Theory of Consumer Behavior

Cardinal approach
The cardinalist school was of the view that utility can be
measured. Various suggestions have been made for the
measurement of utility.
Under certainty of full knowledge about the market
conditions and income levels, some economists have
suggested that utility can be measured by monetary units;
utils, by the amount of money the consumer is willing to
sacrifice for another unit of a commodity.
 Measurement of Utility
1. Utility: Utility is wants satisfying power of a commodity which varies from person
to person. The concept of utility is ethically neutral as harmful and useful things are
both considered. The value-in-use of a commodity is the satisfaction which we get
from the consumption of a commodity.

2. Marginal utility: The additional utility derived from additional unit of a commodity.
It refers to net addition made to the total utility by the consumption of an extra unit
of a commodity.

3. Total utility: The sum of utility derived from the different units of a commodity
consumed by a consumer. The amount of utility derived from the consumption of all
units of a commodity which are at the disposal of the consumer.
 Law of Diminishing Marginal Utility:
Marshall has stated the law of diminishing marginal utility as follows:
 
“The additional benefit which a person derives from a given increase of
his stock of a thing diminishes with every increase in the stock that he
already has.”

This law is based upon two important facts.

• First, while the total wants of a man are unlimited, each single want is
satiable. Therefore, as an individual consumes more and more units of a
good, intensity of his want for the good goes on falling and a point is
reached where the individual no longer wants any more units of the
good. That is, when saturation point is reached, marginal utility of a good
becomes zero. Zero marginal utility of a good implies that the individual
has all that he wants of the good in question.
• The second fact on which the law of diminishing marginal
utility is based is that the different goods are not perfect
substitutes for each other in the satisfaction of various
wants. When an individual consumes more and more units
of a good, the intensity of his particular want for the good
diminishes but if the units of that good could be diverted
to the satisfaction of other wants and obtain as much
satisfaction as they did initially in the satisfaction of the
first want, marginal utility of the good would not have
diminished.

Thus, It is obvious from above that the law of diminishing

marginal utility describes a familiar and fundamental
tendency of human nature.
Explanation of the Law of Diminishing
Marginal Utility:
Consider the Table, where we have presented the total and marginal utilities derived by
a person from cups of tea consumed per day.

 When one cup of tea is taken per day the total utility derived by the person is 12 utils.
And because this is the first cup its marginal utility is also 12 utils with the
consumption of 2nd cup per day, the total utility rises to 22 utils but marginal utility
falls to 10.

It will be seen from the table that as the consumption of tea increases to six cups per
day, marginal utility from the additional cup goes on diminishing (i.e. the total utility
goes on increasing at a diminishing rate).

 However, when the cups of tea consumed per day increases to seven, then instead of
giving positive marginal utility, the seventh cup gives negative marginal utility equal to
– 2 utils.

This is because too many cups of tea consumed per day (say more than six for a
particular individual) may cause acidity and gas trouble. Thus, the extra cups of tea
beyond six to the individual in question gives him disutility rather than positive
satisfaction.
The figure illustrates the total utility and the marginal utility curves. The total utility
curve drawn in Figure 7.1 is based upon three assumptions.

• First, as the quantity consumed per period by a consumer increases his total
utility increases but at a decreasing rate. This implies that as the consumption per
period of a commodity by the consumer increases, marginal utility diminishes as
shown in the lower panel of figure.

• Secondly, as will be observed from the figure when the rate of consumption of a
commodity per period increases to Q6, the total utility of the consumer reaches its
maximum level. Therefore, the quantity Q6 of the commodity is called satiation
quantity or satiety point.

• Thirdly, the increase in the quantity consumed of the good per period by the
consumer beyond the satiation point has an adverse effect on his total utility that
is, his total utility declines if more than Q6 quantity of the good is consumed.
 Hypothesis of Utility Maximization
If MUX > Px, then consumer is not at equilibrium
and he goes on buying because benefit is greater
than cost. As he buys more, MU falls because of
operation of the law of diminishing marginal utility.
When MU becomes equal to price, consumer gets
the maximum benefits and is in equilibrium.

Similarly, when MUX < Px, then also consumer is not

at equilibrium as he will have to reduce
consumption of commodity x to raise his total
satisfaction till MU becomes equal to price.
Marginal Utility (MU x) is equal to Price (Px)
paid for the commodity; i.e. MU = Price.

• The consumer is, thus, in equilibrium (i.e., gets

maximum total utility) if he consumes up to
the point where the marginal utility of a good
equals to the market price of the good
 Law of Equi-Marginal Utility
• The law of equi-marginal utility is based on the law of
diminishing marginal utility. This law operates when different
units of different commodities are consumed and consumer
tries to maximize his satisfaction with his given resources. The
consumer should allocate his resources on different units of
different commodities that in the last the marginal utility of
each commodity is equalized.

• It deals with the multi-commodity consumer behavior when a

consumer consumes different units of different commodities
with his given income and maximizes his satisfaction.
• Modern economists have explained the law of equi-marginal utility
in algebraic form and they call it the law of proportionality.
According to them, a consumer attains the maximization of
satisfaction at the point where he equalizes the marginal utility
from different units of multiple commodities and their price ratios.

The above is the equilibrium of a consumer at the point of maximization of

satisfaction when he consumes different units of a commodity.

• The consumer will attain his equilibrium at the point of equality of

the ratios of the marginal utilities of the individual commodities to
their prices. It will maximize his satisfaction and on the basis of
such adjustment the law is also called the law of proportionality.
Schedule
 Explanation of the schedule
• The table reveals that the consumer has Rs. 9 which he can
spend on the different commodities, namely, A and B. We
also assume that each unit of a commodity has price of Re.
1. The various units of two commodities have been shown
which gives him different marginal utilities. The MU of A and
B are decreasing. He can maximize his satisfaction when he
spends Rs. 5 on commodity A and Rs. 4 on commodity B.

• His total utility is 32+28+24+20+16 of A and 28+24+20+16 of

B which is 208 units. He cannot attain more utility by
spending his given income in different way.
 Limitations:
1. All goods are homogenous, both qualitatively
and quantitatively.
2. Tastes, habits, fashion and income of the
consumer remain unchanged.
3. Consumption has to be a continuous process.
Different units of the good must be consumed
one after the other.
4. Marginal Utility of money remains constant.
 Ordinal approach:
•The ordinalist school claimed that utility is not measurement, but
is an ordinal magnitude. The consumer need not know in specific
units the utility of various commodities to make his choice. It
needed for him to rank the commodities. He must be
able to determine his order of preference among the different
bundles of goods.
Indifference Curve Analysis
The ordinal theory or the indifference curve theory is based on some
assumptions. These assumptions are -

 Two Commodities: It is assumed that the consumer

has fixed amount of money, all of which is to be spent
only on two goods while prices of both goods are
constant.

 Non Satiety: Satiety means full satisfaction. A bigger

bundle is preferred to a smaller bundle.

 Transitivity: If consumer prefers bundles A to B and B to

C, he prefers bundle A to C.
 Diminishing Marginal Rate of Substitution: Marginal rate of
substitution may be defined as the amount of a commodity that a
consumer is willing to trade off for another commodity, as long as
the second commodity provides the same level of utility as the
first one.

 Rational Consumer: A consumer always behaves in a rational

manner, i.e. a consumer always aims to maximize his total
satisfaction.

 Complete Ordering: All possible combinations of goods can be

ordered into preferred, indifferent or inferior combinations when
compared to given combination of the good.

 Consistency: This condition requires that if a consumer prefers

bundle A to bundle B, he does not, at the same time prefer bundle
B to bundle A.
2
2
 Indifference Curves
•A very popular, easier and scientific method of explaining consumer’s
demand is the indifference curve analysis. This approach to consumer
behavior is based on consumer preferences.

•Human satisfaction is psychological phenomenon which cannot be

measured in terms of monetary terms.

•This approach is more realistic to order preferences.

•Consumer preference approach is therefore an ordinal concept based on

ordering of preferences compared with Marshall’s approach of
cardinality.
Definition:
•An indifference curve is the locus of points- particular
combinations or bundles of goods- which yield the same utility
(level of satisfaction) to the consumer, so that he is indifferent
as to the particular combination he consumes.

•In other words, an indifference curve is a graph showing

combination of two goods that give the consumer equal
satisfaction and utility. Each point on an indifference curve
indicates that a consumer is indifferent between the two and all
points give him the same utility.
Graphical Representation:
 Constructing an indifference curve
a

Pears Oranges Point

30
28 30 6 a
24 7 b
26
20 8 c
24 d
14 10
22 e
10 13
Pears

20 8 15 f
18 6 20 g
16
14
12
10
8
6 Combinations of pears and
4 oranges that person X
2 likes
0
0 2 4 6 8 10 12 14 16 18 20 22

Oranges
 30 a
28
Pears Oranges Point
26
b 30 6 a
24
24 7 b
22 20 8 c
20 14 10 d
18 10 13 e
Pears

8 15 f
16 g
6 20
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 30 a
28
Pears Oranges Point
26
b 30 6 a
24
24 7 b
22 20 8 c
20 c d
14 10
18 10 13 e
Pears

8 15 f
16 g
d 6 20
14
12
e
10
f
8
6
g
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
Marginal Rate of Substitution :

Definition:

The MRS of X for Y ( MRS x y) refers to the

amount of Y that a consumer willing to give up
in order to gain one additional unit of X ( and
still remain on the same indifference curves). As
the individual moves down on indifference
curve, the MRS x y diminishes.
Marginal Rate of Substitution shows the rate at which
one good can be substituted for another while keeping
utility constant.

The MRS represents:

 Negative of the slope of the indifference curve.
 Ratio of the marginal utilities of the goods.

Y MU X
MRS   
X MUY
 30 a Deriving the
DY = 4 MRS = 4
26 b Marginal Rate of
DX = 1 Substitution
Units of good Y

20

MRS = Y/X

10

0
0 67 10 20
Units of good X
 30
1. Downward/Negative sloping curve
Units of good Y

20

a
10

I1
0
0 10 20
Units of good X
2. A higher indifference curve shows higher level of
satisfaction
 30 3. The Indifference curves neither touch the axis nor
intersect each other
Units of good Y

20

a
10
c

b I2

I1
0
0 10 20
Units of good X
4. Indifference Curves are convex
to the origin
 Budget line or Iso-Expenditure line

Units of Units of
good X good Y
A budget constraint
line shows all the different 0 30
5 20
combinations of the two
10 10
commodities that a consumer can 15 0
Purchase , given his or her
money income
And the prices of the two
Assumptions
commodities
PX = Rs.2
PY = Rs.1
Budget = Rs.30
A good is demanded by a consumer if he has:
1. A preference for the good.
2. Purchasing power to buy the good.

Thus, the budget line shows all possible commodity bundles that
can be purchased at given prices with a fixed money income.
The purchasing power can be represented in terms of budget
equation:
 Construction of Budget Line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
Units of good Y

20 5 20
10 10
15 0

10 Assumptions

PX = Rs.2
PY = Rs.1
Budget = Rs.30

0
0 5 10 15 20
Units of good X
 30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10 c
15 0

c Assumptions
10
PX = Rs.2
PY = Rs.1
Budget = Rs.30

0
0 5 10 15 20
Units of good X
 30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10 c
15 0 d

c Assumptions
10

PX = Rs.2
PY = Rs.1
Budget = Rs.30

d
0
0 5 10 15 20
Units of good X
 40 Effect of an increase in income
on the budget line
30
Units of good Y

20

Assumptions

10 PX = Rs2
PY = Rs.1
Budget = Rs.30

0
0 5 10 15 20
Units of good X
 When budget increases from Rs. 30 to Rs. 40
40

Assumptions

PX = Rs.2
30 PY = Rs.1
Budget = Rs.40
Units of good Y

n
20

16
m

10 Budget
= £40
Budget
= £30
0
0 5 7 10 15 20
Units of good X
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = Rs.2
PY = Rs.1
Budget = Rs.30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 30
Effect on the budget line of a fall in the price of good X from Rs.
2 to Rs. 1
Units of good Y

20

Assumptions

PX = Rs.1
PY = Rs.1
10 Budget = Rs.30

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30 a
Assumptions

PX = Rs.1
PY = Rs.1
Budget = 30
Units of good Y

20

10

B1 B2

b c
0
0 5 10 15 20 25 30
Units of good X
Consumer’s Equilibrium
 A consumer is in equilibrium when, given personal
income and price constraints , the consumer
maximizes the total utility or satisfaction from his or
her expenditures . In other words, a consumer
equilibrium when, given his or her budget line , the
person reaches the highest possible indifference
curves.

 A consumer shall be in equilibrium where he can

maximize his utility, subject to budget constraints.
 Finding the Consumer’s Equilibrium
Units of good Y

I5
I4
I3
I2
I1
O
Units of good X
 Finding the Consumer’s Equilibrium
Units of good Y

Budget line

I5
I4
I3
I2
I1
O
Units of good X
 Finding the Consumer’s Equilibrium

r
s
Units of good Y

Y1 t

u I5
I4
v I3
I2
I1
O X1
Units of good X
Income Effect
 Effect on consumption of a change in income
Units of good Y

B1 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I2
B1 B2 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

Income-consumption curve

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
Units of good Y Effect of a rise in income on the demand for an inferior good
(normal good)

B1 I1
O Units of good X
(inferior good)
 Effect of a rise in income on the demand for an inferior good

b
Units of good Y
(normal good)

I2

B1 I1 B2
O Units of good X
(inferior good)
 Effect of a rise in income on the demand for an inferior good

Income-consumption curve

b
Units of good Y
(normal good)

I2

B1 I1 B2
O Units of good X
(inferior good)
Price Effect
 Effect of a fall in the price of good X
30
Assumptions

PX = Rs2
PY = Rs1
Budget = Rs30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30
Assumptions

PX = Rs2
PY = Rs1
Budget = Rs.30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30

Units of good X
 Now Price of X falls from Rs. 2 to Rs. 1
30
Assumptions

PX = Rs1
PY = Rs1
Budget = Rs30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20
k
j

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a

Price-consumption curve
Units of good Y

20
k
j

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
 Price Effect
 The Income Effect may be defined as the effect on the purchase
of the consumer caused by changes in income, if prices of goods
remain constant.

 Substitution effect refers to the change in the consumption or

demand of two goods as a result of their relative change in
prices, real income remaining constant.

 Price effect shows how much the satisfaction of the consumer

varies due to change in the consumption of two goods as the
price of one changes the price of other and money income
changes.
Price Effect when there is a fall in price of
good X i.e. Oranges.
Fall in price of oranges lead to increase in
demand for oranges.
The substitution effect when by eliminating the change
in income which the consumer feels because of fall in
price.
The increase in purchase of oranges
The Substitution Effect
The Income Effect
Substitution Effect + Income Effect
Price Effect = Income Effect + Substitution
Effect (for normal goods)
 Indifference analysis

Income and substitution effects of a

change in price:
(b) Inferior good
Price Effect in case of Inferior Goods
Fall in Price of good X i.e. Lentils
To measure the substitution and price effect we
draw a parallel line to new price line
Price Effect in case of inferior goods
Substitution Effect in case of Inferior Goods

A to B is the Substitution Effect

Income and Substitution in case of inferior
goods

Movement from:
A to B Substitution Effect
B to C Income Effect
A to C is Price Effect
Price Effect in case of Inferior Goods

Movement from:
A to B Substitution Effect
B to C Income Effect
A to C Price Effect
Price Effect in case of Giffen goods
Movement from:
H to N is Income Effect
M to H is Substitution Effect
M to N is the Price Effect
THANK YOU