Unit 2: Theory of Consumer Behavior

• The theory of consumer’s behaviour seeks to explain the determination of consumer’s

equilibrium.
• Consumer’s equilibrium refers to a situation when a consumer gets maximum
satisfaction out of his given resources.
• A consumer spends his money income on different goods and services in such a
manner as to derive maximum satisfaction.
Once a consumer attains equilibrium position, he would not like to deviate from it.

Economic theory has approached the problem of determination of consumer’s

equilibrium in two different ways:
(1) Cardinal Utility Analysis/ Cardinal Approach
(2) Ordinal Utility/Ordinal Approach
1. The Cardinal Approach to the theory of consumer behaviour is based upon the
concept of utility. It assumes that utility is capable of measurement. It can be added,
subtracted, multiplied, and so on.• According to this approach, utility can be
measured in cardinal numbers, like 1,2,3,4 etc.
2. The Ordinal Approach is developed by Hicks & Allen. Its also called Indifference curve
analysis.
• In ordinal approach the consumer compares the satisfaction from different combination of
goods.
CARDINAL APPROACH/UTILITY ANALYSIS
• It is developed by Alfred Marshall in 1890
• The Cardinal Approach to the theory of consumer behaviour is based upon the
concept of utility. It assumes that utility is capable of measurement. It can be
added, subtracted, multiplied, and so on.
• According to this approach, utility can be measured in cardinal numbers, like 1,2,3,4
etc. Fisher has used the term ‘Util’ as a measure of utility.
• Thus in terms of cardinal approach it can be said that one gets from a cup of tea 5
utils, from a cup of coffee 10 utils, and from a rasgulla 15 utils worth of utility

Meaning of Utility
 The term utility in Economics is used to denote that quality in a good or service by
virtue of which our wants are satisfied. In, other words utility is defined as the want
satisfying power of a commodity.
 According to Mr. Robison, “utility is the quality in the commodities that makes individuals
to buy them”.
 According to Hibdon, “Utility is the quality of a good to satisfy a want.”

Features of Utility
• Utility has the following main features:
(1) Utility is Subjective: Utility is subjective because it deals with the mental satisfaction of
a man. A commodity may have different utility for different persons. Cigarette has
utility for a smoker but for a person who does not smoke, cigarette has no utility.
Utility, therefore, is subjective.

(2) Utility is Relative: Utility of a good never remains the same. It varies with time and
place.
Fan has utility in the summer but not during the winter season.

(3) Utility and usefulness: A commodity having utility need not be useful. Cigarette
and liquor are harmful to health, but if they satisfy the want of an addict then they have
utility for him.
(4) Utility and Morality : Utility is independent of morality. Use of liquor or
Cigarette may not be proper from the moral point of views. But as these intoxicants
satisfy
wants of the drunkards and smokers they have utility for them.

CONCEPTS OF UTILITY

Initial Utility
I. The utility derived from the first unit of a commodity is called initial utility. Utility
derived from the first piece of bread is called initial utility.
II. Thus, initial utility, is the utility obtained from the consumption of the first unit of a
commodity. It is always positive
 Total Utility

i. Total utility is the sum of utility derived from different units of a commodity
consumed by a household.
ii. According to Left witch, “Total utility refers to The entire amount of satisfaction
obtained from consuming various quantities of a commodity.”
Marginal utility
i. Marginal utility is the utility derived from the additional unit of commodity consumed.
ii. The change that takes place in the total utility by the consumption of an additional unit of a
commodity is called marginal utility.
iii. According to Chapman, “Marginal utility is the addition made to total utility by
consuming one more unit of commodity.

• Supposing a consumer gets 10 utils from the consumption of one mango and 18 utils from two
mangoes, and then the marginal utility of second mango will be 18-10=8 utils.
• Marignal utility can be measured with the help of the following formula
• MUnth = TUn – TUn-1
• Here MUnth = Marginal utility of nth unit, • TUn = Total utility of ‘n’ units,
• TUn-l = Total utility of n-i units
1. LAW OF DIMINISHING MARGINAL
• Law of Diminishing Marginal Utility is an important law of utility analysis. This law is related
to the satisfaction of human wants.
• All of us experience this law in our daily life.
• According to Marshall, Law of Diminishing Marginal Utility is defined as “The additional
benefit which a person derives from a given stock of a thing diminishes with every
increase in the stock that he already has.”
• In short, the law of Diminishing Marginal Utility states that, other things being equal,
when we go on consuming additional units of a commodity, the marginal utility
from each successive unit of that commodity goes on diminishing.

ASSUMPTIONS OF LDMU
1. Utility can be measured in cardinal number system such as 1,2,3 _______ etc.
2. There is no change in income of the consumer. 3. Marginal utility of
money remains constant.
4. Suitable quantity of the commodity is consumed.
5. There is continuous consumption of the commodity. 6. Marginal Utility of
every commodity is independent. 7. Various units of a commodity are
homogeneous
8. There is no change in the tastes, character, fashion, and habits of the
consumer.
9. There is no change in the price of the commodity and its substitutes.
10. Every consumer wants to maximizet utility
Limitations of LDMU
Homogeneity
Suitable time
No change in taste and preference of the consumer
Normal person
Constant income
Homogeneity
• It is assumed that units of the commodity consumed must be homogeneous. The size and
quality of the commodity should be same
Suitable Time
• The time of consumption should not vary. If the consumer is consuming the
commodity at different time periods, this law is not applicable
No Change in Taste and Preference of the Consumer
• The taste and preference of the consumer at the time of consumption should remain
same. The law is not applicable, if the taste and preference of the consumer changes.
Normal Person
• The law of diminishing marginal utility is applicable for normal person only and it is not
applicable for eccentric or abnormal person
Constant Income
• The law assumes that the income of the consumer at the time of consumption should
remain same
Exceptions of LDMU

1. Hobbies:
• Implies that the law of diminishing marginal utility is violated in case of hobbies of an
individual, such as stamp collection and coin collection.
• This is because an individual derives more and more utility from additional unit gained
from a hobby item.
• For instance, a level of satisfaction increases when a new variety of stamps or coins are
received. However, the utility diminishes if the same variety of stamps or coins is gained
every time
2. Misers:
• Implies that the law of diminishing marginal utility cannot be applied to misers. This is
because they derive more and more utility from more and more of any good.
• Utility is a feeling of satisfaction, pleasure, or happiness. The demand of a good
depends on the amount of utility derived by a consumer from that good. Therefore, it is
necessary to measure utility to determine the demand of goods or services.
3. Alcoholics
The consumption of liquor is not subject to this law because more a Person drinks greater
is his intoxication and he drinks more
4. Money
• In case of money this law is not applicable as people are more interested in
making more and more money.
5. Reading
•More reading will give more knowledge and it can be increased by reading more and more
books
6. Arts
• Arts like music, drama, films etc is been appreciated even after first hearing or viewing.

Importance/Uses of LDMU
• The law helps to explain the phenomenon in value theory that the price of a commodity
falls when its supply increases. It is because with the increase in the stock of a commodity, its
marginal utility diminishes.
• The famous “diamond-water paradox” of Smith can be explained with the help of this
law. Because of their relative scarcity, diamonds possess high marginal utility and so a high
price. Since water is relatively abundant, it possesses low marginal utility and hence low price
even though its total utility is high. That is why water has low price as compared to a diamond
though it is more useful than the latter.
• The principle of progression in taxation is also based on this law. As a person’s income
increases, the rate of tax rises because the marginal utility of money to him falls with the rise
in his income.
• LDMU explains the reason for downward slope in demand curve
LAWS OF UTILITY ANALYSIS
2. LAW OF EQUI- MARGINAL UTILITY

Law of Equi-Marginal Utility

The equi-marginal principle states that a consumer will be maximizing his total utility
when he allocates his fixed money income in such a way that the utility derived from the
last unit of money spent on each good is equal.

Suppose a man purchases two goods X and Y whose prices are P and P , respectively. As he
purchases more of X, his MU declines while MU rises. Only at the margin the last unit of money
spent on X has the same utility as the last unit of money spent on Y and the person thereby
maximizes his satisfaction.

• This condition for a consumer to maximize utility is usually written in the following form:
• MUX/PX = MUY/PY• So long as MU /P is higher than MU /P , the consumer will go
on substituting Y for X until the marginal utilities of both X and Y are equalized.
Assumptions of Law of Equi -Marginal Utility
• The consumer behaves rational who seeks to maximize his total satisfaction.
• Utility is measurable in cardinal terms.
• The consumer has a given scale of preference for the goods in consideration. He has perfect
knowledge of utility derived.
• Prices of goods are unchanged.
• Income of the consumer remains constant
• Marginal utility of money is constant.
• Wants and goods are substitutable.

Importance of Law of Equi-Marginal Utility

• This law is helpful in the field of production. A producer has limited resources and tries to get
maximum profit.
• This law is helpful in the field of exchange. The exchange is of anything like some goods, wealth,
trade, import, and export.
• It is applicable to public finance particularly in taxation
• The law is useful for an individual to distribute his assets among different alternatives.
• It is useful in case of saving and spending.
• It is useful to look for substitution in case of price rise.
Limitations of Law of Equi-Marginal Utility
• Consumer cannot be rational always
• Marginal utility of money does not remain constant for all. It varies between rich and poor.
• Utility is a subjective concept and it cannot be measured
• The law cannot be applied if certain commodities are not available
• The equi-marginal principle can work only if goods are divisible

CONSUMER SOVEREIGNTY
Consumer Sovereignty is the idea that consumers hold the power to influence
production decisions, based on what goods and services they purchase.
• Consumer sovereignty is an economic concept described by William Harold Hutt in
his book Economists and the Public: A Study of Competition and Opinion (1936).
• Consumer sovereignty is based on two pillars: knowledge and free will.
• The consumer has freedom of choice in an economy. That is why he is regarded as a
sovereign, king or queen. This is what is meant by consumer’s sovereignty.
• The consumer is free to buy any commodity and in whatever quantities according to his
preference.
• This also implies freedom of production whereby a producer is at liberty to produce
different types of goods to satisfy the consumer who behaves like a king or queen in
making a choice out of those goods with his given money income.
• Thus a consumer’s tastes and preferences are also reflected in the prices of goods and
services.
• Consumer’s choice also guides the operations of industries.
• A person who wants to start an industry will be motivated by the consumer’s choice
for that particular commodity.
• He will choose that commodity which is likely to’ have a large demand and a high price in the
future.

LIMITATIONS OF CONSUMER SOVEREIGNTY

1. Unequal Income Distribution
• Consumer’s sovereignty is limited by unequal income distribution in a society.
• The consumer who is poor has a limited choice of products.
• His wants remain unsatisfied.
• It is only the rich consumer who can choose from a variety of products.
• Thus consumer’s sovereignty has little meaning in a system with unequal
distribution.
2. Availability of Goods
• Consumer’s choice is limited only to those commodities which are manufactured and
supplied by producers in the market.
• The availability of goods, in turn, depends on the availability of natural
resources and the level of technology in the country.
• For instance, a consumer in a village may wish to have a telephone which is not
possible in a country like India
3. Combined Choice
• As a matter of fact, it is not the choice of an individual consumer that governs the production
of goods but the combined choice of consumers that operates the price mechanism.
• In this age of automation, no producer produces a product to meet the demand of an
individual consumer.
rather, he produces a commodity keeping in view the majority of consumer.

4. Consumer not Rational

• The consumer is not a rational buyer.
• He is often ignorant about the utility and quality of the products available at the stores or
shops and thus cannot make a right choice.

5. Society’s Customs
• Consumer’s sovereignty is limited by the prevalent customs of the society in which he lives.
He has to follow certain conventions and customs of his society which limit his freedom of
choice.

6. Fashions
• The consumer’s sovereignty is also adversely affected by the fashions in vogue. He/she may
want to wear a particular dress.

7. Standardized Goods
• There is no place for consumer’s sovereignty in a where standardized goods are produced in
bulk
• The consumer has no choice of his own except to buy them in whatever shape, quantity
quality, etc., they are manufactured and sold

8. Advertisement
• Advertisement in the form of salesmanship, free sampling, tree service, door-to-door
canvassing, newspaper ads, commercial broadcasts, TV visuals, etc. undermine the consumer s
sovereignty.
• The consumer is influenced by them and is unable to make choices of goods
according to his preferences.
9. Monopoly
• The existence of monopoly stand in the way of consumer’s sovereignty.
The consumer has to buy the goods produced by the monopolist at the prices fixed to him.
There is no other choice for consumer except to buy the monopolist’s goods, if he wants to
consume them.
10. Government Restrictions
• The government also controls and regulates the consumption of certain commodities which
restrict the consumer’s sovereignty.
• The consumption of intoxicants likes wine, liquor, etc. and harmful drugs is
regulated and even prohibited by the government.
11. Taxation
• The imposition of income tax and commodity taxes adversely affects the
consumer s sovereignty.• Both tend to reduce the disposable income of the consumer
with the result that his choice of goods is limited.
INDIFFERENCE CURVE APPROACH
 The credit of rendering this analysis as an important tool goes to hicks and Allen in 1934
• An indifference curve is a geometrical presentation of a consumer’s scale of
preferences. It represents all those combinations of two goods which will provide
equal satisfaction to a consumer.
• A consumer is indifferent towards the different combinations located on such a curve.
• Since each combination located on such a curve. Since each combination yields the same
level of satisfaction, the total satisfaction derived from any of these combinations remains
constant.
• An indifference curve is a locus of all such points which shows different combinations of
two commodities which yield equal satisfaction to the consumer.
• Since the combination represented by each point on the indifference curve yields
equal satisfaction, a consumer becomes indifferent about their choice.
• In other words, he gives equal importance to all the combinations on a given indifference
curve.
• According to Ferguson, “An indifference curve is a combination of goods, each of which yield
the same level of total utility to which the consumer is indifferent.”
• According to left witch, “A single indifference curve shows the different combinations of X
and y that yield equal satisfaction to the consumer.”
Scale of Preference

Combination of Two Level of Satisfaction Scale of Preference

Goods
5 Apples 10 Oranges Highest I
4 Apples 11 Oranges Less than 1st II
3 Apples 9 Oranges Less than 2nd IIII
It refers to ordering of different goods and the combination in a set order of
preference

INDIFFERENCE SCHEDULE
• An indifference schedule refers to a schedule that indicates different combinations
of two commodities which yield equal satisfaction.
• A consumer, therefore, gives equal importance to each of the combinations:
• Supposing a consumer two goods, namely apples and oranges.
• The following indifference schedule indicates different combinations of apples
and oranges that yield him equal satisfaction.
INDIFFERENCE SCHEDULE

Combination of Apple Oranges

Apples and Oranges
A 1 10
B 2 7
C 3 5
D 4 4

The above schedule shows that the consumer gets equal satisfaction from all the four
combinations, namely A, B, C and D of apples and oranges. In order to have one more apple
the consumer sacrifice, some of the oranges in such a way that there is no change in the
level of his satisfaction out of, each combination.
INDIFFERENCE CURVE
• Indifference curve is a diagrammatic representation of indifference schedule. Graphically,
the indifference curve is drawn as a downward sloping convex to the origin. The graph
shows a combination of two goods that the consumer consumes.
Assumptions of Indifference Curve

• It assumes that consumer is interested in buying two goods

• The taste and preference of the consumer remains unchanged
• It is assumed that consumer is rational
• It is assumed that consumer will always prefer large amount of goods to a smaller
amount of goods provided
• Income of the consumer remains fixed
• It is based on ordinal analysis
• The principle of diminishing rate of substitution is assumed. The concept marginal rate
of substitution a tool of indifference curve technique.

Marginal Rate of Substitution (MRS)

• It is the rate at which a consumer can give up some amount of one good in
exchange of another good while maintaining equal level of utility or satisfaction.
• It can be defined as rate at which an individual will exchange successive unit of one
commodity for another
 MRS = X / Y
Where, X = No of commodities the consumer is willing to give up
Y = No of commodities gained

Combination Burger Pepsi MRS

A 7 1 -

B 4 2 3/1 = 3

C 2 3 2/1 = 2

D 1 4 1/1 = 1
Properties of Indifference Curve
• Indifference curve slopes downward from left to right, or an indifference curve has a
negative slope: the downward slope of an indifference curve indicates that a consumer
will have to curtail the consumption of one commodity if he wants to consume
large quantity of another commodity to maintain the same level of satisfaction.
• Indifference curve is convex to the point of origin: An indifference curve is
convex to the point of origin. This property is based on the law of diminishing marginal
rate of substitution. The inverse relationship between commodity x and commodity
y in a combination is a reason for the convex shape.
• Two Indifference Curves never cut each other: Each indifference curve represents
different levels of satisfaction, so their intersection is ruled out.
• Higher Indifference Curves represent more satisfaction
• Indifference Curve touches neither x-axis nor y-axis
• Indifference curves need not be parallel to each other:
Price Line or Budget Line
• It shows all possible combination of two goods that consumer can buy at a given level
of income and prices of two goods.
In order to determine the price line the price of two commodities to be disclosed
Consumer Surplus
• Alfred Marshall developed the concept consumer surplus in the year 1890 in his
book “Principles of Economics”
• It is the difference between the potential price and the actual price. In short,
consumer surplus is the difference between the price what you are actually prepared to
pay and the price actually paid