Chapter 2

Theory of Consumer Behavior

Meaning of Utility
The level of satisfaction or happiness that consumer receives from the consumption
of goods and services is called utility.
It is the human want satisfying power of goods and services.
It is a subjective entity and varies from person to person, time to time and place
to place.

Approaches to Utility Analysis:#

Cardinal Approach:
Developed by neo-classical economists (Alfred Marshall)
Utility can be measured in cardinal numbers 1,2,3 etc.
Utility is measurable and additive
Also known as marginal utility analysis.
The measuring unit of utility is ‘Utils’

Cont………..
2. Ordinal Approach:
The modern economists have rejected the concept of cardinal utility and have
instead employed the concept of ordinal utility analysis for analyzing consumer
behavior.
This method assumes that utility cannot be measured in number but it can be ranked
like first, second, more or less.

Cont…………
The ordinal utility implies that the consumer is capable of simply comparing the
different levels of satisfaction.
For example, a consumer may not be able to tell that a orange gives 10 utilities
and an apple gives 20 utilities. But he always tells that apple gives more utility
than orange (comparing/ordering/raking the utilities derived from the consumption
of orange and apple).

Cont………….
Utility being a psychological feeling is not quantifiable (can not be expressed in
number).
 According to the ordinal utility hypothesis, while the consumer may not be able to
indicate the exact amounts of utilities that he derives from commodities or any
combination of them.
But he is capable of judging whether the satisfaction obtained from a combination
of goods is equal to, lower than, or higher than another.

Concepts of Total and Marginal Utility

Total Utility:
it refers to the total satisfaction derived by the consumer from the consumption of
a given quantity of goods.
In other words, it is the aggregate of marginal utilities.
Mathematically,
TU= MU1+MU2+…………..+MUn
TU=∑MU
n
i=1
i

Marginal Utility (MU)

 

Types of Marginal Utility

Positive marginal utility: When total utility increases with the consumption of
additional units of the commodity, then the marginal utility derives in a positive
form even if it is decreasing.
Zero utility: No addition to the total utility by consumption of an additional unit
(total utility becomes maximum).
Negative utility: When the total utility decreases with each successive unit of the
commodity, the marginal utility becomes negative.

Law of Diminishing Marginal Utility

Introduction
This is an important law in economics.
It is equally applicable in all parts of economics.
This law was propounded by a famous economist HH Gossen in 1854 AD.
Therefore it is also called as Gossen’s first law.
Finally this law was fully developed by Alfred Marshall (Neo-classical economist).

Cont………..
b. Statement:
This law says that the additional level of satisfaction goes on diminishing with
every increase in units of consumption within same period of time.
In other words, when consumer consumes more and more units of the same commodity,
the successive level of satisfaction diminishes.

Cont…………..
b. Assumptions
The consumer should be rational,
Cardinal measurement of utility,
Constant Marginal utility of money,
Homogeneous units of goods,
No change in taste and preferences of the consumer,
No time gap in consumption,
Utility is additive: U= f (x1, x2 …xn) and U=U1(x1) +U2(x2)+ U3(xn)

d. Tabular Explanation
Units of goods (Q)
Total Utility (TU)
Marginal Utility (MU)
0
0
-
1
10
10
2
18
18-10=8
3
24
24-18=6
4
28
28-24=4
5
30
30-28=2
6 (point of satiety)
30
30-30=0
7
28
28-30=-2
Both MU and TU obtained from the consumption of first unit of a commodity are equal
(i.e. 10 utils).
TU increases but at diminishing rate when the units of the commodity consumed
increases gradually (i.e. 2nd , 3rd 4th and 5th units are consumed) but MU
decreases .
TU becomes maximum when 6th unit is consumed but MU becomes zero. This indicates
the point of satiety.
Thereafter (beyond the point of satiety), TU starts to decline and MU become
negative if another additional unit is consumed.

e. Graphical Explanation
TU
MU
The MU curve is downward sloping which indicates that MU derived from the
additional level of satisfaction goes on diminishing with every increase in units
of consumption within same period of time.
MU curve lies on X-axis and even falls below the X-axis which indicates zero and
negative utility respectively.
As long as MU is positive the TU increases at a diminishing rate, becomes maximum
when MU is zero and starts to fall as MU is negative. Hence it is a bell-shaped
curve.

Limitations of the Law#

Irrational consumer 
Rare and curious goods like old coins
Goods of entertainments like watching movies, popular TV programs, popular games
like football etc.
Habitual goods like cigarettes, alcohols, drugs etc.
Unequal size and quality
Time gap in consumption
Change in taste and preference
Utility can not be measured in cardinal number
Marginal unity of money does not remain constant.

Consumer’s Equilibrium (one commodity model)

Let a consumer with certain money income and commodity X.
Since both his money income and commodity X have utility for him, he can either
spend his money income on commodity X or retain it in the form of asset.
If MUx > MUm as asset, utility maximizing consumer will exchange his money income
for commodity X until MUx= Px(MUm).
Cont..
MUx is the marginal utility curve of X good. It slopes downwards to the right
indicating that when a consumer consumes more and more units of the same commodity,
utility obtained from each successive units goes on diminishing.
The horizontal line Px(MUm) shows the constant marginal utility weighted by the
price of the commodity X.
e Point be the equilibrium point of the consumer where MUx=Px(MUm). This
equilibrium indicates that he maximizes utility by consuming OQ1 units.
At points above e, MUx> Px(MUm). So if the consumer exchanges his money income for
commodity X, he increases his satisfaction per unit of commodity.
At points below e, Mux<Px(MUm). So consumer can therefore increase his
satisfaction by reducing his purchase.

Derivation of Demand Curve

Initially a consumer is in equilibrium at point e1 where a consumer purchases OQ1
quantity at price P1. This combination shown in lower pane of figure by point A.
If price falls from P1 to P2, a consumer gets new equilibrium at point e2 where he
purchases OQ2 quantity. This combination is denoted by point C in lower panel of
figure.
Similarly, if price rises from P1 to P3, a consumer gets new equilibrium at point
e3 and he purchases OQ3 quantity. This combination is presented by point B in the
lower panel of figure.
If points A, B, and C are joined, the demand curve DD is derived. It slopes
downward from left to the right indicating an inverse relationship between price
and demand.
D
D

Law of Substitution/Law of Equi-marginal Utility

a. Introduction
This law was propounded by a famous economist HH Gossen in 1854 AD.
Therefore it is also called as Gossen’s second law of utility.
Finally this law was fully developed by Alfred Marshall (Neo-classical economists).

Cont..
 

Cont..
c. Assumptions:
This law is based on the following assumptions:
The consumer is rational.
The utility can be measured in cardinal numbers.
The marginal utility of money remains constant.
No change in the price of goods/ prices remain same.
It is based on two commodity.
Law of diminishing MU operates on consumption.
Consumer has a given money income and has to spend his whole income on consumption
of selected goods.
Goods are divisible and all units of the commodities are homogeneous.
Wants are comparable, substitutable and complementary

d. Tabular Explanation
As shown in above table, a consumer is in equilibrium by purchasing 6th unit of
good x and 4th unit of good y
24=6x2+4x3=24 (all income is spent)
Mux/Px= MUy/Py= 5

e. Graphically
 

Limitations
Irrational consumer.
Cardinal measurement is impossible.
Marginal utility money does not remain same.
Price does not remain same
Indivisibility.
Consumer’s ignorance

Indifference Curve/ preference curve

a. Meaning:
An indifference curve is a locus representing various combinations of two goods
which yields the same level of satisfaction (utility) to the consumer.
b. Assumptions:
The consumer must be rational: he aim at the maximization of his utility at his
given income and market prices of goods and services and he has full knowledge of
all relevant information.
Two wants are satiable (possible to satisfy or sate) at a time.
Ordinal measurement of utility.
The total utility depends on the quantities of the commodities consumed. i.e
U=f(q1,q2,…..qn)

Cont..
5. Consumer has non-satiety in nature: the consumer prefers more goods to less of
it.
6. Consumer has definite scale of preferences for goods and services.
7. Operation of diminishing marginal rate of substitution
8. Consistency: if one period a consumer chooses bundle A over B, he will not
choose B over A in another period if both bundles are available to him i.e.if A> B,
then no B>A.
9. Transitivity: A>B, B>C, then A>C

c. Indifference Schedule: A schedule of various combinations of the two goods that

will give the same level of utility to the consumer.
Combinations
X
Y
U
MRSXY
A
1
12
U0
-
B
2
8
U0
4/1
C
3
5
U0
3/1
D
4
3
U0
2/1
E
5
2
UO
1/1
All the combinations ( i.e. A, B, C, D and E ) give the same level of utility to
the consumer.
The consumer is indifferent as to whether he gets A combination of 1 unit of X + 12
units of Y, or the combination B of 2 units of X + 8 units of Y, or the E
combination of 5 units of X + 2 units of Y.
The quantity of X is increasing while that of Y is decreasing to attain the same
level of satisfaction.

Indifference Curve: A graphical representation of indifference schedule

In figure, IC is indifference curve which shows that 1 of X and 12 of Y per unit of
time (combination A) gives the consumer the same level of satisfaction as 2 of X
and 8 of Y (combination B) and so on.
A(1,12)
B(2,9)
C(3,5)
D(4,3)
E(5,2)
IC=U0

Indifference Map
it is a set of indifference curves
In the figure, a set of four indifference curves i.e. 1C1, 1C2, 1C3 & IC4, is
indifference map of four indifference curves.

Properties of Indifference Curve

#1. IC Always Slopes Downwards From Left to Right:#

X
Y
Y
X
According to figure, any points lying on IC yield same level of satisfaction i.e.
TUA=TUB=TUC=TUD
The consumer should sacrifice units of Y in order to get more units of X to
maintain the same level of utility.
The negative slope (downward sloping ) of indifference curve shows that two goods
are substituted for one other without change in the level of satisfaction

X Good
Y Good

These possibilities are impossible

Y Good
X Good
Y Goof
X Good
Y Good
X Good
More units of Y good are consumed
More unit of X good are consumed
More units of both X and Y are consumed

2. IC is Convex to the Origin

 

3. Higher IC yields higher level of satisfaction than lower one:#

X good
Y good
It is because that the higher IC contains more units of both goods or more units of
at least one good than lower IC.
TU(IC3)> TU(IC2) >TU(IC1)

#4. Indifference curves do not intersect each other: #

If two indifference curves intersect each other, it would imply that an
indifference curve indicates two different levels of satisfaction or two different
combinations- one being larger than other- yield same level of satisfaction.
TU(IC1)=TU(IC2) at the intersect point. But TU(IC1) >TU(IC2) at the left side of
intersect point , whereas TU(IC1)< TU(IC2) at the right side.
This violets the assumptions of consistency and transitivity.
D
E

Marginal Rate of Substitution (MRS)

 

Law of Diminishing Marginal Rate of Substitution

a. Statement:
The amount of Y which the consumer has to give up for the gain of additional units
of X goes on diminishing.
b. Causes:
Changes in intensity of want: As the consumer has more and more units of a good,
the intensity of his wants for that good goes on diminishing.
Imperfect substitution: Goods are not prefect substitutes of each other (utility
given by X good is different from the utility given by Y good)
Assumption of MRS: The increase in the quantity of one good does not increase the
want satisfying power of the other.

Budget Line
Meaning
A budget line is a locus representing various combinations of two goods that can be
purchased by spending fixed income at a given prices.
Mathematically,
M=QxPx+QyPy
Where,
Px= price of X good
Py= price of Y good
Qx= quantity of X good
Qy= quantity of Y good
Graphically
 
C
D

Shift in budget line due to change in price of X keeping M and Py constant

In the figure, AB is a initial budget line.
Other things remaining the same, If the price of X good falls then the budget line
shits rightward from AB to AC.
Similarly, the budget line shits leftward from AB to AD due to fall rise in price
of X good.

Shift in budget line due to change in Money Income (M) keeping Px and Py Constant
AB is a initial budget line.
Other things remaining the same, if the income of the consumer increases then the
budget line shifts rightwards from AB to CD parallelly.
Other things remaining the same, if the income of the consumer decreases then the
budget line shifts leftwards from AB to EF parallelly.

Numeric Question
Q. Let a consumer selects two goods i.e. X and Y for consumption having prices with
Rs. 800 and Rs. 400 and fixed income with Rs. 4000.
Derive budget line.
Identify his equilibrium point where he allocates entire budget equally on two
goods.
Let price of X good falls to Rs 400, sketch the new budget line/ constraint.
When he spends Rs. 1600 on X good and Rs. 2400 on Y good after fall in price of X
good. Show the new equilibrium to the consumer.
Derive price demand curve.

Consumer’s Equilibrium
a. Statement
A consumer’s equilibrium is defined as a point where he/she has maximized the level
of his/her satisfaction, given his/her resources and other condition.

b. Assumptions
Consumer must be rational.
Consumer must have budget line and indifference curve
Prices of two goods remain unchanged
Consumer has to maximize utility by spending fixed budget on two goods

#c. Conditions of Consumer’s Equilibrium#

 

d. Explanation: Consumer’s equilibrium can be explained with the help of

indifference curve and budget line graphically.
As shown in the figure, consumer is in equilibrium at point E where two conditions
for equilibrium (AB ) budget line is tangent to the IC2 and IC2 is convex to the
origin) are satisfied.
Consumer gets maximum satisfaction by spending total budget on combination E which
contains 0X1 units of X good and 0Y1 units of X goods.
Consumer can not attain equilibrium at higher indifference curve IC3 because any
points lying on IC3 are unattainable because of budget constraint (Although IC3 is
desirable, it is unattainable due to budget constraint )
The points P and Q lie on the IC2 but they are lying outside the budget line AB and
unattainable. Therefore, they can not be equilibrium points.
Similarly, points R and S also can not be equilibrium points because they lie at
lower indifference curve IC1 and give lower level of satisfaction than by IC2.

Price Effect
Ceteris paribus, the price effect shows the change in quantity demanded for a
commodity due to change in its price.
Symbolically,
PE=
Where,
Qx= quantity of X Good
Px= price of X Good
PY= Price of Y good (constant)
M= Money income (constant)

1. Price Effect of Substitute Goods

b. Substitute Goods:
They are those goods which can be used in place of the other.
For example, tea and coffee.
A rise in price of one commodity will cause the demand for the other to rise, other
things remaining the same.
For example, a rise in price of tea will cause a rise in the demand for coffee and
vice versa.
In case of substitute goods, price of one commodity and demand for another one are
positively related/ as price of one commodity goes up demand for another one also
goes up and vice-versa.

Graphically
e2 is the initial equilibrium point to the consumer where AB budget line is tangent
to the IC2 and IC2 is convex to the origin and consumer purchases 0X2 units of X
good and E2X2 units of Y good.
Les us assume that price of X good falls, price of Y good and his money income
remains unchanged.
This increases the purchasing power of the consumer for X goods and budget line
shits rightwards from AB to AC and the consumer will be in equilibrium at point e3
on higher indifference curve and consumes Ox3 units of X good and e3X3 units of Y
good. He increases his demand for X and reduces demand for Y good (0X3>0X2 and
E3x3<E2X2).
This is because X good becomes cheaper than before and consumer substitutes X good
for Y good.
Level of satisfaction has increased as a consequence of the fall in the price of X
good.

Cont..
Similarly, let us assume that price of X good rises, price of Y good and his money
income remains unchanged.
This decreases the purchasing power of the consumer for X goods and budget line
shits leftwards from AB to AD and the consumer will be in equilibrium at point e1
on lower indifference curve and consumes Ox1 units of X good and e1X1 units of Y
good. He decreases his demand for Y and increases demand for Y good (0X1<0X2 and
e1x1>e2X2).
This is because Y good becomes cheaper than before and consumer substitutes Y good
for X good.
Level of satisfaction has decreased as a consequence of the rise in the price of X
good.
Price consumption curve PCC is obtained by joining three consumer’s equilibrium
points e1, e2 and e3. it slopes downwards from left to the right indicating
negative price effect.
PCC is a locus of various consumer’s equilibrium points at various level of prices
of the commodity, other things remaining the same.

2. Price Effect of Complementary Goods

They (car and petrol) are those goods which are consumed/demanded together/jointly
to satisfy a particular want (travel). They are jointly demanded. For example, ink
and pen. A fall in price of one commodity will cause the demand for the other to
rise, other things remaining the same. For example, a rise in price of pen will
cause a fall in the demand for ink and vice versa.
In case of complementary goods, price of one commodity and demand for another one
are negatively related/ as price of one commodity goes up demand for another one
goes down and vice-versa.

Graphically
explain the graph as in substitute goods

3. Price Effect of Giffen Goods

Those inferior goods in which there is a positive relationship between price and
demand are called Giffen goods.

Income Effect
Ceteris paribus, the income effect shows the change in quantity demanded for a
commodity due to change in income of the consumer.
Symbolically,
Income effect (IE)=
Qx= quantity of X Good (constant)
Px= price of X Good
PY= Price of Y good (constant)
M= Money income

1. Income Effect for Normal Goods/Positive Income Effect:#

Those goods whose demand increases as income of the consumer rises and decreases
as income falls (positive income effect and negative price effect)
For example, branded clothes, television, car etc.

Cont..
As shown in the figure, initially consumer is in equilibrium at point e1 where two
conditions of consumer’s equilibrium are fulfilled (IC1 is tangent to the budget
line AB and IC1 is convex to the origin). By consuming OX1 units of X and OY1 units
of Y, the consumer maximizes his/her utility.
Let us suppose that the income of consumer increases, at constant price of X and Y,
budget line of the consumer shifts rightwards from AB to CD and tangent to new
indifference curve IC2 at point e2 thereby purchasing OX2 units of X and OY2 units
of Y. consumer increases his demand for both goods.
Let us suppose that the income of consumer decreases, at constant price of X and Y,
budget line of the consumer shifts leftwards from AB to EF and tangent to new
indifference curve IC3 at point e3 thereby purchasing OX3 units of X and OY3 units
of Y. consumer decreases his demand for both goods.
By joining consumer’s equilibrium points e1, e2 and e3. income consumption curve
(ICC: a locus of equilibrium points at various levels of consumer’s equilibrium
which slopes upwards to the right indicating positive income effect) is derived.

2. Negative Income Effect/ Inferior Goods

There is an inverse relationship income of the consumers and the demand for
inferior goods, other things remaining the same. (If demand for a commodity
decreases as a result of increase in income of the consumer, then such commodity is
called inferior goods and vice versa)
Explain the graph as in positive income effect.
Here, Y being an inferior goods and X is superior goods, demand for X increases to
X2 and that of Y decreases to OY2 as income increases and demand for X decreases
to OX3 and that of Y increases to OY3 as income decreases
ICC slopes downwards to the right in case of inferior indicating negative income
effect.

3. Substitution Effect
The substitution effect is a change in the quantity demanded of a commodity which
results from a change in its price, relative to the prices of other commodities.
It happens when the consumer’s real income or satisfaction level becomes constant.
SE=

Decomposition of Price Effect into Income and Substitution Effects for Normal Goods
Define price effect
Define income effect
Define substitution effect
Define normal goods
PE= SE+ IE
It can be explained with the help of indifference curve and budget line (consumer’s
equilibrium)
Hicksian Approach: Consumer’s real income is so adjusted (by way of taxation) after
fall in price of X commodity that he returns to his initial indifference curve no
matter if his consumption basket changes.

Graphically
In the given figure, e1 is an initial equilibrium point of the consumer where two
conditions of equilibrium (the budget line AB is tangent to IC1 and IC1 is convex
to the origin) are satisfied. Here, he consumers OX1 units of X and OY1units of Y.
1. PRICE EFFECT (PE)
Let us assume that price of X falls at constant price of Y and money income, the
budget line shifts rightward from AB to AC and tangent to IC2 at point e2 thereby
consuming OX2 units of X and OY2 units of Y.
Here, he increases units of X by X1X2 units and reduces Y1Y2 units of Y.
This process of adjustment on the consumption of X and Y is called price effect
(movement from e1 to e3).
Here price effect is negative because demand for X increases as price of it falls.

Cont..
2. SUBSTITUTION EFFECT (SE)
The real income of the consumer increases by BC due to fall in price of X.
According to Hicksian approach, consumer’s real income (i.e. BC) is so adjusted (by
way of taxation) after fall in price of X commodity that he returns to his initial
indifference curve (IC1) no matter if his consumption basket changes.
When government increases income tax, the budget line AC shifts parallely to DE and
tangents to initial indifference curve IC1 at point e3 thereby consuming OX3 units
of X and OY3 units of Y.
Here, he reduces his demand for X by X2X3 units and for Y by Y2Y3.
The movement from e2 to e3 is called substitution effect which is always positive
(as price of X falls, its demand also falls)

Cont..
3. INCOME EFFECT (IE):
If the money taken from consumer by the way of taxation returns to him, a consumer
goes back to e2 from e3.
This is called income effect (movement from e3 to e2) which is positive because
demand increases from OX3 to OX2 due to increase in income.
PE=SE+IE
e1e2=e1e3+e2e3
X1X2=X1X3+X2X3

Decomposition of Price Effect into Income and Substitution Effects for Inferior
Goods
Define price effect
Define income effect
Define substitution effect
Define inferior goods
PE= SE+ IE
It can be explained with the help of indifference curve and budget line
Hicksian Approach: Consumer’s real income is so adjusted (by way of taxation) after
fall in price of X commodity that he returns to his initial indifference curve no
matter if his consumption basket changes.

Cont..
Explain the graph as in normal goods
PE ()=SE (+)+IE (-)
e1e2=e1e3+e2e3
X1X2=X1X3+X2X3
SE (+)(e1e3)>IE (-)(e3e2)

Thank you
Any questions ???