Ordinal and Cardinal Utility - Essay Example

UTILITY THEORY Student’s Name Course Professor’s Name University Date Utility Theory Consumer behavior is one area of interest to many economists and business scholars. One aspect of consumer behavior that receives a lot of attention is the Utility theory. Utility is the satisfaction that a consumer derives from the consumption of a good or service. In other words, Utility is the power of goods and services to satisfy the wants of consumers (Kapteyn, 1985). For any business to remain relevant and continue enjoying profits there is a need for an intricate understanding of utility theory. Study and understanding of Utility theory are therefore of paramount importance for any business and economics student. For one to effectively display the understanding of utility theory, examples are a necessary aid in explaining the various concepts. In this paper, rice (used interchangeably with Nasi Lemak; meal made from rice) and wheat flour (used interchangeably with cake; meal made from wheat flour) will be used in explaining the various concepts in utility theory. Utility gotten from rice or wheat flour is the satisfaction derived from consumption of meals prepared using rice or wheat flour respectively. Since the two goods are foodstuffs, the consumer can only indicate the level at which their wants are satisfied once the goods are ingested. Even if a consumer indicates that they prefer one over the other, the meaning will be understood that the consumers get more satisfaction from meals prepared from that good over the meals of the other good. To begin with, it is important to analyze the various characteristics of utility. These characteristics are: a) Utility is an introspective or psychological term. By referring to utility as a psychological term, the intended meaning is that utility is defined by the mental attitude of the consumer toward a good or service. The experiences of a consumer will, therefore, play a significant role is a selection of a good or service. This psychological aspect of utility means that the utility derived from consumption of a good or service differs from one consumer to another (Milonakis, and Fine, 2009). For example, Nasi Lemak is a dish prepared from rice. Two consumers, Rania and Alan, are presented with the meal. Nasi Lemak is Rania's favorite meal while Alan is not such a fan. The utility derived by the two consumers of rice in the form of the meal Nasi Lemak is different. Rania is deriving more satisfaction (utility) from consuming the meal than Alan. This difference is all in the mind where psychological aspects of liking and disliking a good or service are developed. Every consumer has different likes and dislikes hence the difference in utilities derived from consumption of the same good or service among consumers. b) Utility is relative and different among individuals. Time and place play an important role in determining the utility derived from the consumption a good or service (Sippel, 1997). Take the example of Rania who loves Nasi Lemak. Despite her love for this meal, the utility she derives from consumption is affected by time. If she prefers to consume Nasi Lemak at breakfast and not at lunch, then the utility derived is different at the two time periods. Utility derived from taking the meal during a bus ride will also differ from the utility that Rania will derive if she is to take the meal in the comfort of her home. Place, like time, does also determine utility derived from consumption of the same good. c) Utility does not consider ethical or moral rules. Deriving satisfaction does not matter whether you are morally right or wrong. Take for example a knife. In the hands of a chef, it is an important tool in the preparation of food and utility is derived once the food is ready. In the hands of an assassin, the knife can be used to kill somebody and still elicit satisfaction. The use of the knife in the kitchen is considered morally right while the use of the same knife to kill somebody is morally wrong yet utility is derived from the two acts. Utility, therefore, has no moral consideration. d) Utility is not essentially equal with usefulness. There exist several commodities from which utility may be derived, but these commodities are not necessarily beneficial to the consumers. Tobacco/cigarette is a very good illustration. Despite the health hazards associated with cigarette smoking, smokers still derive utility/satisfaction from the consumption of cigarettes. The same scenario can be extended to the topic of junk food. It is therefore clear that utility drives demand and not usefulness. Difference between Utility and Pleasure A consumer may get utility from the consumption of a good or service without necessarily gaining pleasure from the consumption. Take an injection in a hospital or even surgery. Despite the unpleasant nature of the aforementioned services, utility regarding getting better is still obtained. Since the onset of studies in utility theory, there have emerged two classes of scholars who have contributed substantially in this field. These two classes are neo-classical economists and modern economists. The differing views of the two groups of scholars have resulted in the development of two types of utility namely; cardinal utility and ordinal utility. An analysis of the difference between the two types of utility is thus significant. Definition. Cardinal utility is defined as the form of utility where utility is measured discretely hence can be expressed numerically. On the other hand, the ordinal utility is defined as the utility whereby consumer satisfaction is measured regarding preferences. Measurement. In any discussion of the differences between cardinal and ordinal utilities, the issue of measurement tends to take center stage. In cardinal utility, neo-classical economists front the units "utils" as a measurement of utility. Taking into account the example of Rania and Alan, Rania can argue she gets 70 utils from rice meals and 30 utils from flour meals while Alan may argue that he gets 40 utils from rice meals and 60 utils from meals made from wheat flour. However, modern economists argue that it is impossible to quantify utility. In the ordinal utility theory, modern economists argue that one can only rank utility derived from different goods. Ranks are therefore the measurement used in ordinal utility. In simpler terms, one can only state that there got more satisfaction from one good than they got from the other good or they got equal satisfaction from any two goods. Rania, therefore, can only say that rice meals give her more satisfaction than wheat flour meals which is the reverse for Alan. In ordinal utility, the order of preference is important in determining which goods bring more satisfaction. Core ideas. In the discussion of cardinal utility, the main idea that is addressed is utility itself. Utility is broken down to total utility, average utility and marginal utility. In addressing marginal utility, the law of diminishing marginal utility suffices. In the ordinal utility theory, the core idea that is addressed is the analysis of indifference curves. Indifference curves trace the area where consumers do not show any preference in a bundle of goods/services. In the ordinal utility theory, the issue of marginal rate of substitution is addressed. Reality. Regarding the reality in the business and economic world, the cardinal utility is less realistic than ordinal utility. Most consumers rank the satisfaction from consumption of goods and services from their preferences. It is a common occurrence to hear consumers comment, " I prefer this over that" thus effectively ranking the utility derived from consumption of the two goods (Rubinstein, 2012). In contrast, it is rare or even nonexistence to hear consumers commenting on how many utils they derive from consumption of different goods/services. Cardinal Utility As indicated, the cardinal utility is the utility theory that leans toward quantitative measurement of utility regarding utils. Some of the main aspects of utility in cardinal utility are total utility and marginal utility. In the example of Rania, she may prefer rice because the utils from rice are more than double those of wheat. Rania's total utility from eating Nasi Lemak is seventy, but the utility of the first unit is fifteen, the second unit is thirty-five, the third unit is forty-seven, the fourth unit is fifty-seven, fifth unit is sixty-five, the sixth unit is seventh, and the seventh unit is still at seventy (the units are in terms of helpings). Total utility is the whole utility derived from eating the whole Nasi Lemak meal by Rania (completing all her helpings/units) (Keen, 2001). Quantity/helpings by Rania Total utility for Rania Marginal utility for Rania 1 15 15 2 35 20 3 47 12 4 57 10 5 65 8 6 70 5 7 70 0 On the other hand, the increase in total utility gotten from consumption of an extra unit of a good is referred to as marginal utility. For Rania, her marginal utility in the first bite is fifteen while those of the second and third helpings are twenty and twelve respectively. Marginal utility is, therefore, the change in total utility divided by the change in quantity. From Rania's example, it is clear that marginal utility increased up to the second bite then reduced (Stretton, 1999). This is known as the law of diminishing marginal utility. The law indicates that Rania's marginal utility will increase up to a certain point from whence it will start to decrease with a further increase in the quantity consumed. Rania finally got so full that extra consumption did not bring any utility in the end. Consumer equilibrium under cardinal utility Despite the theoretical assumptions that the goods are supplied free of charge and consumers can consume goods until their total utility is realized, this is not the case on the ground. Consumers are faced with financial constraints and have to adopt a position of equilibrium. Marginal utility indicates how eager the consumer is for another unit and thus how much they are willing to pay for the extra unit. In the Case of Rania, where she is only consuming Nasi Lemak and only the cost of rice matters, she will achieve equilibrium only when her marginal utility equals the price. If the price per unit of rice is RM8, then Rania's equilibrium is at the fifth unit of consumption. If Rania was eating a helping of both Nasi Lemak and a piece of cake and only the prices of rice and wheat flour mattered, then Rania's equilibrium occurs only when marginal utility for Nasi Lemak divided by its price equals the marginal utility of consuming cake divided by its price (MUnl/Pnl=MUc=Pc) Quantity/helpings by Rania Rania’s MU for Nasi Lemak Price for rice=price for Nasi Lemak MU/P Rania’s MU for cake Price for cake=price for flour MU/P 1 15 8 1.875 5 5 1 2 20 8 2.5 6 5 1.2 3 12 8 1.5 8 5 1.6 4 10 8 1.25 7 5 1.4 5 8 8* 1 3 5 0.6 6 5 8 0.625 1 5 0.2 7 0 8 0 0 5 0 *Rania's equilibrium for Nasi Lemak (rice) consumption only. Rania's equilibrium when she takes both Nasi Lemak and cake is when Rania takes five helpings of Nasi Lemak and one slice of cake since MUnl/Pnl=MUc=Pc=1. The budget will be RM45. Ordinal utility The ordinal utility has been identified as the theory of utility that uses ranks to identify which goods/services the consumer prefers over other goods. As earlier indicated, the analysis of indifference curves is vital in understanding ordinal utility. The path (connection of different combinations) traced by combinations of two goods/services which yield the same amount of satisfaction is the indifference curve. Nasi Lemak 6 a b Indifference curve. c d 1 2 4 6 Cake. Indifference curves are negatively sloped because Rania will have to give up some of Nasi Lemak to gain some cake to remain in the same indifference curve (Knetsch, 1989). At point (a), Rania is consuming a lot of Nasi Lemak. At point (b), however, Rania loses more units of Nasi Lemak and gains few units of cake. This is because she derives more utility from the extra units of cake than she derives from the excess units of Nasi Lemak. As one comes down the indifference curve, fewer units of Nasi Lemak are derived from by more units of cake as Rania needs more units of cake to replace the units of Nasi Lemak to stay on the same indifference curve. This shows imperfect substitution hence the diminishing marginal rate of substitution. Consumer equilibrium under ordinal utility When analyzing the equilibrium, the concept of a budget line comes to mind due to the financial constraints faced by Rania and other consumers. A budget line is a curve that shows the combinations of goods/services that can be purchased at a given income. Budget line shows the affordability of choices and priorities made by a consumer. Equilibrium is therefore attained when the budget line is tangent to the indifference curve (Fullbrook, 2004). NL Rania’s equilibrium Rania’s indifference curve Rania’s budget line Cake Summary Utility is the satisfaction that a consumer derives from consuming a good or service. Some characteristics of utility include the psychological nature of utility, the indifference towards morality and the relativity of utility. There are two theories of utility which are ordinal and cardinal utility. Cardinal utility focuses on discrete measurement of utility while ordinal utility focuses on the ranking of preferences on goods. In the cardinal utility theory, the main focus is on total utility and marginal utility while ordinal utility mainly focuses on indifference curve and budget line analysis. References Fullbrook, E. ed., 2004. A guide to what's wrong with economics. Anthem Press. Kapteyn, A., 1985. Utility and economics. De Economist, 133(1), pp.1-20. Keen, S., 2001. Debunking economics: The naked emperor of the social sciences. Zed Books. Knetsch, J.L., 1989. The endowment effect and evidence of nonreversible indifference curves. The American Economic review, 79(5), pp.1277-1284. Milonakis, D. and Fine, B., 2009. From political economy to economics: Method, the social and the historical in the evolution of economic theory. Routledge. Rubinstein, A., 2012. Lecture notes in microeconomic theory: the economic agent. Princeton University Press. Sippel, R., 1997. An experiment on the pure theory of consumer's behaviour. The Economic Journal, 107(444), pp.1431-1444. Stretton, H., 1999. Economics: A new introduction. Pluto Press. Read More