION NO : 880415085842001

IDENTITY CARD NO. : 880415-08-5842

TELEPHONE NO. : 016-2362506

E-MAIL : sarprit_kaur@oum.edu.my

LEARNING CENTRE : NEGERI SEMBILAN

BBMP1103

Table of contents Pages

Choice and Utility Theory......................................................................................................... 1

Cardinal Utility Theory………………………………………………………………….....… 2

Total Utility and Marginal Utility………….…...……………………………….………....… 3

The Law of Diminishing Marginal Utility………………………….………………...……… 5

Ordinal Utility Theory…………………………………………………………..……….…… 6

Difference between Cardinal and Ordinal Utility..................................................................... 7

Consumer Equilibrium.............................................................................................................. 8

Indifference Curve................................................................................................................... 11

Budget Line............................................................................................................................. 12

Conclusion............................................................................................................................... 15

Bibliography............................................................................................................................ 16

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Choice and Utility Theory

The utility theory is considered as one of the important element in the economic sector.

The concept of “utility” was introduced to the social thought by Jeremy Bentham in the year

1789 and in the economics thoughts by Stanley Jevons in 1871. According to Jeremy Bentham,

society should be organized on the principle of utility which he defined as the “property in any

object that gives pleasure or happiness”. According to Stanley Jevons “The theory of economics

must begin with a correct theory of consumption”. The utility theory can be defined as the power

of satisfaction gained by the consumers from consumption of the goods purchased by the

consumer. Consumer choice can be divided into three stages. In the first stage, the importance is

given to the satisfaction level that a consumer gains from consuming a good. The second stage is

the price that the consumer willing to pay for it and the third stages are the income that is

available for the consumer to fulfill their choice. Consumer evaluates a good based on the level

of utility gained by the consumer from the consumption of the goods. Therefore, the utility

theory can be divided into two which are the cardinal approach and the ordinal approach. The

classical and neo-classical holds a different point of view on the ability of the utility to be

measured in certain terms. The classical and neo-classical economics believes that the utility can

be measured cardinally in the form of a number. For example, eating a pizza gives 4 utils, while

eating popcorn gives 2 utils. In the other hand, the modern economists believe that the utility can

be measured ordinarily which can be seen in the term of comparison. For example, eating a pizza

gives more satisfaction compared to eating popcorn.

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Cardinal Utility Theory

The cardinal theory was developed by neo-classical economists like Alfred Marshall, Leon

Walrus and Carl Meneger. According to these economists, the cardinal utility theory can be

measured. Here it implies that utility can be quantified. In the cardinal theory, the unit used to

measure utility is known as “util”. The term “util” was given by Leon Walrus. The assumptions

in the cardinal utility theory can be analyzed as the consumer is assumed to be rational. The

consumer seeks to maximize satisfaction from the good based on the value of money. For

example, according to the cardinal utility theory, a consumer will gain 4 utils by eating a pizza

meanwhile eating popcorn will gain only 2 utils. This reflects that a pizza gives double utility

compared to popcorn. This shows that consumer’s utility can be measured in the form of a

number. The utility level is normally seen through the willingness of a consumer to pay based on

the value of money. The higher the amount of price willing to be paid, the higher level of

satisfaction will be gained by the consumer. The cardinal utility also is known as independent

utilities because a consumer doesn’t depend to other goods to gain more satisfaction. For

example, a consumer who chooses to consume a pizza to gain a higher level of utility when the

consumer is hungry as the satisfaction level can be maximized from the consumption of a pizza.

In the cardinal utility theory, the diminishing marginal utility can be seen through the more piece

of pizza consumed constantly by the consumer at one time, the level of satisfaction will keep

decreasing. For example, when a consumer is hungry and constantly consume a piece of pizza

but at a stand when the consumer is less hungry the consumption level of a piece of pizza will

start to decrease and the satisfaction level will continue to decrease as well.

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Total Utility and Marginal Utility

The utility theory can be divided into two basic concept which are known as the total

utility and the marginal utility. The total utility (TU) can be defined as the total satisfaction

gained by the consumer from the given level of consumption of a good. Meanwhile the marginal

utility (MU) can be defined as the increasing total of utility when the consumption of the good

increases by per unit. The formula to calculate marginal utility is per below:

Table 1.1 shows the relationship between the total utility and the marginal utility based on

the consumption of a piece of pizza when the consumer is hungry.

Quantity (Q) Total Utility (TU) Marginal Utility (MU)

1 4 4

2 16 12

3 24 8

4 30 6

5 32 2

6 32 0

Table 1.1

Therefore, the marginal utility for the first unit is equivalent to the total utility of that unit

while for the second unit is 12 (16-4) utils and follow by the other quantity. When we add up the

marginal utility up to 5 level of consumption, we will get 32 utils which equivalent to the total

utility of the piece of pizza consumed by the consumer.

MU = Change In TU Change In Q

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Figure 1.1

Figure 1.1 is the illustration of the total utility and the marginal utility derived from Table

1.1. In this figure, we can observe that the marginal utility is equivalent to the slope of the total

utility at each consumption of a piece of cake. As we can observe, at the first piece of pizza the

total utility gained from the consumption is 4 utils. At the second piece of pizza, the total utility

gained by consumer is 16 utils. At the third piece of pizza, the total utility gained by the

consumer is 24 utils. At the fourth piece of pizza the total utility gained by the consumer is 30

utils. At the fifth and six piece of pizza the total utility gained by the consumer is 32 utils. In the

total utility when the consumption of a piece of pizza increase by per piece, the satisfaction gain

by the consumer eventually increase. Based on the marginal utility, at the first piece of pizza the

marginal utility gained by the consumer is 4 utils. At the second piece of pizza, the marginal

utility gained by the consumer is 12 utils which is more compared to the first piece of pizza. At

the third piece of pizza the marginal utility decrease to 8 utils. At the fourth piece of pizza the

marginal utility decreases to 6 utils compare to the third piece of pizza. At the fifth piece of pizza

the marginal utility gained by the consumer decreases to 2 utils and at the sixth piece of pizza the

marginal utility gained by the consumer is zero. As a result, the total utility reaches a maximum

level when the marginal utility is zero.

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The Law of Diminishing Marginal Utility

The law of diminishing marginal utility means that the marginal utility gained from the

consumption of additional units will start to decrease after a certain level of consumption when

the amount consumed increases. Whenever a consumer interacts with a good, the consumer will

surely act in a way that demonstrates the order in which the consumer values the maximizing the

use of the good. Thus, the first unit of a good has always dedicated to the consumer’s most

valued utility, the second unit is dedicated to the second most valued utility and this slowly

decreased to the lower valued utility. For example, when an individual is hungry, a piece of pizza

will give a certain amount of satisfaction. After consuming the first piece of pizza, the individual

is still hungry a second piece of pizza will give a higher satisfaction level compared to the first

piece. But the third piece of pizza will decrease because the individual is no longer hungry. If the

satisfaction is measured in the term of ringgit, in which the marginal utility is MUs for a piece of

pizza is the sum of money the consumer willing to pay to get that piece. Therefore, when the

marginal utility decreases, the willingness to pay for the extra piece of pizza will also eventually

decrease.

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Ordinal Utility Theory

The ordinal utility theory is another term widely used in microeconomics. The ordinal

utility theory can be defined as the benefit or satisfaction gained by the consumer cannot be

measured in a quantitative form but can be measured in the form of comparison with the

consumption of other goods. In the ordinal utility theory, the consumer behavior in maximizing

satisfaction is depicted by an indifference curve. This approach is based on comparison with the

consumption of other good to determine the level of satisfaction. In this approach the consumer

is consider to be rational has the consumer will choose to maximize the level of satisfaction from

the source of income that the consumer has. The consumer is also considering being consistent in

his or her choice. Consumer will choose the choice of good which is consider priority because

the consumer can only choose one good at one time and will also consider the ability to pay for

the good.

Choice and Priority

In the economics, the choice does not depend on the price of the good or income. The

consumers choice might change but it is not based on the ability to pay. Even though the

consumer cannot afford to own a good at a time due to certain circumstance , this does not mean

that the consumer cannot like both good. Choice also determine the consumer unlimited wants

and need but since the consumer is rational the consumer will always choose a good that will

bring more benefit to the consumer. Priority is a contrary to choice. The consumer might have

their own choice or preferences, but the consumer will have to choose only one choice which

will become their priority. The consumer will use the concept of priority when facing various

choices and the ability to pay.

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Differences between Cardinal and Ordinal Utility Theory

The cardinal and ordinal utility which are the two theories used to explain the level of

satisfaction gained by the consumer from consuming a good or services. Therefore, there are a

number of differences between this two theories. The cardinal utility theory uses the quantitative

measurement method in where a consumer can use a number to measure their satisfactions level.

For example, a hungry consumer will gain 4 utils when consuming a pizza. Meanwhile, in the

ordinal utility theory uses the qualitative measurement method in where the level of satisfaction

gained by the consumer cannot be measured in the form of number but can used the ranking

system or the comparison level to explain the satisfaction level gained by the consumer. For

example, when a consumer is hungry and eats a pizza or popcorn to satisfy the hunger feeling it

will prove that the consumer gained more satisfaction level from consumption of pizza compared

to consumption of popcorn. In the cardinal utility theory, basically the consumer gain satisfaction

through the consumption of one good at a time. For example, when a consumer gain a level of

satisfaction form a pizza when the consumer is hungry. In the ordinal utility theory, the

consumer gain a level of satisfaction from the consumption form a combination of two or more

goods. For example, a consumer might gain a level of satisfaction from consuming a pizza or

popcorn when the consumer is hungry but the consumer will rank his or her choice by comparing

which item has given more satisfaction either a piece of pizza or popcorn.

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Consumer Equilibrium

Consumer equilibrium can achieved at the maximizing of satisfaction achieved by the

consumer from each consumption of good. Through the definition of demand, the consumer

is aware that the wants must be balance with the ability to pay. In order to maximizing

satisfaction, consumers are restricted by limited income and a price of goods. Consumer’s

objectives are achieved and the consumer are said to achieved consumer equilibrium when

the maximum utility can be gained in the certain sum of money or income. Consumer

equilibrium can be measured in the based on one good consumption or more then one. The

consumer equilibrium for the consumption of one good can be been seen through how the

consumer managed to maximize his or her satisfaction in a limited income. The suggestive

way to maximize satisfaction from a limited income is by measuring util in a monetary

value. The marginal utility becomes the sum of money willing to be paid to obtain an

additional unit of a good. For example, when a consumer is willing to pay RM 4 for an

additional piece of pizza which means the piece of pizza has MU = RM 4. This method is

only applied when the consumer is consuming one type of good. The utility is maximized

when the price is equivalent to marginal utility, as we can observe that the marginal utility

is representing the willingness to pay.

The concept of consumer equilibrium actually describe why a demand curve has a

negative gradient. The willingness of the consumer to pay for the good that the consumer

consume for the additional piece of pizza becomes lower when the consumer starts to

consume pizza more then one piece. Along with the demand curve, marginal utility is

equivalent to the price in where the consumer is at an optimum condition.

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Quantity (Q) Total Utility (TU) Marginal Utility (MU) Price (P)

1 4 4 4

2 16 12 4

3 24 8 4

4 30 6 4

5 32 2 4

6 32 0 4

Table 1.2

Table 1.2 represent the total utility, marginal utility and the price for a piece of pizza.

From the table we can observe that the consumer achieved the consumer equilibrium at the

first piece of pizza where the marginal utility is equivalent to the price of a piece of pizza.

This also proven that a hungry consumer gains more satisfaction when consuming a piece of

pizza. In the above table, we can observe that the consumer will remain to consume a piece

of pizza up to the fifth piece and once reached to the sixth piece of pizza, the marginal

utility will start to decease as the consumer will start to fell uncomfortable due to excessive

consumption of pizza.

Therefore when the consumer has a certain amount of income to purchase a pizza and

popcorn. As a rational consumer, he or she will choose to spend all the money to choose a

combination of good where the per unit price will be the same for the both pizza and

popcorn.

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MUx = MUy , where MU = marginal utility Px Py P = price

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If MUx > MUy the marginal utility gained from the consumption of a pizza (X)

Px Py

is more compared to marginal utility gained from the consumption of popcorn (Y) then as a

rational consumer, the consumer will increase the consumption of a piece of pizza because

the consumer will gain additional satisfaction for every ringgit that the consumer has spent

to buy a piece of pizza. Whereby the consumer will reduce the consumption of popcorn.

When there is a increase demand for a piece of pizza, the price for a piece of pizza will

eventually increase. At the same time, MUy the marginal utility gained from the

Py

consumption of popcorn becomes larger due to the less demand in the consumption of

popcorn.

On the other hand, if MUx < MUy the marginal utility gained from the consumption

Px Py

of popcorn. This happens because of the price of popcorn is expensive. This causes the

marginal utility and price for popcorn becomes smaller and the marginal utility and price for

a pizza is bigger. This both situation will remain until the marginal utility and price of a

pizza is equivalent to the marginal utility and price of popcorn.

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Indifference Curve

When choice involves only two goods which are pizza and popcorn an indifference

curve will indicate various combination which involves a piece of pizza and popcorn that

can give equal satisfaction to the consumer. For example as per Figure 1.2, if in

combination A a consumer can get 3 piece of pizza and 9 popcorn and in combination B a

consumer can get 3 piece of pizza and 6 popcorn. As a rational consumer, will choose

combination A because although the quantity of pizza is same in both combination but the

quantity of popcorn in combination A has more. If the consumer has a choice to choose

goods in combination C which contains 4 piece of pizza and 3 popcorn, in where the

quantity of popcorn is less compare to the quantity piece of pizza. A consumer will not be

able to make choice because the consumer may fell that both combination A and C can give

equal satisfactions.

Figure 1.2

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Budget Line

The budget line also plays an important role in analysis the difference curve as it

determines the actual choice that helps the consumer to make right choice. The budget line

is known as a curve that shows the combinations of two or more goods that can be

purchased by the consumer using a certain amount of income and based on the market price

of the good. For example, the consumer has allocated a sum of amount of RM 10 to spend

on pizza and popcorn where the price of a piece of pizza (Px) is RM 2 and popcorn (Py) is

RM 4. The combination of consumption that a consumer can afford to purchase is shown in

Table 4.3 and Figure 1.2

Combination Pizza Popcorn

A 5 0

B 4 2

C 3 4

D 2 6

E 1 8

F 0 10

Table 1.3 Combination of Budget

Figure 1.3 Budget Line 12

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As per Table 1.3 and Figure 1.3 if the consumer spend all the money to purchase a

pizza then the consumer will gain 5 piece of pizza and same goes when the consumer plan

to consume to purchase popcorn then the consumer will gain 10 units of popcorn. The

consumer can choose any of the combination that satisfies the rule I = Px pizza + Py

popcorn that is (I) is equivalent to the the total expenditure (Px Pizza + Py Popcorn).

Therefor if there is changes in the income in where the consumer has more income from

RM 20 to RM 30 and the price of pizza and popcorn remains same. In this case, the

consumer will get to consumer 6 piece of pizza and 2 popcorn.Therefore the budget line

will shift in parallel with the initial line because the relative price (gradient of the curve)

remains unchanged. Figure 1.4 represents the effect change in the income as per below :

Figure 1.4 The effect of change in income

Therefore, when there is a change in the price of pizza and popcorn it will effect the

budget line as well. As the consumer is aware that along the budget line, income (I) is

equivalent to the total expenditure (PxX + PyY). Hence, budget line cn be stated as the

following equation:

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I = PxX + PyY

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When Y (popcorn) is placed at the Y-axis, the equation can be written as :

Therefore, he price ratio Px / Py is the gradient of the budget line. If either one of the price

changes then the gradient of the curve will also change.

Figure 1.5 The effect of price change on the budget line.

In Figure 1.5 if the price of pizza is RM 2 and price of popcorn is RM 4 and the income is

RM 10, the budget line is the AA line in Figure 1.5 (a) .When the price of popcorn drops to

RM 2, the slope becomes steeper (AA’). This indicates that more popcorn can be bought

with the available income. The budget line intersects the popcorn axis at 10 unit of popcorn,

but with no changes on the pizza axis. If the pizza price decreases instead, the curve will

shift outside of the pizza axis.

3170 words

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Y = I - PxX Py

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Conclusion

In conclusion, we can see how the ordinal and cardinal utility theory has influence the

consumer to behave according to the Law of Demand. The consumer behavior is crucial in

the market of economy because there are many producer who always compete with each

other to attract consumers to buy their goods. In this both theories analysis, we get to see

how the consumer achieve the maximum satisfaction from the limited income. Besides that

we get to observe how the budget line changes if there is any changes in the price of the

goods. As a rational consumer, the consumer will choose the goods which will help the

consumer to gain more satisfaction from the consumption of the good which is within their

budget because the consumer is aware that every purchase made will take up a part of the

consumers limited income.

(3300 words)

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Bibliography:

An Introduction to the Principles of Morals and Legislation Oxford (1789).Jeremy

Bentham quoted “Property in any object that gives pleasure or happiness”. Retrieved

from http://polisci2.ucsd.edu/foundation/05Bentham1789.pdf

Principle of Microeconomics / Microeconomics 1. Second Edition December 2013.

Unzarina Ahmad Samidi, Norehan Abdullah, Jamal Ali, Zalina Mohd Mohaideen.

The theory of polictical economics. Stanley Jevon quoted “The theory of economics

must begin with a correct theory of consumption”. Retrieved from

http://www.econlib.org/library/YPDBooks/Jevons/jvnPE3.html

Difference between Cardinal and Ordinal Utility (30th April 2013).Retrieved from

http://www.differencebetween.com/difference-between-cardinal-and-vs-ordinal-utility/

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