Theory of

Consumer
Behaviour
SUVANKAR ROY
Utility
Utility is the want satisfying capacity of a commodity.
The more the utility obtained from an item, the greater the need for it or the
stronger the desire to have it.
Utility is a subjective concept. The same product can provide various levels of
utility to different people.
A consumer's desire for an item is usually determined by the utility (or
satisfaction) he obtains from it.
Approaches of Utility Analysis
 Cardinal Utility analysis : It was given by Professor Alfred Marshall. This analysis suggests
that utility may be stated numerically. It describes how the level of pleasure following the
consumption of any goods or services can be graded in terms of countable numbers. It is
measured in terms of “Utils”.

Example : A Basket of oranges offers 10 utils of utility to a consumer

 Ordinal Utility analysis : It was given by professor Hicks and Allen. It explains that the level
of satisfaction following the consumption of any goods or services cannot be quantified. These
items, on the other hand, can be placed in order of preference. The utility of a product is
determined by its level of psychological satisfaction. It is more realistic and logical.

Example : A pizza offers a greater satisfaction to a consumer than a Chapati.

Concept of Cardinal Utility
The two main concepts of Cardinal Utility are as follows;
Total Utility (TU): The total satisfaction derived from the consumption of a given quantity of a
commodity at a given time is known as total utility.

To put it another way, it is the total of marginal utility.

TU = ∑ or TU = + + …….
 Marginal Utility (MU): The marginal utility is the change in total utility caused by the
consumption of an additional unit of the commodity.

To put it another way, it's the utility gained from each additional unit.

= - or MU = ∆TU/∆Q
 Law of Diminishing Marginal
Utility (DMU)
Statement : According to the law of diminishing marginal utility, as a consumer consumes more units of a
commodity, the marginal utility derived from each successive unit continuously falls and becomes negative.

Dr. Alfred Marshall states the law as “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.” The law highlights that it is only
the additional benefit that decreases and not the total benefit.

Assumptions :

1) Cardinal measurement of utility.

2) Consumer is rational.

3) Consumption should be of identical units and it should be continuous.

4) Income of the consumer and prices of the goods are constant.

5) Consumer’s tastes and preferences should not change.

 Law of Diminishing Marginal
Utility (DMU) (Continued)
This law can be explained with the help of the following schedule and diagram : TU is
maximum
Units of apple consumed TU from apples(utils) MU from apples (utils)
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
1. TU keeps on increasing at a decreasing rate.MU is always
falling, as the satisfaction we derive from the consumption of MU = 0
an additional unit is less than the previous unit.
2. When TU is maximum, that is 50 at the 5th unit, MU becomes
0. (Point of saturation)
3. After this point, MU becomes negative, as TU starts falling.
4. TU will increase only up to the situation when MU is
Fig : The values of marginal and total utility derived from
positive, once MU turns negative, TU starts falling.
consumption of various amounts of a commodity
 Consumer’s Equilibrium
A consumer is said to be in equilibrium when he has derived maximum satisfaction and does not want to change his
consumption level. Hence, Consumer’s Equilibrium is a situation in which a consumer has maximum satisfaction with limited
income and does not tend to change his existing way of expenditure.

As a consumer has to pay for each unit of commodity, he cannot purchase or consume unlimited quantities. Besides, according
to the Law of Diminishing Marginal Utility, as the consumer consumes an additional unit of a commodity, the utility derived
from the same decreases. Also, by purchasing more units of a commodity, the income of the consumer decreases.

Therefore, the aim of a rational consumer is to balance his expenditure in a way that he gets maximum satisfaction by spending
a minimum amount of income, and when the consumer successfully accomplishes his aim, he is said to be in equilibrium.

Two different situations in which Consumer’s Equilibrium can be studied are:

1. When a consumer spends his entire income on a Single Commodity

2. When a consumer spends his entire income on Two Commodities

 Consumer’s Equilibrium:
Single Commodity Case
Consumer’s Equilibrium in the case of a single commodity can be explained with the help of the Law of
Diminishing Marginal Utility.

Hence, to study the case of a single commodity, all the assumptions of the Law of DMU are considered in this
study. A consumer purchasing a single commodity will be at equilibrium when he buys the commodity in such a
quantity that gives him maximum satisfaction.

Besides, the two factors which affect the number of units of the given commodity to be consumed are the Price
of the given commodity and the Marginal Utility from each successive unit.

In order to determine the equilibrium point, the consumer compares the price of the given commodity with the
satisfaction level derived from it (utility). Being a rational consumer, he will be at an equilibrium level when the
price paid for the commodity is equal to marginal utility.
Single Commodity Case
Now, we know that Marginal Utility is measured in utils and the price is expressed in rupees; therefore,
to determine the equilibrium level it is essential to express MU in terms of money, as:

Utility differs from one person to another as it is a subjective concept. Under the single commodity case,
it is assumed that a consumer defines the Marginal Utility of one rupee himself, in terms of satisfaction
from the given bundle of goods.

[ Marginal Utility of one rupee is the extra utility obtained when an additional rupee is spent on other
goods. ]
Equilibrium Condition under
Single Commodity
A consumer, when consuming a single commodity (say x) will be at equilibrium when: Marginal
Utility (MUx) is equal to the Price (Px) paid for the commodity.
MUx = Px

If MUx > Px, then the consumer will not be at equilibrium and he continues to purchase the
commodity as the benefit gained from the consumption is more than the cost of the commodity. As the
consumer buys more, Marginal Utility falls because of the Law of DMU, and when it becomes equal
to the price, the consumer gets maximum satisfaction and is said to be in equilibrium.

Similarly, if MUx < Px, then also the consumer will not be at equilibrium and he will have to reduce
the consumption of the commodity in order to increase the satisfaction level, till MU becomes equal to
the price.
 Example
Let’s assume, a consumer wants to buy a good (say x),
of price ₹10 per unit and the marginal utility derived
from each successive unit (in utils and in ₹) is as
follows (let’s assume that 1 util/MUm= ₹1)

This result can be shown with the help of a diagram:

 Explanation
In the above graph, the slope of the curve is going downward, which indicates that the marginal utility falls when an
additional commodity of x is consumed (because of the Law of DMU). Also, the Price (Px) is a straight horizontal line as the
price of the commodity is fixed at ₹10 per unit.

With the help of the above schedule and graph, it can be said that the consumer will be at equilibrium at point E, when he
consumes 3 units of commodity x because at that point MUx = Px.

The consumer will not consume 4 units of the commodity x because the MU of ₹0 is less than the price paid for x; i.e., ₹10.
Similarly, he will not consume 2 units of the commodity x because the MU of ₹20 is more than the price paid for x; i.e., ₹10.

Hence, in conclusion, it can be said that a consumer consuming a single commodity (say x) will be at equilibrium when the
Marginal Utility from the commodity (MUx) is equal to the price paid for the commodity (Px).

The equilibrium condition in the case of a single commodity can be expressed as:
Two commodity case:
Law of Equi-Marginal Utility
In the real world, a consumer may purchase more then one commodity. Let us assume that a consumer
purchases two goods X and Y. How does a consumer spend his fixed money income in purchasing two
goods so as to maximize his total utility? The law of equi­-marginal utility tells us the way how a consumer
maximizes his total utility.

Before elaborating this law, let us assume:

a) The consumer acts rationally.

b) Tastes and preferences, money income, prices of goods, etc., remain constant.

The equi-marginal principle is based on the law of diminishing 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.
Law of Equi-Marginal Utility
Suppose a man purchases two goods X and Y whose prices are Px and Py, respectively. As he purchases more of X,
his MUx declines while MUy 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.

Only when this is true, the consumer will not be distributing his money in buying good X and Y, since by
reallocating his expenditure he cannot increase his total utility.

This condition for a consumer to maximize utility is usually written in the following form:

MUx/Px = MUy/Py

So long as MUy/Py is higher than MUx/Px, the consumer will go on substituting Y for X until the marginal utilities
of both X and Y are equalized.

The marginal utility per rupee spent is the marginal utility obtained from the last unit of good consumed divided by
the price of good (i.e., MUx/Px or MUy/Py). A consumer thus gets maximum utility from his limited income when
the marginal utility per rupee spent is equal for all goods.
Example
This equi-marginal principle or the law of substitution can be explained in terms of an arithmetical example. In Table (2.6)
below, we have shown marginal utility schedule of X and Y from the different units consumed. Let us also assume that
prices of X and Y are Rs. 4 and Rs. 5, respectively. Money income = Rs. 35

MUX and MUY schedules show dimini­shing marginal utilities for both goods X and Y from the different units consumed.
Dividing MUX and MUY by their respective prices we obtain weighted marginal utility or marginal utility of money
expenditure. This has been shown in Table (2.7) below.
 Example
MUx/Px and MUy/Py are equal to 6 when 5 units of X and 3 units of Y are purchased. By purchasing
these combinations of X and Y, the consumer spends his entire money income of Rs. 35 (= Rs. 4 x 5 +
Rs. 5 x 3) and, thus, gets maximum satisfaction [10 + 9 + 8 + 7 + 6] + [11 + 10 + 6] = 67 units.
Purchase of any other combination other than this involves lower volume of satisfaction.

The equilibrium condition can now be written as:

MUX/PX= MUY/PY
This equation can, however, be rearranged in the following form:
MUX/MUY = PX/PY
This equation states that a consumer reaches equilibrium when he equalizes the ratio of marginal utilities of
both goods with the price ratio.
However, this equilibrium condition can be extended to ‘n’ number of commodities.
For ‘n’ number of commodities, the equilibrium condition is:
MUA/PA= MUB/PB= MUC/PC = ……… = MUn/Pn
What happens if
 Indifference Curve Approach
(Ordinal Theory)
Indifference Curve (IC) is the locus of all possible bundles/combinations of 2 goods that gives the
consumer equal level of satisfaction.
Since all of the combinations provide the same level of satisfaction, the consumer favors them all
equally. As a result, the indifference curve got its name.
Combination Popcorn Cold Drinks
A 1 15
B 2 10
C 3 6
D 4 3
E 5 1

All the points such as A, B, C, D and E lying on an indifference

curve provide the consumer with the same level of satisfaction.
Indifference Map
The group or set of Indifference curves showing different combination of 2
goods is called Indifference map.
> >
Monotonicity of preferences imply that
between any two indifference curves, the
bundles on the one which lies above are
preferred to the bundles on the one which
lies below. (More is better)
Properties of Indifference Curves
There are four main properties of Indifference Curves (IC) and we will study them one by one.

1) Indifference Curves are Negatively Sloped: As the consumer increases the consumption of X
commodity, he has to give up certain units of Y commodity in order to maintain the same level of
satisfaction. Therefore indifference curve slopes downward from left to right.

An indifference curve slopes downwards from left to right, which means

that in order to have more of bananas, the consumer has to forego some
mangoes. If the consumer does not forego some mangoes with an
increase in number of bananas, it will mean consumer having more of
bananas with same number of mangoes, taking her to a higher
indifference curve. Thus, as long as the consumer is on the same
indifference curve, an increase in bananas must be compensated by a fall
in quantity of mangoes.
 Properties of Indifference Curves
2) Indifference curves are convex to the origin : This happens due to the Diminishing marginal rate of substitution (DMRS).

Marginal rate of substitution (MRS) : The rate at which the consumer is willing to substitute one good for another without changing
the level of satisfaction. Combination Popcorn Cold Drinks Marginal Rate of Substitution
A 1 15
= , where ∆Y = Quantity of Good Y sacrificed B 2 10 5
C 3 6 4
∆X = Quantity of Good X obtained D 4 3 3
E 5 1 2
The marginal rate of substitution is the slope of the indifference curve.

According to the law of Diminishing Marginal return of substitution (DMRS), Marginal rate of substitution (MRS) continuously falls.
As the consumer consumes more and more units of good X, he would like to sacrifice lesser and lesser units of good Y. This happens
because the marginal utility derived from the consumption of an additional unit of good X goes on decreasing ( Law of DMU).

It is because of the MRS diminishing, that the indifference curve is convex to the origin.
 Properties of Indifference Curves
3) Higher indifference curve gives greater level of utility : As long as marginal utility of a commodity
is positive, an individual will always prefer more of that commodity, as more of the commodity will
increase the level of satisfaction.

As > > (monotonic preferences)

Hence, C ≥ B ≥ A ,where ≥ implies “is preferred to”
Properties of Indifference Curves
4) Two indifference curves never intersect each other: Two IC’s cannot give the same level of
satisfaction. Two indifference curves intersecting each other will lead to conflicting results.

If two IC’s intersect, (assume)

A ~ B (lies on ) and A ~ C (lies on )

Hence, By Transitivity B ~ C, but this is not true.

Clearly, B (9,7) will be preferred to C (9,5). [B > C]

So, 2 IC’s can never intersect each other.

Budget Constraint
 Let us consider a consumer who has only a fixed amount of money (income) to spend on two
goods.
 The prices of the goods are given in the market.

 The consumer cannot buy any and every combination of the two goods that she may want to
consume.
 The consumption bundles that are available to the consumer depend on the prices of the two
goods and the income of the consumer.
 Given her fixed income and the prices of the two goods, the consumer can afford to buy only
those bundles which cost her less than or equal to her income.
Consumer’s Budget
Budget set : The budget set of a consumer is the collection of all the bundles that the consumer
can purchase with his or her income at current market prices.

+ ≤M

Budget line : The budget line is a graphical representation of all the bundles that cost the same as
the consumer's income.

+ =M

Where, and are the prices of good 1 and good 2, respectively. Budget line /Price line

and are the quantities of good 1 and good 2, respectively.

 Slope of Budget line
The equation of the budget line is given as, + =M

It can be re-written as, = -- () +

Now, comparing it to the eqn. of a straight line y = mx + c, we get the slope of the budget line as -- ().

Main Properties of the Budget line :

i. Negatively sloped line.

ii. Slope of the budget line, is equal to the price ratio of the 2 commodities.

iii. It is a straight line, as we assume the give prices of the 2 commodities to be constant.

The budget line is a straight line with horizontal intercept and vertical intercept .

The horizontal intercept represents the bundle that the consumer can buy if she spends her entire income on good 1.

The vertical intercept represents the bundle that the consumer can buy if she spends her entire income on good 2.
 Changes in the Budget Set
When the price of either of the goods or the consumer’s income changes, the set of available bundles is also likely to change.

Case – 1 : Change in Income. Suppose the consumer’s income changes from M to M′ but the prices of the two goods remain
unchanged. With the new income, the consumer can afford to buy all bundles ( , ) such that + ≤ M’

Now the equation of the budget line is, + = M’

It can be re-written as, = -- () +

Note that the slope of the new budget line is the same as the slope of the budget line prior to the change in the consumer’s income.
However, the vertical intercept has changed after the change in income. Now, there can be 2 subcases.

i. If there is an increase in the income, i.e. if M' > M, the vertical as well as horizontal intercepts increase, there is a parallel outward
shift of the budget line. If the income increases, the consumer can buy more of the goods at the prevailing market prices.

ii. If there is an decrease in income, i.e. if M' < M, both intercepts decrease, and hence, there is a parallel inward shift of the budget
line. If income goes down, the availability of goods goes down.
Changes in the set of available bundles resulting from
changes in consumer’s income when the prices of the two
goods remain unchanged
 Changes in the Budget Set
Case – 2: Change in prices. Now suppose the price of good 1 changes from to but the price of good 2 and the consumer’s income remain
unchanged. At the new price of good 1, the consumer can afford to buy all bundles (, ) such tha t,

+ ≤ M.

The equation of the budget line is + = M

It can be re-written as, = -- () +

Note that the vertical intercept of the new budget line is the same as the vertical intercept of the budget line prior to the change in the price
of good 1. However, the slope of the budget line and horizontal intercept have changed after the price change. Now, there can be 2 subcases.

i. If the price of bananas increases, i.e. if > , the absolute value of the slope of the budget line increases, and the budget line becomes
steeper (it pivots inwards around the vertical intercept and horizontal intercept decreases).

ii. If the price of bananas decreases, i.e., , the absolute value of the slope of the budget line decreases and hence, the budget line becomes
flatter (it pivots outwards around the vertical intercept and horizontal intercept increases).
Changes in the Set of Available Bundles of Goods Resulting
from Changes in the Price of good 1 when the price of the
other good and consumer’s income remain unchanged
 Optimal choice of the consumer
The optimum bundle of the consumer is located at the point where the budget line is tangent to one of
the indifference curves.

If the budget line is tangent to an indifference curve at a point, the absolute value of the slope of the
indifference curve (MRS) and that of the budget line (price ratio) are equal at that point.

= Slope of Indifference Curve = Slope of Budget line

The equilibrium will be at point F, for the figure shown.

Consumer’s equilibrium will not be at the following points, because

I. At point C, the consumer derives lesser satisfaction as it appears on
a lower IC.
II. At point A, it is an unattainable combination of 2 goods.
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