Very Short Question Answer

Define utility.

Utility is defined as the human wants satisfying power of the commodity. It is the subjective concept, which changes person to person, time to time and place to place.

What do you mean by cardinal utility approach?

Cardinal utility approach means that method of analyzing utility which believes that utility is quantitative concept and it can be measured numerically. Its unit of measurement is utils.

List out the assumptions of cardinal utility analysis.

The four assumptions of cardinal utility analysis are as follows:
i. Rational consumer
ii. Cardinal measurement of utility
iii. Constant marginal utility of money
iv. Diminishing marginal utility
v. Independent utilities

Define the concept of ordinal utility approach.

Ordinal utility approach is the method of analyzing utility as a subjective phenomenon. According to this concept, utility can not be expressed quantitatively. Utility can be ranked and put in order according to consumer’s preference.

Define indifference curve.

Indifference curve is defined as the locus of different combinations of any two goods which yields same level of satisfaction or utility. It is downward slopping and convex to the origin.

Write down assumptions of indifference curve analysis or ordinal utility analysis. Or, Write any four assumptions of indifference curve.

The four assumptions of ordinal utility analysis or indifference curve analysis are as follows:
i. Rational consumer
ii. Ordinal measurement of utility
iii. Diminishing marginal rate of substitution
iv. Transitivity and consistency in choice
v. Non-satiety

Short Question Answer

Why the Hicksian utility analysis is superior to the Marshallian utility analysis?

Hicksian utility analysis is regarded superior over the Marshallian utility analysis. The causes behind it are as follows:

i. More realistic measurement of utility: The measurement of utility by ordinal approach is more realistic. It does not measure utility in number as measured by cardinal utility analysis. It ranks the utility of different baskets of goods according to the preference of consumer.
ii. More general theory of demand: Ordinal utility analysis is regarded as the more general theory of demand. It can analyze Giffen paradox but cardinal utility analysis can not analyses Giffen paradox.
iii. Analysis of price effect: Ordinal utility analysis can explain price effect decomposing it into income and substitution effect. But cardinal utility analysis, can not analyze price effect decomposing it into income and substitution effect.
iv. Study of combination of two goods: The cardinal utility analysis studies only one commodity model. But in real life, a consumer consumes not only one commodity but combination of two or more commodities. The ordinal utility analysis or indifference curve analysis is two commodity model which gives importance on both commodities.
v. No assumption of constant marginal utility of money: The cardinal utility analysis assumes constant marginal utility of money. But ordinal utility analysis is not based on unrealistic assumption of constant marginal utility of money.
vi. Less restrictive: Cardinal utility analysis is based on too many assumptions but ordinal utility analysis is based on fewer assumptions.

What is price effect? Discuss effect of change in price of a Commodity on Consumer.

Price effect is defined as the change in purchase of goods due to change price of a commodity, other things remaining the same. In other words, it is t the change in consumer’s equilibrium position due to change in price of the commodity, other things remaining the same means income, taste, fashion e of the consumer remain constant.
Effect of Change in Price of a Commodity on Consumer Equilibrium :
When price of a commodity real income changes. Rise in price results fall in real income and fall in price results rise in real income. If price of a commodity falls, consumer moves from lower indifference curve to higher indifference curve and versa-versa. It depends on the nature a commodity. It has been shown in the following figures.

In the diagram, X-axis shows quantities of good-X and Y-axis shows quantities of good-Y. AB is the initial budget. The initial budget line AB is tangent to the indifference curve IC, at point E₁. The point E₁ is the initial equilibrium point. The consumer is in equilibrium by consuming OX, quantities of good-X and OY, quantities of good-Y. Let us suppose, price of good-x decreases. Consequently, the initial budget line AB swings towards right from AB to AB₁. The new budget line AB, is tangent to the higher indifference curve IC₂ at E2, which is new equilibrium point. The consumer is deriving higher satisfaction on the indifference curve IC₂ consuming OX2 quantities of ‘good-X and OY2 quantities of good-Y. This is known as the price effect. If we join successive equilibrium points E₁ and E2, we will get a curve, which is known as the price consumption curve (PCC). Here, price consumption curve is sloping downward from left to right because good-X and good-Y are substituted goods.

Define price effect, Income effect and substitution effect. Decompose price effect into Income and substitution effect.
OR, Decompose price effect into income effect and substitution effect.

Price Effect
Price effect is defined as the change in purchase of goods due to change in price of a commodity, other things remaining the same. In other words, it is the change in consumer’s equilibrium position due to change in price of the commodity. Other things remaining the same means income, taste, fashion et of the consumer remain constant.
Income Effect
Income effect is defined as the change in demand for a commodity due to change in income of the consumer. In other words, income effect is the change in consumer’s equilibrium due to change in income of the consumer. Income effect is positive in case of normal goods. Therefore, income consumption curve (ICC) is upward slopping in case of normal goods. Income consumption curve (ICC) is the curve which joins various equilibrium points of income effect
Substitution Effect
Substitution effect is defined as the increase in quantity of a commodity purchased as price of the commodity falls, after adjusting income so as to keep the real purchasing power of the consumer same as before. The adjustments on income is called compensating variation. It is shown by a parallel shift of the new budget line until it become tangent to the initial indifference curve. The purpose of the compensating, variation is to allow consumer to remain in the same level of satisfaction as before the price change. The substitution effects a part of price effect. In other words, price effect is the sum of income effect: and substitution effect.
Decomposition of Price Effect into Income and Substitution Effect
In the figure, x-axis represents quantities of good-x and y-axis represent quantities of good-y. The initial budget line is AB. This initial budget line AB tangent to the indifference curve IC₁ at point E₁. The point E₁ is the initial equilibrium point. Let us suppose, the price of good-x falls. Consequently, income of the consumer increases. In this situation, the budget AB shifts AB₁ i.e. towards right. The new budget line AB₁ is tangent to the ne indifference IC2 at point E₂ which is new equilibrium point.

 

The movement from E₁ to E₂ is called price effect. This price effect is the sum of income effect and substitution effect. In order to separate price effect into income and substitution effect, we draw a parallel line, which is called compensating variation, to the new budget line AB₁ until when it becomes tangent to the initial indifference curve IC₁. The compensating variation is MN. It is tangent to the IC₁ at point E3. The consumers get same level of satisfaction to point E3 as in E₁. The movement from E3 to E2 is call income effect and movement form E1 to E3 is called substitution effect.
In the figure,
Price effect = X₁X₂
Income effect = X3X2
Substitution effect = X₁X3
Price effect = Income effect + Substitution effect
X₁X₂ X3X2 + X₁ X3

Derive demand curve using cardinal utility approach.

Demand curve shows the inverse relationship between price of a commodity and its quantity demanded. According to cardinal utility approach, consumer’s equilibrium can be shown as follows:
MUX = Px …………..(i)
where
MUX = Marginal utility of good-X
Px = Price of good-X
In the cardinal utility approach, marginal utility of money is assumed to be constant. Using this conditions, we can derive demand curve as follows:
According to the cardinal utility approach, marginal utility of good-x decreases continuously and becomes negative beyond a point. In the figure (i) x-axis represents marginal utility. Since, in cardinal utility approach measures marginal utility in monetary terms, the positive segment of the marginal utility curve is demand curve. At quantity X₁, marginal utility MU₁, at quantity X2, marginal utility is MU₂ and at quantity X3, marginal utility is MU3. Since, marginal utility is decreasing with rise in quantity consumed, the marginal utility curve (MU) is slopping downward. In the figure (ii), x-axis represents quantity and y-axis represent price of commodity. At quantity X₁, marginal utility is MU₁ which is equal to price P₁. At quantity X2, marginal utility is MU2 which is equal to price P2 and at quantity X3, marginal utility is MU3 which is equal to price P3. It means that at price P₁, P2 and P3, the consumer purchases X₁, X2 and x3 quantities of good-x. On the basis of this negative relationship between price and demand, we have derived demand curve Dx in the figure (ii).

Long Question Answer

What do you mean by cardinal utility approach? List out the assumptions of cardinal utility analysis. Derive demand curve using cardinal utility approach.

Cardinal utility approach means that method of analyzing utility which believes that utility is quantitative concept and it can be measured numerically. Its unit of measurement is utils.
The four assumptions of cardinal utility analysis are as follows:
i. Rational consumer
ii. Cardinal measurement of utility
iii. Constant marginal utility of money
iv. Diminishing marginal utility
v. Independent utilities
Demand curve shows the inverse relationship between price of a commodity and its quantity demanded. According to cardinal utility approach, consumer’s equilibrium can be shown as follows:
MUX = Px (i)
where
MUX = Marginal utility of good-X
Px = Price of good-X
In the cardinal utility approach, marginal utility of money is assumed to be constant. Using this conditions, we can derive demand curve as follows:

According to the cardinal utility approach, marginal utility of good-x decreases continuously and becomes negative beyond a point. In the figure (i) x-axis represents marginal utility. Since, in cardinal utility approach measures marginal utility in monetary terms, the positive segment of the marginal utility curve is demand curve. At quantity X₁, marginal utility MU₁, at quantity X2, marginal utility is MU₂ and at quantity X3, marginal utility is MU3. Since, marginal utility is decreasing with rise in quantity consumed, the marginal utility curve (MU) is slopping downward. In the figure (ii), x-axis represents quantity and y-axis represent price of commodity. At quantity X₁, marginal utility is MU₁ which is equal to price P₁. At quantity X2, marginal utility is MU2 which is equal to price P2 and at quantity X3, marginal utility is MU3 which is equal to price P3. It means that at price P₁, P2 and P3, the consumer purchases X₁, X2 and x3 quantities of good-x. On the basis of this negative relationship between price and demand, we have derived demand curve Dx in the figure (ii).

 

Define indifference curve.. Define price effect, Income effect and substitution effect. Decompose price effect into Income and substitution effect.
OR, Decompose price effect into income effect and substitution effect.

Indifference curve is defined as the locus of different combinations of any two goods which yields same level of satisfaction or utility. It is downward slopping and convex to the origin.

Price Effect
Price effect is defined as the change in purchase of goods due to change in price of a commodity, other things remaining the same. In other words, it is the change in consumer’s equilibrium position due to change in price of the commodity. Other things remaining the same means income, taste, fashion et of the consumer remain constant.
Income Effect
Income effect is defined as the change in demand for a commodity due to change in income of the consumer. In other words, income effect is the change in consumer’s equilibrium due to change in income of the consumer. Income effect is positive in case of normal goods. Therefore, income consumption curve (ICC) is upward slopping in case of normal goods. Income consumption curve (ICC) is the curve which joins various equilibrium points of income effect

Substitution Effect
Substitution effect is defined as the increase in quantity of a commodity purchased as price of the commodity falls, after adjusting income so as to keep the real purchasing power of the consumer same as before. The adjustments on income is called compensating variation. It is shown by a parallel shift of the new budget line until it become tangent to the initial indifference curve. The purpose of the compensating, variation is to allow consumer to remain in the same level of satisfaction as before the price change. The substitution effects a part of price effect. In other words, price effect is the sum of income effect: and substitution effect.
Decomposition of Price Effect into Income and Substitution Effect
In the figure, x-axis represents quantities of good-x and y-axis represent quantities of good-y. The initial budget line is AB. This initial budget line AB tangent to the indifference curve IC₁ at point E₁. The point E₁ is the init equilibrium point. Let us suppose, the price of good-x falls. Consequently, income of the consumer increases. In this situation, the budget AB shifts AB₁ i.e. towards right. The new budget line AB₁ is tangent to the ne indifference IC2 at point E₂ which is new equilibrium point.

The movement from E₁ to E₂ is called price effect. This price effect is the sum of income effect and substitution effect. In order to separate price effect into income and substitution effect, we draw a parallel line, which is called compensating variation, to the new budget line AB₁ until when it becomes tangent to the initial indifference curve IC₁. The compensating variation is MN. It is tangent to the IC₁ at point E3. The consumers get same level of satisfaction to point E3 as in E₁. The movement from E3 to E2 is call income effect and movement form E1 to E3 is called substitution effect.
In the figure,
Price effect = X₁X₂
Income effect = X3X2
Substitution effect = X₁X3
Price effect = Income effect + Substitution effect
X₁X₂ X3X2 + X₁ X3

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