Chapter 2

Utility approach
• Consumer behaviour refers to the study of
consumer while engaged in process of
consumption.
• When a person gets highest satisfaction he
reaches equilibrium position.
• The process of equilibrium position can be
reached by two approaches:
• (i) Utility approach (ii) The indifference curve
analysis.
 Cardinal analysis
• Traditional analysis.
• Utility is measurable quantitatively.
• Utility refers want satisfying power in a commodity.
• Total utility:-utility of a commodity is additive. Tu
refers to the total satisfaction which a consumer
receives by consuming various units of a commodity,
he eventually reaches maximum point and if
consumption increases beyond this point total utility
diminishes.
 Marginal utility
• Mu refers to utility derived from additional
units.
• Mu can be defined as a change in total utility
resulting from one unit change in the
consumption of commodity at a particular
point of time.
• Every person weighs utility with price. He tries
to equalise mu with price.
Law of diminishing marginal utility
• The law of DMU states that if a consumer
consumes more and more of one commodity
the utility derived from additional unit
consumed diminishes.
• This law is given by Alfred Marshall. He defines it
as follows:
• “The additional benefit which person derives
from given increase in stock of thing diminishes
with every increase in the stock he already has”
 Assumptions

• Units of commodity must homogenous.

• There is no time gap.
• Every consumer wants to maximise utility.
• Taste and preference of consumer remains the
same.
• Marginal utility of money remains constant.
• Units Total utility Marginal utility
• 1 20 20
• 2 37 17
• 3 51 14
• 4 62 11
• 5 68 6
• 6 68 0
• 7 64 -4
 Explaination
• Total utility goes on increasing until consumption
of fifth unit.
• It is increasing at diminishing rate.
• Total utility is maximum at sixth unit and then it
diminishes.
• Marginal utility is 20 in first unit later it
diminishes.
• In the 6th unit it becomes zero and becomes
negative for subsequent unit.
graph
 Relationship between TU &MU
• TU increases at diminishing rate.
• When TU is increasing MU is falling
• When TU becomes maximum MU becomes
zero
• When TU falls MU becomes negative.
 limitations
• Homogeneity
• Suitable time
• No change in the taste of consumer.
• Normal person.
• Constant income.
 Exceptions
• Alcoholics
• Misers
• Money
• Reading
• Hobbies and rare collections.
• Arts
 Importance
• Determining the price.

• Explains paradox of value.

• Basis for downward sloping curve.

• Useful for field of taxation

 Law of Equi-Marginal Utility
• Consumer given money spends on various
commodities.
• The question arises as how he should allocate the
given money among various commodities.
• Suppose he buys one commodity he would be in
equilibrium at the position were MU=PRICE
• In case of more than one commodity also the same
principle applies.
• It means marginal utilities of goods and their
utilities prices must be equal
• This is called Law of equi-marginal utility.
• The law states that consumer would distribute
his income in such a way that utility derived from
the last rupee spent on each good is equal.
• In other words a consumer attains equilibrium
when marginal utility of money expenditure on
each good is same. In other words,
MU OF X COMMODITY = MU OF Y COMMODITY
• PRICE OF X PRICE OF Y
 Assumptions

• Perfect competition in market.

• Utility is measurable.
• The income of consumer remains constant and it is
limited.
• The consumer behaves rationally.
• The marginal utility of money remains constant.
• The utility schedule of one commodity is
independent of the utility schedule of other
commodities.
• The LDMU is applicable.
 Illustration

• Units MU of X MU of Y
• 1 20 24
• 2 18 21
• 3 16 18
• 4 14 15
• 5 12 9
• 6 10 3
• Let as assume the price of X commodity is Rs 2 and Y is Rs 3
per unit. Reconstructing the table by dividing them with price
the reconstructed table will be as follows:
• Units MU of X/P OF X MU of Y/P of Y
• 1 10 8
• 2 9 7
• 3 8 6
• 4 7 5
• 5 6 3
• 6 5 2
• With the given money income if he allots Rs
19 to buy these goods he will purchase 5 units
of X commodity and 3 units of Y commodity
and attains equilibrium. At 5th unit of X
commodity mu of X = mu of Y
• price of X price of y
of 3rd unit of commodity.
Daigram
 limitations
• Consumer cannot act as a rational person always.
• Mu of money never remains constant.
• This law cannot be applied if certain commodities
are not available in the market for consumption.
• Utility is a subjective concept it cannot be measured.
• Equi-marginal principle can be applied if goods are
divisible but certain goods are not divisible. This
restricts free working of the equi-marginal
approach.
 Importance of law
• Helps in determining optimum budget.
• Helps in distributing of earnings between
savings and consumption.
• Entrepreneur can use this concept to
maximize his profits
• It is applicable to public finance.
• An individual can distribute his assets among
alternative forms using this principle.
 Importance of utility analysis
• Basis for demand theory.
• LDMU is universal truth.
• Explains equilibrium condition of consumer
• Utility concept forms basis for ordinal measurement
of utility that is indifference curve analysis.
• Helps the consumer in distributing his assets and
commodities which gives maximum satisfaction.
• Utility analysis also forms a basis for taxation policy
of government.
 Indifference curve approach
• The utility analysis suffers from certain shortcomings. It
assumes utility is measurable cardinally and can be
assigned definite numbers. Since utility is a mental
concept it cannot be measured cardinally. We can have
ordinal measurement of utility.
• In ordinal measurement utility is comparable not
measurable. We do not use cardinal numbers 1,2,3, but
use ordinal numbers 1st ,2nd , 3rd etc. This approach came
to be called ordinal approach. This approach was
propounded by Hicks and Allen and was called
indifference analysis.
 Indifference curve
• An indifference curve can be defined a graphic
representation of the various quantities of two
goods that yield same satisfaction.
• An indifference curve is drawn from
indifference schedule of the consumer.
• An indifference schedule is a list of different
combinations of two goods which will give
equal level of satisfaction to the consumer
 Indifference schedule
• Combination Apples Mangoes MRS
• A 20 1 _
• B 16 2 4:1
• C 13 3 3:1
• D 11 4 2:1
• E 10 5 1:1
• An indifference map can be defined as a
collection or group of indifference group.
• It represents various levels of satisfaction. In
this the higher indifference curve represents
higher level of satisfaction. A consumer always
want to move to higher indifference curve than
lower one.
• An indifference map of consumer portrays the
consumer scale of preference.
 Properties of indifference curve
 Slopes downwards .
 Convex to the origin.
 Do not intersect each other.
 Higher IC shows higher level of satisfaction.
 Should not touch X or Y axis.
 Need not be parallel to one another.
 Marginal rate of substitution
• Marginal rate of substitution shows the rate at which a
consumer is willing to substitute one commodity for
another.
Symbolically
MRS= Δx/Δy
where, MRS=Marginal rate of subsitution
Δx= a small change in x
Δy= a small change in y.
MRS decides the slope of IC curve.
MRS is defined the rate at which a n individual will
exchange successive units of one commodity for another.
 Price line
• Price line is also called budget line or as income line.
• It represents all the possible combinations of two goods that
consumer can buy at a given level of income and prices of two
goods.
• It is called as income line because it represents the real income of
consumer.
• In order to determine the price line we should know the price of
two commodities and money outlay to buy these commodities.
Supposing a consumer has set apart Rs.30 from his income to buy
two commodities apples and mango and if we assume price of
apple is Rs.2 and Rs.3 and if he spends Rs.30 on apples, he gets 15
apples or (OA) and 10 (OB) mangoes.
 DAIGRAM

• Y
A

Apples
N1

O M M1 B MANGOES
.
• AB points in the diagram are connected by a line
and this is called price line. This line shows all
possible combinations of two goods that consumer
can buy if he spends whole of his outlay, prices
being unchanged.
• Supposing he buys ON apples he has to buy OM of
mangoes. If he prefers to buy OM1 of mangoes he
has to buy ON1 of apples. Any combinations lying
beyond AB price line is not possible.
 Consumer’s equilibrium
• We have seen a consumer is in equilibrium when his
mu=price. A consumer is in equilibrium when he is
buying such combination of goods as he leaves him
with no tendency to rearrange his purchases of
goods.
• The consumer has before him the indifference map
showing three or four indifference curves. He has
also price-line before him. The consumer is in
equilibrium when the price-line is tangent to IC
curve.
 A

IC 3 (3000)
apples

n E
IC 2 (2000)

IC 1 (1000)

O B X
m
Mangoes
• There are three IC curves showing different levels of
satisfaction. Price line AB contains all the possible combination
of two goods that are open to the consumer.
• Any point of the IC curve lying on the price-line is combination
of two goods which gives consumer maximum satisfaction. This
is called equilibrium position.
• Any point not lying on price line on the price line cannot be an
equilibrium point. The consumer will be equilibrium at point E
where the consumer will be buying om of mangoes and on of
apples. The consumer maximizes his satisfaction and will be in
equilibrium position where the price line is tangent to IC curve.
 Income effect
• Money income of the consumer changes or
prices of goods change. The consequence of
such change are studied here.
• Whenever the money income rises prices of
goods remain the same the consumer will buy
more quantities of goods. This is known as
income effect .
 A2

A A1 INCOME CONSUMPTION
P CURVE
P P
L A S
E R
S IC3 (3000)
IC2 (2000)
Q
IC1(1000)
P

O M M1 M2 Y

MANGOES B1 B2
B
• With the given money income and prices of two
commodities as indicated in price line AB the
consumer will be in equilibrium at point Q. on
the IC curve IC1 buying ON of apples and OM of
mangoes. Now his money income increases.
The new price-line is A1 B 1 as a result he is
buying more units of apples and mangoes. If his
income increases he further moves. If we join
points Q,R,S we get income consumption curve.
 Types of income effect
• Income consumption curve slopes upwards to the right.
This means as consumer income increases he buys more
of any each of the goods he is consuming.
• The effect of income consumption curve may be positive
or negative. If the consumption increases with increase in
income it is called positive. Such goods are called superior
goods.
• Income effect is negative where with increase in income
consumer reduces his consumption of goods. Such goods
for which consumption decreases are called inferior
goods.
 Price effect
• Let us now explain the effect of how a consumer
reacts to changes in price of goods his money
income constant taste and preference unchanged.
• Price effect shows the reaction of the consumer
whenever the price of one commodity falls. When
the price changes consumer will be better off or
worse of than before, depending upon whether
price rises or falls. As a result of change in price
equilibrium position will change.
 Price effect consumption curve

Y
A

N Q
APPLE N1 Q1
Q2 PCC
N2
IC3
IC2
IC3

O M M1 M2 X
B B1 B2
MANGOES
 Diagram
• AB is the original price line and is tangent to IC 1 at Q. The
consumer is at equilibrium buying ON of apples and OM of
mangoes. The price of mangoes falls while price of apples remain
the same. The new price line is AB1 . Since the consumer gets more
units of mangoes he goes to higher IC curve. The new price line IC 2
at Q1 the consumer is at equilibrium buying ON 1 apples and OM1 of
mangoes. If price falls the new price line is AB 2 and equilibrium
point is Q2 on 1C3. When all equilibrium Q, Q1, Q2. Price
consumption traces the effect of changes in price of a commodity.
• The price consumption curve is downward sloping. It indicates as
price of commodity falls, more units of that commodity are
bought.
 Substitution Effect
• When the price of good falls, the consumer feels better
off. There is an increase in the potential purchasing
power of the consumer’s income following fall in the
price. This is called Income effect. The income effect is
the first component of the price effect.
• Income effect will lead to the better purchase of
commodity. This is called substitution effect. A
consumer will substitute cheaper good for dearer one.
The second component of price effect is substitution
effect.
 SUBSTITUTION EFFECT
Diagram

APPLE N IC2
E
N1 F
IC1

O M M1 B1X

MANGOES
• Initially the consumer is equilibrium price line AB is tangent to the IC 1 .
With fall in the price of X goods, a new price line AB1 comes into
existence. The consumer is the equilibrium at point E at initial price line
AB. When price line shifts AB1 and the shifts to higher IC curve and attain
equilibrium point at G.
• If we measure pure substitution then we should resort to compensating
variation in income an hence hypothetical income line CD is drawn which
is parallel to new price line AB1 is tangential to the original IC1 . Thereby
the consumer shifted to original level of satisfaction . Now his
equilibrium position is changed to F. The substitution effect is measured
by movement from one point to another on the same indifference
curve. This effect may be large or small but it is always positive .
• PRICE EFFECT= INCOME EFFECT+ SUBSITITUTION EFFECT.
 LIMITATIONS
This analysis assumes consumer has full knowledge about his
preferences but it is not so.
Hicksian principle of diminishing rate of substitution is based
on LDMU.
Taste and preference of consumer never remain constant.
IC technique cannot be extended to those cases where
consumer prefer more than two goods.
IC analysis is not applicable to indivisible goods.
IC curve analysis is introspective and hence it cannot be
subjected to empirical tests and statistical verification.
It is also criticized as unscientific because it is based on
individual’s preferences and tastes.
 Uses of IC curve
• The IC curve technique was applied.. to the theory of consumption but now
extended to other fields of study of economics, like production, distribution,
taxation etc.
• Hicks gives importance to income effect and substitution effect of a fall in the
price of a commodity . He states when price falls the consumer’s real income
increases and he may substitute this commodity for costly commodity. He
reaches a better position this can be called as consumer’s surplus.
• It is useful in the field of taxation where individual welfare and his tax is
concerned.
• IC curve can be of great help to the consumer in deciding preference between
present goods and future goods. If he wants to save more he would prefer
spending less on present goods.
• This technique can be used during the times of scarcity of esential goods for its
distribution
Comparison of cardinal and ordinal analysis
• IC curve has avoided the unrealistic assumption of measuring
utilities.
• The analysis does not assume MU of money remains constant.
• IC technique splits price effect, income effect, and substitution
effect. This helps us to measure the real income of the consumer.
• Marshallain analysis is based on single good model but Hicksain
analysis is based on two or more goods.
• Utility analysis of marshall is not able to analyses the cases of
substitute goods and complementary goods whereas Hicksain
analysis considers both.
• IC curve analysis examines the phenomenon of Giffen Paradox
which is considered as a exception to law of demand