Definition and Nature of Economics

Economics is that branch of social science which is concerned with the study of how
individuals, households, firms, industries and government take decision relating to the
allocation of limited resources to productive uses, so as to derive maximum gain or
satisfaction.

Simply put, it is all about the choices we make concerning the use of scarce resources that
have alternative uses, with the aim of satisfying our most pressing infinite wants and
distribute it among ourselves.

Nature of Economics

There is a great controversy among the economists regarding the nature of economics,
whether the subject ‘economics’ is considered as science or an art.

If it is a science, then either positive science or normative science.

1. Economics as a Science

Before we start discussing whether economics is science or not, it becomes necessary to have
a clear idea about science. Science is a systematic study of knowledge and fact which
develops the correlation-ship between cause and effect. Science is not only the collection of
facts, according to Prof. Poincare, in reality, all the facts must be systematically collected,
classified and analyzed.

There are following characteristics of any science subject, such as;

(i) It is based on systematic study of knowledge or facts;

(ii) It develops correlation-ship between cause and effect;

(iii) All the laws are universally accepted

(iv) All the laws are tested and based on experiments;

(v) It can make future predictions;

(vi) It has a scale of measurement.

A. Economics and Positive Science

The following statements can ensure economics as a positive science, such as;

(i) Logically based

The ideas of economics are based on absolute logical clarifications and moreover, it develops
relationship between cause and effect.

(ii) Labour Specialization

Labour law is an important topic of economics. It is based on the law of specialisation of

labour Economists must concern with the causes and effects of labour-division.

(iii) Not Neutral

Economics is not a neutral between positive and normative sciences. According to most
economists, economics is merely positive science rather than normative science.

B. Economics and Normative Science

The following statements can ensure economics as a normative science, such as,

(i) Emotional View

A rational human being has not only logical view but also has sentimental attachments and
emotional views regarding any activity. These emotional attachments are all coming under
normative statements. Hence, economics is a normative science.

(ii) Welfare Activity

Economics is a science of human welfare, All the economic forwarded their theories for the
development of human standard of living Hence, all the economic statements have their
respective normative views.

(iii) Economic Planning

Economic planning is one of the main instruments of economic development. Several

economists have given their personal views for the successful implementation of economic
plan. Hence, economics is coming under normative science.

All these lead us to the conclusion that ‘Economics’ is both positive and normative science. It
does not only tell us why certain things happen however, it also gives idea whether it is right
thing to happen.

2. Economics as an Art

According to Т.К. Mehta, ‘Knowledge is science, action is art.’ According to Pigou, Marshall
etc., economics is also considered as an art. In other way, art is the practical application of
knowledge for achieving particular goals. Science gives us principles of any discipline
however, art turns all these principles into reality. Therefore, considering the activities in
economics, it can claimed as an art also, because it gives guidance to the solutions of all the
economic problems.

Therefore, from all the above discussions we can conclude that economics is neither a science
nor an art only. However, it is a golden combination of both. According to Cossa, science and
art are complementary to each other. Hence, economics is considered as both a science as
well as an art.

Scope of Economics
Economists differ in their views regarding the scope of economics. The scope of economics’
is a broad subject and encompasses not only its subject matter but also various other things,
such as its scientific nature, its ability to pass value judgments, and to suggest solutions to
practical problems.

By making economics a human science, Robbins has unnecessarily widened the scope of the
subject. Thus, in accordance with the view of Robbins, economics would also study the
problem faced by Robinson Crusoe, who lives in an isolated island with no contact with the
rest of the world.

He has to face the problem of choice between work and leisure. He has to spend some time
for his survival — for collecting fruits and roots. He utilises the rest of his time in sleeping or
enjoying leisure. Thus, he has also to face the problem of distributing his time between
various ends. Thus, Robinson Crusoe has also to face the problem of choice and would surely
come within the purview of Robbins’ definition.

However, most modern economists, like R. G. Lipsey, Paul Samuelson Milton Friedman,
etc., held the view that, economics is not a human but a social science. Thus, economics
should not study the problem of choice faced by a single individual like Robinson Crusoe.

It should instead study the choice problem where it has a social impact, because man lives in
society and an individual often interacts with other members of society.

For example, price controls on Kerosine oil have the desired effect of reducing cooking
expenditures for some consumers, but they also reduce both conservation of Kerosene by
those consumers and the incentive of producers to bring more Kerosene to the market.

Other consumers will therefore be forced to rely more heavily on other more expensive
sources of energy pushing the prices of these energy sources upward. Thus, the controls also
generate an unintended result an increase in the energy costs for some consumers.

1. Subject Matter

If we take a broad view of the subject matter of economics we may say that, Economics is the
study of all phenomena relating to wealth and value. It is one of the social sciences that deal
with economic goods, the creation of wealth through the satisfaction of human wants, the
explanation of wealth, value and price, the distribution of income and the mechanism of
exchange and markets of an economy.

According to Robbins, economics is the study of the problem of using available factors of
production as efficiently as possible so as to attain the maximum fulfillment of society’s
demands for goods and services. The ultimate purpose of economic endeavour is to satisfy
human wants for goods and services.

The problem is that, whereas wants are virtually without limit, the resources—land, labour,
capital and organisation—available at any one time to produce goods and services, are
limited in supply, i.e., resources are scarce relative to the demands for them.

The fact of scarcity means that we must always be making choices. If, to take a simple
example, more resources are devoted to producing motor cars fewer resources are then
available for constructing roads or bridges or setting up schools and hospitals. Thus,
economics is a science of scarcity or is a study of the problems of scarcity.

However, economics does not study the behaviour of human beings in the way other subjects
like Physiology or Psychology study it. Economics is no doubt a Science, but it is not a pure
(exact) science like Physics, Chemistry.

2. Science or Art

For quite a long time there was controversy among economists as to whether it is a science or
an art. The members of the English classical school, such as Adam Smith, T. R. Mathus and
David Ricardo, held the view that it was a pure science whose task was just to explain the
cause of economic phenomena such as unemployment, inflation, slow growth or even trade
deficit.

According to classical writers, economics is simply the study of cause and effect relationship.

However, neo-classical and modern economists have pointed out that economics is both a
science and an art. Just to treat economics as a science is to rob it of its practical value. As
Keynes has commented, “Practical men……. are usually the slaves of some defunct
economist.” So, economics has both a theoretical side and a practical or applied side. In other
words, economics is no doubt a science, but it is both ‘light-bearing and fruit bearing’.

Inflation, unemployment, monopoly, economic growth, pollution, free markets versus central
planning, poverty, productivity and other current issues are all covered in the study of
economics. Economics is a problem- based social science, and the problems with which it is
especially concerned are among the central issues of our times.

Economics is relevant not only to the big problems of society, but also to the personal
problems, such as one’s job, wages, unemployment, the cost of living, taxes and voting.

3. Positive or Normative

Another controversial aspect of economics is whether it should be neutral or pass value

judgments. The members of the English classical school were of the opinion that economists
were not supposed to make any normative statement or pass any value judgment on the
desirability or otherwise of the economic decisions.

Some later members of the classical school even went to the extent of suggesting that
economists should not give any advice on any issue.

This means that economics should stand neutral as regards ends. However, the same view has
been reaffirmed by Robbins, who commented that the function of the economist is to explore
and explain, not to uphold or to condemn. This simply means that economists should take
ends as given. Their task is just to discover ways and means of achieving these ends (i.e., to
find out ways of accomplishing objectives).

No doubt, by restricting himself to positive aspect of economic science (with its focus on
resource allocation and valuation of commodities and factors) Robbins has narrowed
(restricted) the scope of economics. He denied economics the right to study welfare.

As he has commented, “Whatever economics is concerned with it is not concerned with the
causes of material welfare as such.” He has also ignored macroeconomics altogether as also
the problems of developing countries like India.

So, Robbins’ view of economic science is not only one-sided but misleading, too. The task of
economists is not just to explain why certain things happen (i.e., why there is so much of
unemployment in India in spite of her planned economic development or why there is so
inequality in the distribution of income and wealth notwithstanding the prevalence of the
progressive income tax system).

It is equally vital to pass judgment as to whether certain things are good or bad from society’s
welfare point of view. For example, it is not enough for an economist to explain the present
problem of unequal distribution of income and wealth in India.

4. Problem-solving Nature

The classical economists believed that economics could not solve practical problems, because
there were non-economic (social, political, ethical, religious and other) aspects of people’s
lives.

As J.M. Keynes commented in 1923

“The theory of economics does not furnish a body of settled conclusions immediately
applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a
technique of thinking which helps its possessor to draw correct conclusions.”
Micro vs. Macro Economics
Micro Economics

Microeconomics is the social science that studies the implications of human action,
specifically about how those decisions affect the utilization and distribution of scarce
resources. Microeconomics shows how and why different goods have different values, how
individuals make more efficient or more productive decisions, and how individuals best
coordinate and cooperate with one another. Generally speaking, microeconomics is
considered a more complete, advanced, and settled science than macroeconomics.

Microeconomics is the study of economic tendencies, or what is likely to happen when

individuals make certain choices or when the factors of production change. Individual actors
are often grouped into microeconomic subgroups, such as buyers, sellers, and business
owners. These groups create the supply and demand for resources, using money and interest
rates as a pricing mechanism for coordination.

The Uses of Microeconomics

As a purely normative science, microeconomics does not try to explain what should happen
in a market. Instead, microeconomics only explains what to expect if certain conditions
change. If a manufacturer raises the prices of cars, microeconomics says consumers will tend
to buy fewer than before. If a major copper mine collapses in South America, the price of
copper will tend to increase, because supply is restricted. Microeconomics could help an
investor see why Apple Inc. stock prices might fall if consumers buy fewer iPhones.
Microeconomics could also explain why a higher minimum wage might force The Wendy’s
Company to hire fewer workers. Microeconomics can address questions like these that might
have very broad implications for the economy; however, questions about aggregate economic
numbers remain the purview of macroeconomics, such as what might happen to the gross
domestic product (GDP) of China in 2020.

Method of Microeconomics

Most modern microeconomic study is performed according to general equilibrium theory,

developed by Léon Walras in Elements of Pure Economics (1874) and partial equilibrium
theory, introduced by Alfred Marshall in Principles of Economics (1890). The Marshallian
and Walrasian methods fall under the larger umbrella of neoclassical microeconomics.
Neoclassical economics focuses on how consumers and producers make rational choices to
maximize their economic well being, subject to the constraints of how much income and
resources they have available. Neoclassical economists make simplifying assumptions about
markets – such as perfect knowledge, infinite numbers of buyers and sellers, homogeneous
goods, or static variable relationships – in order to construct mathematical models of
economic behavior.

These methods attempt to represent human behavior in functional mathematical language,

which allows economists to develop mathematically testable models of individual markets.
As logical positivists, neoclassicals believe in constructing measurable hypotheses about
economic events, then using empirical evidence to see which hypotheses work best. Unlike
physicists or biologists, economists cannot run repeatable tests, so their empirical research
depends on the collection and observation of economic data from real world markets. The
economic efficiency of markets is then determined by how well real markets adhere to the
rules of the model.

Basic Concepts of Microeconomics

The study of microeconomics involves several key concepts, including (but not limited to):

(i) Production theory

This is the study of production — or the process of converting inputs into outputs. Producers
seek to choose the combination of inputs and method of combining them that will minimize
cost in order to maximize their profits.

(ii) Utility theory

Analogous to production theory, consumers will choose to purchase and consume a

combination of goods that will maximize their happiness or “utility”, subject to the constraint
of how much income they have available to spend.

(iii) Price theory

Production theory and utility theory interact to produce the theory of supply and demand,
which determine prices in a competitive market. In a perfectly competitive market, it
concludes that the price demanded by consumers is the same supplied by producers. That
results in economic equilibrium.

(iv) Industrial organization and market structure

Microeconomists study the many ways that markets can be structured, from perfect
competition to monopolies, and the ways that production and prices will develop in these
different types of markets.

KEY TAKEAWAYS
  Microeconomics studies the decisions of individuals and firms to allocate resources of
production, exchange, and consumption.
 Microeconomics deals with prices and production in single markets and the
interaction between different markets, but leaves the study of economy-wide
aggregates to macroeconomics.
 Microeconomists use mathematics as a language to formulate theories and
observational studies to test their theories against the real world performance of
market.

Macro Economics

Macroeconomics is a branch of economics that studies how the aggregate economy behaves.
In macroeconomics, economy-wide phenomena are examined such as inflation, price levels,
rate of economic growth, national income, gross domestic product (GDP), and changes in
unemployment.

Understanding Macroeconomics

There are two sides to the study of economics: macroeconomics and microeconomics. As the
term implies, macroeconomics looks at the overall, big picture scenario of the economy. Put
simply, it focuses on the way the economy performs as a whole, and then analyzes how
different sectors of the economy relate to one another to understand how the economy
functions. This includes looking at variables like unemployment, GDP, and inflation.
Macroeconomists develop models explaining relationships between these factors. Such
macroeconomic models, and the forecasts they produce, are used by government entities to
aid in the construction and evaluation of economic policy, by businesses to set strategy in
domestic and global markets, and by investors to predict and plan for movements in various
asset markets.

Given the enormous scale of government budgets and the impact of economic policy on
consumers and businesses, macroeconomics clearly concerns itself with significant issues.
Properly applied, economic theories can offer illuminating insights on how economies
function and the long-term consequences of particular policies and decisions.
Macroeconomic theory can also help individual businesses and investors make better
decisions through a more thorough understanding of what motivates other parties and how to
best maximize utility and scarce resources.

It is also important to understand the limitations of economic theory. Theories are often
created in a vacuum and lack certain real-world details like taxation, regulation and
transaction costs. The real world is also decidedly complicated and their matters of social
preference and conscience that do not lend themselves to mathematical analysis.

Even with the limits of economic theory, it is important and worthwhile to follow the major
macroeconomic indicators like GDP, inflation and unemployment. The performance of
companies, and by extension their stocks, is significantly influenced by the economic
conditions in which the companies operate and the study of macroeconomic statistics can
help an investor make better decisions and spot turning points.
  Macroeconomics is the branch of economics that deals with the structure,
performance, behavior, and decision-making of the whole, or aggregate, economy,
instead of focusing on individual markets.
 The two main areas of macroeconomic study are long term economic growth and
shorter term business cycles.
 Macroeconomics first came to be distinguished from microeconomics with the work
of John Maynard Keynes and his arguments that macroeconomic aggregates can
behave in ways quite different from analogous microeconomic phenomena.

Managerial Economics and its Relevance in

Business Decisions
Managerial Economics: Definition

To quote Mansfield, “Managerial economics is concerned with the application of economic

concepts and economic analysis to the problems of formulating rational managerial decisions.

Spencer and Siegelman have defined the subject as “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management.”

Managerial Economic’s Relevance in Business Decisions

1. Useful in Business Organization

In any institution or firm. How should any production be done, and for whom should be
produced? The answer to all these questions remains only with the managerial economy
because he plays the most important role in these tasks.

So we can say that managerial economics plays a very big role and significance in the
important decisions of the business.
So this is a very good Role and Importance of Managerial Economics in Choosing Right
Decisions of any business.

2. Helpful in Chalking Out Business Policies

The art is only in business economics to maximize the profit of any institution and minimize
cost and whatever policies are made from this.

It is very useful for any business or firm so that every firm and business can get the maximum
benefit.

Then we can say that there is a huge contribution of managerial economics to profit
maximization and determining policies. It also helps in doing it.

3. Help in Business Planning

Business economics is very useful in planning a complete prospect among the successful
operation and production of any business or firm. Which acts as a balance bridge between the
production tools and operating systems and where to go.

So this is the biggest and important role of business economics in any business or firm.

4. Helpful in Cost Control

Managerial economics decides the business is going towards profit or loss. managerial
economics decides which way is good for the business.

And it is only possible when managerial economics plays a very big and important role in
cost control decisions.

Thus, Role and Importance of Managerial Economics in Choosing Right Decisions is very
powerful.

5. Useful in Coordination of Business Activities

Managerial economics is useful in coordinating the various activities of a business.

6. Useful In Demand for Casting

Managerial economics provides useful tools for economics managers in demand forecasts
and is useful in demanding production planning.

The managerial economy deals with future losses easily. So that any business can be
protected against future losses.

7. Helpful in Profit Planning and Control

Managerial economics helps managers to decide on the planning and control of the benefits.
Managerial Economics is synchronized between the planning and control of any institution or
firm and hence its importance increases.

Thus, it plays a huge role in business decisions. So its Role And Importance Of Managerial
Economics In taking Right Decisions.

8. Helpful for Business Prediction

It is not known to anyone about what is going on in the business. Therefore, business
economics tells us that the business can see what is troubling in the future.

So, Then the managerial economics gives its solutions. So that they can be avoided and the
benefits can be increased.

9. Helpful in Price Determination

Managerial Economics provides the necessary guidance in managing the pricing of its
business. This proves this in order to raise the required data in pricing and get the maximum
benefit.

So that is the major role of managerial economics in the business decision critical. Without
this, no business can progress.

10. Helpful in Solutions of Business Taxation Problems

Managerial Economics provides useful guidance in solving problems caused by various types
of tax done in business. And contracting of business helps reduce problems. To maximize
profit at low cost and minimize business costs.

11. Useful in Understanding the Mechanism of Economic System

Managerial Economics/Business economics is useful in understanding the complex cause of

the entire economy. From which business decisions get help.

The entire economy is very complex but business economics solves it with ease. it is helpful
to understand that in this way.

12. Helpful in Analysis of Effects of Government Policies

Business economics/Managerial Economics helps in analyzing the effect of the various

policies of the Government in the operation of the business sector. Reducing their bad
influence and giving benefit to the good effect.

13. Attempt to Put Out the Friendly Business

Managerial Economics guides managers to adjust to suit the external conditions of the
business.

14. Supporting the Manufacture and Use of Models

Managerial Economics creates an economic model for managers to inspire their use in
business. In order to maximize production and maximum profit, at least cost can be paved.

Thus, Business economics only tells how to manage everything in a way that everything
should be corrected in order to maximize profits. Business economics has a very important
role and role in doing all this work in business decisions.

15. Useful in Showing the Path of Economic Well-Being

Managerial Economics inspires managers to operate the business in such a way that the path
of maximum economic welfare is paved.

16. Gives the Right Direction

Inside the business, managerial economics has a very big role because it handles that
business.

Shows the right path to every member of the business, and also gives the right direction of
what his duty and job.

17. Maintains of Costs

It is the job of managerial economics to say how much to spend in business and how to spend
those expenses so that it can get more profit at lower costs and increase business growth.

18. Distribute Profit

Inside any business, managerial economics tells us how to distribute the profits and invest in
where to make the business more profitable in the coming time and more growth in the
business field.

19. Measurement of the Efficiency of the Firm

Managerial Economics provides useful tools for managers in measuring the efficiency of the
business firm. Managerial Economics plays big salient features and significance of
managerial economics In Choosing Right Decisions in helping business in many ways.

Fundamental Principles of Managerial

Economics- Incremental Principle,
Marginal Principle, Opportunity Cost
Principle, Discounting Principle, Concept of
Time Perspective Principle, Equi-Marginal
Principle
Managerial Economics is both conceptual and metrical. Before the substantive decision
problems which fall within the purview of managerial economics are discussed, it is useful to
identify and understand some of the basic concepts underlying the subject.

Economic theory provides a number of concepts and analytical tools which can be of
considerable and immense help to a manager in taking many decisions and business planning.
This is not to say that economics has all the solutions. In fact, actual problem solving in
business has found that there exists a wide disparity between economic theory of the firm and
actual observed practice.

Therefore, it would be useful to examine the basic tools of managerial economics and the
nature and extent of gap between the economic theory of the firm and the managerial theory
of the firm. The contribution of economics to managerial economics lies in certain principles
which are basic to managerial economics. There are six basic principles of managerial
economics. They are:-

1. The Incremental Principle

The incremental concept is probably the most important concept in economics and is
certainly the most frequently used in Managerial Economics. Incremental concept is closely
related to the marginal cost and marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue.
Incremental cost denotes change in total cost, whereas incremental revenue means change in
total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

(iv) It reduces costs more than revenues.

2. Marginal Principle

Marginal analysis implies judging the impact of a unit change in one variable on the other.
Marginal generally refers to small changes. Marginal revenue is change in total revenue per
unit change in output sold. Marginal cost refers to change in total costs per unit change in
output produced (While incremental cost refers to change in total costs due to change in total
output). The decision of a firm to change the price would depend upon the resulting
impact/change in marginal revenue and marginal cost. If the marginal revenue is greater than
the marginal cost, then the firm should bring about the change in price.
3. The Opportunity Cost Principle

Both micro and macro economics make abundant use of the fundamental concept of
opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are
unable to articulate its significance. In Managerial Economics, the opportunity cost concept is
useful in decision involving a choice between different alternative courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one com-
modity, we have to forego the production of another commodity. We cannot have everything
we want. We are, therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision.

Sacrifice of alternatives is involved when carrying out a decision requires using a resource
that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or
revenue forgone by pursuing one course of action rather than another.

The concept of opportunity cost implies three things:

(i) The calculation of opportunity cost involves the measurement of sacrifices.

(ii) Sacrifices may be monetary or real.

(iii) The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost is just a notional idea which does not appear in the books of account of the
company. If resource has no alternative use, then its opportunity cost is nil.

In managerial decision making, the concept of opportunity cost occupies an important place.
The economic significance of opportunity cost is as follows:

(i) It helps in determining relative prices of different goods.

(ii) It helps in determining normal remuneration to a factor of production.

(iii) It helps in proper allocation of factor resources.

4. Discounting Principle

This concept is an extension of the concept of time perspective. Since future is unknown and
incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today
is worth more than a rupee will be two years from now. This appears similar to the saying
that “a bird in hand is more worth than two in the bush.” This judgment is made not on
account of the uncertainty surrounding the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out
if the same sum is available only at the end of the period. In technical parlance, it is said that
the present value of one rupee available at the end of two years is the present value of one
rupee available today. The mathematical technique for adjusting for the time value of money
and computing present value is called ‘discounting’.
5. Concept of Time Perspective Principle

The time perspective concept states that the decision maker must give due consideration both
to the short run and long run effects of his decisions. He must give due emphasis to the
various time periods. It was Marshall who introduced time element in economic theory.

The economic concepts of the long run and the short run have become part of everyday
language. Managerial economists are also concerned with the short run and long run effects
of decisions on revenues as well as costs. The main problem in decision making is to
establish the right balance between long run and short run.

In the short period, the firm can change its output without changing its size. In the long
period, the firm can change its output by changing its size. In the short period, the output of
the industry is fixed because the firms cannot change their size of operation and they can vary
only variable factors. In the long period, the output of the industry is likely to be more
because the firms have enough time to increase their sizes and also use both variable and
fixed factors.

In the short period, the average cost of a firm may be either more or less than its average
revenue. In the long period, the average cost of the firm will be equal to its average revenue.
A decision may be made on the basis of short run considerations, but may as time elapses
have long run repercussions which make it more or less profitable than it at first appeared.

6. Equi-Marginal Principle

One of the widest known principles of economics is the equi-marginal principle. The
principle states that an input should be allocated so that value added by the last unit is the
same in all cases. This generalization is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is
involved in five activities viz., А, В, C, D and E. The firm can increase any one of these
activities by employing more labour but only at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is greater in
one activity than in another. It would be, therefore, profitable to shift labour from low
marginal value activity to high marginal value activity, thus increasing the total value of all
products taken together.

Utility Analysis
Utility analysis is a quantitative method that estimates the dollar value of benefits generated
by an intervention based on the improvement it produces in worker productivity. Utility
analysis provides managers information they can use to evaluate the financial impact of an
intervention, including computing a return on their investment in implementing it.
Utility analysis, a subset of consumer demand theory, provides insight into an understanding
of market demand and forms a cornerstone of modern microeconomics. In particular, this
analysis investigates consumer behavior, especially market purchases, is based on the
satisfaction of wants and needs (that is, utility) generated from the consumption of a good.

Utility analysis is primarily taught in introductory courses. A more sophisticated version of

consumer demand theory relies on the analysis of indifference curves and is more commonly
found at the intermediate course level and above.

Basic Assumptions

1. The first assumption of utility analysis is that human performers generate results that
have monetary value to the organizations that employ them. This assumption is also
the basis on which people claim compensation for the work they do.
2. The second assumption of utility analysis is that human performers differ in the
degree to which they produce results even when they hold the same position and
operate within like circumstances. Thus, salespersons selling the same product line at
the same store on the same shift will show a variation in success over time with a few
doing extraordinarily well, a few doing unusually poorly, and most selling around the
average amount for all salespersons. This assumption is broadly supported in common
experience and in research. It is, for example, the basis on which some performers
demand and receive premium compensation.

The direct implication of these assumptions is that the level of results produced by performers
in their jobs have different monetary consequences for the organizations that employ them.
Performers are differentially productive and the productivity of performers tends to be
distributed normally.
What Is Needed to Complete a Utility Analysis?

In completing the analysis, the performer needs to generate the following:6

 A method for measuring role productivity,

 A way to assign monetary value to role productivity,
 The distribution of productivity among performers of the role,
 The dollar value of a one standard deviation difference in role productivity (SD$), and
 A method to measure the intervention’s impact on role productivity.

Difference between Cardinal Utility and

Ordinal Utility
Cardinal Utility

The Cardinal Utility approach is propounded by neo-classical economists, who believe that
utility is measurable, and the customer can express his satisfaction in cardinal or quantitative
numbers, such as 1,2,3, and so on.

The neo-classical economist developed the theory of consumption based on the assumption
that utility is measurable and can be expressed cardinally. And to do so, they have introduced
a hypothetical unit called as “Utils” meaning the units of utility. Here, one Utils is equivalent
to one rupee and the utility of money remains constant.

Over the passage of time, it was realized that the absolute measure of utility is not possible,
i.e. it was difficult to measure the feeling of satisfaction cardinally (in numbers). Also, it was
difficult to quantify the factors that cause a change in the moods of the consumer, their tastes
and preferences and their likes and dislikes. Therefore, the utility is not measurable in
quantitative terms. But however, it is being used as the starting point in the consumer
behavior analysis.
The cardinal utility approach used in analyzing the consumer behavior depends on the
following assumptions:

1. Rationality

It is assumed that the consumers are rational, and they satisfy their wants in the order of their
preference. This means they will purchase those commodities first which yields the highest
utility and then the second highest and so on.

2. Limited Resources (Money)

The consumer has limited money to spend on the purchase of goods and services and thus
this makes the consumer buy those commodities first which is a necessity.

3. Maximize Satisfaction

Every consumer aims at maximizing his/her satisfaction for the amount of money he/she
spends on the goods and services.

4. Utility is cardinally Measurable

It is assumed that the utility is measurable, and the utility derived from one unit of the
commodity is equal to the amount of money, which a consumer is ready to pay for it, i.e. 1
Util = 1 unit of money.

5. Diminishing Marginal Utility

This means, with the increased consumption of a commodity, the utility derived from each
successive unit goes on diminishing. This law holds true for the theory of consumer behavior.

6. Marginal Utility of Money is Constant

It is assumed that the marginal utility of money remains constant irrespective of the level of a
consumer’s income.

7. Utility is Additive

The cardinalists believe that not only the utility is measurable but also the utility derived from
the consumption of different commodities are added up to realize the total utility.

Thus, the cardinal utility approach is used as a basis for explaining the consumer behavior
where every individual aims at maximizing his/her utility or satisfaction for the amount of
money he spends on the consumption of goods and services.

Critique of the Cardinal Approach:

There are three basic weaknesses in the cardinalist approach. The assumption of cardinal
utility is extremely doubtful. The satisfaction derived from various commodities cannot be
measured objectively. The attempt by Walras to use subjective units (utils) for the
measurement of utility does not provide any satisfactory solution. The assumption of constant
utility of money is also unrealistic.

As income increases the marginal utility of money changes. Thus money cannot be used as a
measuring-rod since its own utility changes. Finally, the axiom of diminishing marginal
utility has been ‘established’ from introspection, it is a psychological law which must be
taken for granted.

Ordinal Utility

An ordinal utility function is a function representing the preferences of an agent on an ordinal

scale. Ordinal utility theory claims that it is only meaningful to ask which option is better
than the other, but it is meaningless to ask how much better it is or how good it is. All of the
theory of consumer decision-making under conditions of certainty can be, and typically is,
expressed in terms of ordinal utility.
Consider a simple case where the consumer purchases only two goods, Q1 and Q2.

Ordinal utility function is:

U = f(q1, q2)

Where U is the ordinal utility number, and q1 and q2 are the quantities consumed of the two
goods. Assume that U is a single-valued function of q1 and q2, and f (q1, q2) is continuous,
and it has continuous first-order and second-order partial derivatives. Remember also that U
has to be a regular strictly quasi-concave function of qi and q2.

Since, it shall be assumed that the consumer will desire to have more of both the goods, the
partial derivatives of U (w.r.t.) q1 and q2 will be positive unless otherwise mentioned as in
some unusual cases. But remember some more points about the utility function.

First, the consumer’s utility function is not unique. Any function which is a positive
monotonic transformation of his utility function may also be taken as a utility function of the
consumer, for it would represent the same preference-indifference pattern.

Second, as noted, U in stands for the ordinal utility number for a particular combination of
the goods. This number has no cardinal significance. It has only ordinal significance. It
indicates the utility-rank of the said combination to the consumer.

Since the utility numbers have no cardinal significance, the two numbers indicating two
utility-ranks of two particular combinations of goods may be, say, 2 and 3, or they may even
be 2 and 300, the higher number indicating the higher utility rank of the two.

Third, the utility function is defined for a particular time period. The consumer’s optimal
expenditure pattern is analysed only with respect to this period. The possibility of transferring
consumption expenditure from one period to another has not been considered here.
Remember that the time period should not be so short that the desire for variety cannot be
satisfied, neither should it be so long that the consumer’s tastes and the shape of his utility
function might change meanwhile. Any intermediate period should be appropriate for the
static theory of the consumer behaviour.

Ordinal Utility Cardinal Utility

An ordinal utility function is a function Consumer derived satisfaction after
representing the preferences of an agent on an consumption of products evaluated in
ordinal scale. numerical numbers
Ordinal utility used qualitative approach Cardinal utility used quantitative approach
during analysis of degree of the satisfaction. during analysis of degree of satisfaction.
Consumer in ordinal utility rank of preference Consumer in cardinal utility makes
according to their derived satisfaction after measurements of degree of satisfaction
consumption of products. derived after consuming products in utils.
Ordinal utility measurements promoted by Cardinal utility measurement promoted by
modern economist traditional economist.
Qualitative Approach Quantitative Approach
Cardinal utility measurement results
Ordinal utility measurements results
considered not realistic in comparison with
considered as more realistic.
ordinal utility.
Measurement by Ranks Measurement by Utils
Indifference curve analysis used for Marginal utility analysis used for explanation
explanation ordinal utility. of cardinal utility.