Theory of Consumer behaviour

- Utility tries to quantify satisfaction

- Utility of a good is the expected or anticipated capacity of satisfaction.
Satisfaction is the actual realisation of the outcome of the good.
- Utility is the basis of demand.

Why do people demand goods at some price?

The theory of consumer behaviour attempts to seek the consumption of goods that maximize
consumers’ utility. It also helps a consumer in his decision making about how to allocate his
consumption expenditure on different goods so that his total utility could be maximized.

● Cardinal Curve
● Ordinal Utility

Cardinal utility gives a value of utility to different options. The ordinal utility just ranks in terms of
preference. Cardinal Utility is the idea that economic welfare can be directly observable and be given a
value. A consumer compares the utility of a good to the price he/she pays for the utility of the good.

Cardinal Utility

Consumers are confronted in making a choice and in making this choice, a certain utility is given to the
choices. Consumers Alfred Marshall and his followers. Neoclassical economists. They believed that
utility can be expressed in cardinal numbers. That hypothetical number of utility is known as utils. An
economist called Boulding who expressed this idea. It is to be measured in absolute units.

Assumptions

1. How a consumer decides an optimal quantity of a good that he chooses to consume and how
he meets his equilibrium.
2. How a consumer would allocate his/her economy between different commodities to ensure that
total utility is maximized.
3. Occam Razor: a scientific and philosophical rule that entities should not be multiplied
unnecessarily which is interpreted as requiring that the simplest of competing theories be
preferred to the more complex or that explanations of unknown phenomena be sought first in
terms of known quantities.
4. Rationality: A consumer is a rational being in the sense that he/she satisfies his wants in the
order of his preferences. The consumer makes a list as to what he wants the most to least in
order to get the highest satisfaction from his good
5. Budget Constraint: limited money income. Our resources are scarce with regard to our wants.
6. Quantifiable and Measurable: Cardinal approach: the assumption is that utility can be
measured in numbers. 1util= 1 unit of money that a consumer is willing to pay for the good.
7. Law of diminishing marginal utility: As you consume more and more quantities of a
particular good, its marginal utility subsequently decreases with the consumption of each
additional unit.
 8. Additive Property of MU: Utility can be added. Ux= U1X1+U2X2+U3X3……….UnXn MUx
derived from commodity X1- MUx greater than or equal to PUx * MUm Marginal Utility from
commodity X is greater than the cost
9. Constancy of Marginal Utility of Money: Marshall assumed the marginal utility of money to
be constant. However, if you have more real income the marginal utility of money attached
goes down. It was needed in order to keep the scale of utility fixed. Individual expenditure on
anyone good is a small part of his total expenditure and thus it can be ceded that it is constant.
If the price of the commodity changes real income changes, the Constant marginal utility of
money means that the utility per unit of money remains unchanged for the consumer. This
implies that each additional unit of money provides the consumer with the same level of
satisfaction. This leads to the use of money as the measuring rod in utility analysis.

Law of Equimarginal principle

The Equi marginal principle states that consumers will choose a combination of
goods to maximise their total utility. This will occur where:-

Consumer Equilibrium= a utility maximising consumer reaches equilibrium when the allocation of
expenditure in such a manner that the last penny which is spent on each commodity gives him the
same level of utility.

- When the allocation of expenditure is such that the unit of money you are paying for any commodity
is equal to the satisfaction you are paying for that commodity.

The condition is that MU of money does not

exceed the MU of the commodity purchased

The consumer cannot increase his total satisfaction by shifting his expenditure from one commodity to
the other

In case of two commodities:

Normally, the consumer is not able to buy a commodity for a rupee at a time. He has to buy a full unit
of it or not at all. And the prices of different commodities also differ from each other. Therefore, in order
to arrive at MU per rupee expenditure on a commodity, the utility of the last unit of the commollity
purchased (MU of the commodity) is divided by the price of the commodity. In symbols, it would be
MU,/PA for commodity A, MU,/P, for commodity B, and
so on. Then according to the law of Equimarginal Utility, the consumer tries to
equate these ratios with each other and also with MU of money.

- A consumer is subjected to 2 things,

1. MUx law of diminishing marginal utility

 2. Paradox of value: Adam Smith put the Water/Diamond paradox in his book Wealth of Nations.
Whether the value of a good is the same as that of its price. He could not differentiate between
value in use and value in exchange of a commodity

Value in use: Utility of a commodity. High value in use of water over a diamond.
Value in exchange: The worth of a commodity that is expressed in terms of its price.

For example, Diamonds command high value in exchange. We get a decent amount of money if we
exchange it.

What determines the value of a commodity?

Stanley Jevons, Carl Menzer, Walrus: The three economists gave rise to the marginalist revolution.
Their work is known as the Marginalist revolution.

The total utility of water does not determine its price. It's the marginal utility that determines its
price. The usefulness of the additional unit of water. The marginal utility of water will be less since
it's relatively abundant. Since the relative supply of diamonds is less, marginal utility is higher.

Consumer surplus: the difference between the price that consumers actually pay and the maximum
price that they are willing to pay. Difference between potential price and actual price.

- Alfred Marshall defined consumer surplus as the excess of price which a consumer is willing to pay
rather than go without it.
- Thus we pay for each unit what the last unit is worth. But by our fundamental law of diminishing
marginal utility, the earlier units are worth more to us than the last.

As more of a commodity is acquired by the consumer, its marginal utility falls. Therefore, while the
utility derived from the marginal (or last) unit of a commodity is equal to the price paid for it, the utility
derived from intra-marginal (or earlier) units is not. It exceeds the price. The inference is that while the
consumer pays fulI for the utility derived frbm the last unit, the utility derived from earlier units is only
partly paid for. Thus, we enjoy a surplus of utility.

Ways to calculate consumer surplus:

1. CS=∑MU-PQ
 2. The area enclosed between the triangle formed above the equilibrium and is enclosed by
the demand curve.

- Managers, producers
- Government: designing tax regime

Ordinal Utility

Criticism of the Cardinal Approach

1. To assign cardinal values to utility seems miscalculated because the utility is subjective.
2. Marginal utility of money to be constant is not true as you have more money, the money
utility falls
3. Interdependence of goods was completely ignored by marshall
4. Restrictive Assumptions of cardinal approach to derive demand curve from utility curve- they
were restrictive in the sense that

In 1881, Edgeworth became the first economist to make the indifference curve theory but it was used
by V. Pareto. In 1915 Slutsky derived the consumer equilibrium with the indifference curve. JR Hicks
and RD Allen. It also came to be known as the indifference curve analysis

Economists and critics of the cardinal utility approach felt that utility could not be put down in cardinal
numbers but the consumers could rank their preferences in their order of preferences.

In contrast to the concept of cardinal utility, ordinality means that the consumers can rank his or give
scale of preference from the commodities.

- We are not measuring the utility, we are ranking our preferences on a scale.
- Scale of preference: the ranks given to the scale of priorities with respect to the
different combinations
- Indifference: consumers find one alternative equally preferable to another.
- Scale of preference is independent from other effects, such as everyone else’s demands

Analysis of consumer behaviour: Ordinal Utility approach

Assumptions

1. Rationality: A consumer is rational with budget restraint. A consumer aims to maximise their
utility with their given money income.

2. Ordinality: Preferences can be ranked

3. Perfect Knowledge: Consumers have perfect information about prices therefore sellers
cannot manipulate prices and there is perfect knowledge about perfect conditions. However,
this is not always true because information can be asymmetrical in nature. Perfect market
conditions exist.

4. Transitivity and consistency of choice: if we prefer x over y and you prefer y over z, x is
preferred over z. If X=Y and Y=Z, X=Z. This is transitivity of choice. If X is preferred over Y in
one time period then the consumer will not prefer Y over X in the next time period.

5. Monotonic preferences/ Non- Satiety: a consumer is never over-supplied with goods. A

consumer always prefers more goods. He always prefers more units to fewer units.

6. DMRS: Diminishing marginal rate of substitution. The rate at which a consumer is willing to
give up good x for one more unit of good y is falling. While leaving total utility unchanged.

Indifference Curve: A locus of a combination of two goods that give equal utility to the consumer.
The goods are substitutes, that are imperfect substitutes for each other.

ISO Utility curve: same utility throughout the curve

Diminishing Marginal rate of substitution: The rate at which a consumer is willing to give up good
Xfor one more unit of good Y.

The MRS provides the slope for the curve

Y2-Y1 Units willing to sacrifice
X2- X1 Units willing to gain

It is important to note that MRS of X for Y keeps falling as the stock of X with the consumer increases
because that leads to a fall in MUx and an increase in MUy arid thus a fall in the ratio. Further,
geometrically, MRS is represented by the
slope of the tangent to the indifference czrrve at the relevant poirit of reference.
Higher satisfaction on a higher indifference curve. (due to non- satiety)

You can never have intersecting indifference curves. (due to transitivity of choice)

Bowel Indifference Curve

Perfect Substitutes

Change in X/ Change in Y= 1
MRS- slope of the curve

Perfect Complements
L-shaped Lenteef Curve
- Infinite amount of one good required to substitute another
- The goods can only be used together so no amount of a good can change the satisfaction the
combination provides
- MRS= Change in X/ Change in Y= Infinite (along the vertical stretch)
- MRS= 0 (along the horizontal stretch)

Cardinal v Ordinal

1. Restrictive assumptions in Ordinal Utility. In the Cardinal approach the assumption is less
stringent and restrictive.The indifference curve approach is used widely in economics and
public policy.
2. Cardinal approach takes MRS while Ordinal approach takes DMRS.
3. Equimarginal approach of cardinal approach, MRS= PX/PY
4. Marginal Utility of X/ Marginal Utility of Y

Indifference Curve Properties

1. Convex to the origin: due to the DMRS, the Marginal Rate of substitution declines because of the
marginal rate of substitution
2. Indifference curve slopes downwards: as a consumer consumes more of a certain good he must
reduce the consumption of a certain good, this is to maintain the same level of total utility at a certain
level of money income. One individual better off without making at least one other individual worse off-
Pareto Efficiency

An indifference curve slopes downwards to the right: That is to say, an indifference curve has a
negative slope. This property shows that any increase in the amount of commodity X is accompanied
by a reduction in the quantity of Y. This property is derived from the assumption that both X and Y
have positive marginal utility. As a result, when there is an addition to the total utility on account of
more of X, there has to be an equivalent reduction in total utility through a reduction in the quantity of Y
3. Higher indifference curve shows a higher level of satisfaction.

4. Indifference Curves never intersect as different curves represent different levels of

satisfaction
No two indifference curves intersect each other: This property of indifference curves follows from the
assumption that both X and Y have positive marginal utilities. In cases the curves intersect each other,
this assumption is violated.