CCT Unit-4 theory of consumers behavior

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Theory of consumer’s behaviors

The traditional theory of demand of starts with the examination
of the behavior of the consumer. The theory of consumer’s
behavior is two types. First cardinal approach or marginal utility
analysis of consumes behavior and second is ordinal approach or
indifference curve analysis.

Concept of utility

Consumer demands goods because he gets satisfaction through

consuming that commodity. Thus utility of any commodity gives
satisfaction to the consumer. Hence utility is the want satisfying
power of commodity. For example- If a person is hungry then he
want to reduce his appetite by eating bread or something. When
he eats bread his hunger is lost. So the bread has the consumer’s
want satisfying power i.e. bread has utility to the consumer. Now
the question may be raised whether the utility is expected
satisfaction or realized satisfaction because realized satisfaction
may or may not be equal to expected satisfaction. Modern
economists say that in economics we only analysis the expected
utility or satisfaction. One economist says that utility is identified
with “desiredness” rather than with “satisfyingness”. So the
consumers demand goods in accordance to the expected
satisfaction.

Utility is a subjective entity and resides in the mind of person. The

utility varies according to the personal interest. For example- the
utility of a novel will be very high for an educated people but the

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utility of same novel will be zero for an illiterate person. Utility

may be different in various conditions. For example- the utility of
cold drinks will be high in summer season and less in winter
season.

Although utility is a subjective entity. Marshall and his followers

say that utility can be measured in monetary scale. According to
them price paid for a commodity is equal to the utility of that
commodity. Hence if a person is ready to pay Rs 50 for a pen then
utility of that pen for him is 50. So, Marshall and his followers say
that utility can be measured in cardinal numbers such as 1, 2,
3,...etc.

Concept of marginal, total and Average utility

A) Marginal utility (MU)

Marginal utility may be defined as the change in total utility due

to the consumption of one additional unit of commodity. Thus
marginal utility is nth unit of commodity equal to the total utility
derived after the consumption nth unit minus total utility derived
after the consumption (n-1)th unit of commodity.

Symbolically, MUn=TUn-TUn-1

Where, MUn=Marginal utility from nth unit of good

TUn=Total utility derived after the consumption of nth

unit

TUn-1=Total utility derived after the consumption of (n-

1)th unit
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The concept of marginal utility will be clear from the following

table.

Unit of bread Total utility Marginal utility

consumed
1 4 4-0=4
2 7 7-4=3
3 9 9-7=2
4 10 10-9=1
5 10 10-10=0
6 8 8-10=-2
Above table shows when a consumer consumes 1st unit of bread,
he will get 4 unit of utility. Hence his total utility is 4. As he
consumes 2nd unit of bread his total utility reaches to 7unit. Here,
the change in total utility 7-4=3 is the marginal utility of 2nd unit
of bread. Similarly, marginal utility of 3rd ,4th ,5th and 6th units of
bread are 2, 1, 0, and -2 respectively. Marginal utility can be
explained with the help of following diagram.

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B) Total utility

Total utility of consuming a certain amount of commodity is the

sum of marginal utilities of all the units. According to the Myers
“total utility is the sum of marginal utilities associated with the
consumption of the successive units.”

In the table above total utility derived by the consumer after the
consumption of 4th units of bread is 10, which is the sum of
marginal utilities of 1st, 2nd, 3rd and 4th unit of bread i.e.
4+3+2+1=10.

In the above example it is observed that:

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1- As consumer increases the consumption of commodity total

utility increases at decreasing rate.

2- When marginal utility becomes zero, total utility reaches to

its maximum level.

3- When marginal utility becomes negative, total utility

decreases.

In the figure above utility and quantity of commodity has been

measured along vertical and horizontal axis respectively. TU is the
total utility curve and MU is the marginal utility curve. Downward
slope of MU curve represents diminishing marginal utility. In the
figure it is seen that when a consumer consumes OP units of
commodity marginal utility becomes zero so MU curve intersects
horizontal axis. When marginal utility becomes zero total utility
becomes maximum. If the consumer consumes more than OP unit
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of goods then he will get negative utility or satisfaction means MU

becomes negative. TU curve initially increases at decreasing rate
reaches to maximum when MU becomes zero and starts to
decrease.

C) Average utility: Average utility is the ratio of total utility by unit

of commodity consumed. symbolically,
Totalutili ty
Average utility = quantity

The cardinal utility theory (marginal utility analysis)

The cardinal utility theory has been based on the following

assumption:

1- Rationality: The consumer is supposed to be rational.

Rationality means given his income and price of various
commodities, he plans to spend his money so as to attain
the highest possible satisfaction. In other words a rational
consumer always tries to maximize his satisfaction.

2- Cardinal measurement of utility: This theory assumes that

utility can be measured in cardinal numbers by monetary
scale or units. For example- if a person is ready to spend Rs
50 for a pen then utility of that pen for his is 50. So utility
can be measured in cardinal numbers like 1 2 3…etc.

3- Constant marginal utility of money: This assumption is

necessary because the monetary units are used to measure

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the utility. As money is the measuring rod of utility if the

marginal utility of money changes as income changes, the
measuring rod for utility becomes like an elastic ruler
inappropriate for measurement. So the marginal utility of
money remains same.

4- Diminishing marginal utility: The marginal utility of a

commodity diminishes as the consumer increases the
consumption of commodity.

Based on above assumption cardinal utility theory has two laws

about how a consumer maximizes his satisfaction by allocating his
limited resources on goods.

Law of diminishing marginal utility

The law of diminishing marginal utility explains how a consumer

maximizes his satisfaction by consuming successive units of single
commodity. In other words this is the single commodity case of
consumer’s equilibrium.

Statement- This law states that as the amount of a commodity

consumed increases the marginal utility of that commodity tends
to diminishes According to Boulding- “As a consumer increases
the consumption of any one commodities, the marginal utility of
the variable commodity must eventually decline.”

There are mainly two reasons for diminishing marginal utility:

1- None of the two commodities are perfect substitute of each

other.
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2- Although human wants are unlimited but wants for

particular commodity is satiable.

This law is can be explained with the help of following table and
diagram:

Unit of bread Marginal utility(MU) Total utility(TU)

1 6 6
2 4 10
3 2 12
4 1 13
5 0 13
6 -2 11
In the above, MU and TU of a consumer derived by the
consumption of different units of bread has been shown. In the
example our hypothetical consumer gains 6 unit of utility by
consuming 1st unit of bread. When he consumes 2nd unit of
bread he gets 4 unit of utility i.e. Marginal utility of bread
decreased from 6 to 4 unit. 1st unit of bread keeps high
importance for the hungry consumer. When he consumes 1st unit
of bread his appetite diminishes by which 2nd unit of bread is less
important for the consumer than 1st unit of bread. So the
marginal utility deceases from 6 units to 4 units for him. By the
same logic marginal utility decreases to 2 and 1 when he
consumes 3rd and 4th unit of bread. In the stage of consuming
5th unit bread, appetite of consumer has already been exhausted
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(fulfilled). So that the marginal utility of 5th unit of bread

becomes zero for him. This point at which marginal utility
becomes zero is called point of satiety and at this point total
utility becomes maximum. 6th unit of bread will be harmful for
consumer instead of useful, so the marginal utility of 6th unit of
bread is negative.

In the figure above utility and quantity of commodity has been

measured along vertical and horizontal axis respectively. TU is the
total utility curve and MU is the marginal utility curve. Downward
slope of MU curve represents diminishing marginal utility. In the
figure it is seen that when a consumer consumes OP units of
commodity marginal utility becomes zero so MU curve intersects
horizontal axis. When marginal utility becomes zero total utility
becomes maximum. If the consumer consumes more than OP unit
of goods then he will get negative utility or satisfaction means MU
becomes negative. TU curve initially increases at decreasing rate
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reaches to maximum when MU becomes zero and starts to

decrease.

Limitations of law

1- Uniform quality and size of the commodity: This law

assumes that the units of a commodity should be similar and
homogeneous. If the quality and size of the commodity are
not uniform then the law does not operates.

2- Suitable units: The unit of commodity consumed by a

consumer should be suitable. It should not too small and too
large for example- If a consumer is consuming tea then
suitable unit will be a cup of tea not a spoonful of tea or a
kettle of tea.

3- Consumption with in the same time: There must not be time

gap in the consumption of different units of a commodity
the commodity must be consumed continuously. For
example- If a person takes first unit of bread in the morning
and 2nd unit in the evening then the marginal utility will not
diminish.

4- No change in the marginal utility will not diminish: This law

operates only when if the price of commodity and its
substitutes remains unchanged. For example- let the price of
an orange is Rs 1 per unit. If the price falls to 50 paisa per
unit after the consumption of 2 oranges then utility of 3rd
unit of orange will certainly increases because from Rs 1 he
can buy two units of orange now.
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5- Mental condition: This law assumes that mental condition of

the consumer should be same during the consumption of
different units. If the mental condition is changed then the
law does not hold true or does not operates.

Importance of the law

Following are the importance of the law of diminishing marginal

utility.

1- Basic of the law of demand: Law of demand says that there

is inverse relationship between price and quantity
demanded when a consumer buys more units of a
commodity, marginal utility of that commodity decrease. So
the consumer will be ready to pay less price for more
commodities. In other words consumer will purchase larger
quantity in lower price. This is law of demand.

2- Basis of price determination: This law explains that to

increases in the supply of a commodity the price must be
decreased because larger quantity will be demanded in
lower price. Hence this law helps to determine the price of a
commodity and importance for the general consumer and
business man too.

3- Basis of modern tax system: Modern tax system i.e.

progressive tax box has been based on the law of
diminishing marginal utility. The more tax is imposed on rich
while less tax is imposed on the poor because the utility of
money is less to rich and more to poor.
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4- Explaining the concept of consumers surplus: In course of

purchasing any particular commodity when a consumer
purchase 1st unit of commodity, he feels that he utility of
that unit of commodity is greater the price he paid for that.
As he purchase more and more units of that commodity the
marginal utility of that commodity gradually deceases and
he reaches to the point where marginal utility and price
becomes equal. At this point consumer’s surplus is zero.
Before reaching this pint there is consumer’s surplus. Hence
it can be said that the concept of consumer’s surplus has
been based on the law of diminishing marginal utility.

Law of substitution or Law of equi-marginal utility

Human wants are unlimited and resources are limited. Hence

consumers can not fulfill all their wants at once. So the
consumer selects few of his wants which have immediate
importance and spends his limits resources. On doing so he
always tries to maximize his satisfaction.

This law explains that how a consumer maximizes his

satisfaction or utility by consuming successive units of more
than one commodity. In other words it is the more than one
commodity. In other words it is the more than one commodity
case of consumer’s equilibrium. To explain this law we take the
example as how a consumer maximizes his satisfaction by
consuming only two commodities at once.

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Statement: The law of substitution states that a consumer with

a fixed income and given market prices of goods, will achieves
maximum satisfaction or utility when marginal utilities of each
goods on which last units of money spend are equal.

It happens like this: Suppose a consumer is buying two

commodities say A and B. If the marginal utility of A derived by
spending last unit of money on it is greater than of B then he
buys more units of A and less units of B by which marginal
utility of A decreases. In other words he substitutes A for B.
That’s why this law is called “law of substitution”.

The consumer will contribute this process of substitution until

the marginal utilities of both goods derived from the spending of
last unit of money becomes equal.

In other words consumer will get maximum satisfaction when

ratio of marginal utilities and prices is equal to marginal utility of
money.

The concept of this law will be cleared by the help of following

example.

Suppose,

1- He is purchasing two commodities say orange and mango.

2- Price of per unit Mango and orange are Rs 4 and Rs 3

respectively.

3- Marginal utility of money Rs 1 = 8 unit

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The concept of law of equi marginal utility can be explained

with the help of following table.

Marginal Marginal MUm MUo

Pm Po
utility of utility of
mango(MUm) orange(MUo)
40 33 10 11
36 30 9 10
32 27 8 9
28 24 7 8
24 21 6 7
20 18 5 6

In the table above it is shown that during the purchasing

process. The consumer spends 1st unit of money on orange
because marginal utility derived from orange by spending 1
unit of money is greater than marginal utility of mango. Due to
the same reason he will spend his 2nd unit of money also on
orange but he will spend 3rd unit of money on 1st unit of
mango because marginal utility of 1st unit of mango is greater
than the marginal utility of 3rd unit of orange. Following this
process the consumer will buy 4 units of orange and 3 unit of
mango and equalizes the marginal utility of both goods. By this
adjustment the consumer will maximizes his satisfaction or
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total utility. The total utility derived from this combination of

orange and mango (i.e. 4 unit of orange and 3 unit of mango) =
40+36+32+33+30+27+24=222 units and total expenditure of
utility = 4×3+3×4=24=24×8(Rs1=8)=192. Total benefit=222-
192=30 be greater than any other combination of orange and
mango. For example- if he consume 4unit of mango and 4unit
of orange then total utility he will get =
40+36+32+28+33+30+27+24=250 and total expenditure of
utility =4×4+4×3=28=28×8=226. Total benefit=250-226=24 is
less than previous combination.

Limitation of the law:

1- Law of substitution involves very careful calculation of

marginal utilities. But none of the consumers are able to do
so. In reality consumers expenditure is governed by their
habits not by marginal utilities.
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2- For applying this law in real life consumers must be able to

measure the marginal utility in cardinal numbers. But it is
not possible for a consumer to measure the utility in cardinal
numbers.

3- Another limitation of the law of substitution is found in case

of indivisibility of goods. Goods are often available in large
indivisible units. If goods are indivisible then it is not possible
to equate the marginal utility of derived from the last units
of money spent on them.

4- The law of substitution has no place when the resources are

unlimited as in the case of free goods. In such cases, there is
no need to re-arrange expenditure because the consumer
can consumes goods without paying money.

Importance of the law of substitution

The law of substitution has very wide application in

economics. It is applicable to all branches of economics.

1-Importance to the consumer: Every consumer wants to

maximize his satisfaction from his limited resources. For this he
must substitute the things of greater utility for one possessing
less utility till marginal utilities are equalized. On this way the
consumer’s satisfaction can be maximized.

2-Importance to the producer: A producer always works

towards the most economical combination of the factors of

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production employed by him. For this purpose, he substitutes

one factor for another till their marginal productivities are to
be made same for example- if the marginal production of labor
is greater than that of capital then he will substitute labor for
capital.

3 Importance in the public expenditure: A government

increases public expenditure to those sectors which gives
higher rate of returns. And reduces the expenditure from
those sectors which give lower rate of returns.

Ordinal approach

Ordinal approach of consumers’ behavior says utility cannot be

measured in cardinal numbers like 1, 2, 3 ……. But consumer
can compare the utility of different goods and can say this gives
more and this gives less satisfaction without evaluating or
measuring utility in cardinal numbers. For example mango
gives more satisfaction than orange. In reality we consume
more than one commodity so we make our scale of preference.
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While making our scale of preference we do not consider the

price. In short consumer goes to market with his hypothetical
scale of preference. When consumer makes scale of preference
he does not consider the price.
Scale of preference schedule

combination Good X Good Y Comparing

with 4th
combination
1 5 100 More
2 10 95 More
3 15 90 More
4 20 70 Equal
5 25 65 Equal
6 30 60 Equal
7 35 55 Equal
8 40 20 Less
9 45 15 Less
10 50 10 Less

In the table above it is shown that combination 1, 2, 3 gives

more satisfaction than combination 4 and combination 8, 9, 10
give less satisfaction than combination 4. So our rational
consumer will choose combination 1, 2, 3, instead of other
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combination and he will not choose combination 8, 9, 10.

Combination 4, 5, 6 and 7 gives equal satisfaction to our
consumer. Among them consumer will be indifferent means
ready to buy any one combination.

If we convert those combinations of commodity which gives

equal satisfaction to our consumer into graph we will get
indifferent curve.

The indifference curve theory(IC)

1 Rationality: The consumer is supposed to be rational.

Rationality means given his income and price of various
commodities, he plans to spend his money so as to attain
the highest possible satisfaction. In other words a rational
consumer always tries to maximize his satisfaction.

2 Utility is ordinal: utility cannot be measured in cardinal

numbers like 1, 2, 3, … but consumer can rank his preference
according to the satisfaction of each basket.

3 Diminishing marginal rate of substitution: it assumed that

marginal rate of substitution for one to another good
diminishes. IC curve is assumed to be convex to the origin.

4 Total utility depends on quantity of commodity consumed

means higher the quantity higher will be the utility and vice
versa.

5 Consistency and transitivity of choice: if in one period he

chooses bundle A over B he will not choose B over A.
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If A > B then B will not choose over A.(consistency)

Similarly, If A > B and B > C then A > C.(transitivity)

Indifference curve may be defined as the locus of point which

represents the combination of commodities such that the
consumer derives the same level of satisfaction.
Indifference curve can be derived with help of following indifferent schedule.

Combination Apple Mango Marginal rate

of substitution
of mango for
apple
M 15 1 _
N 11 2 4:1
O 8 3 3:1
P 6 4 2:1
Q 5 5 1:1

Fourth column shows marginal rate of substitution.

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In the figure above M, N, O, P and Q are the combination of

commodity which gives equal level of satisfaction. If we join these
points we get indifference curve.

Indifference map

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Diminishing marginal rate of substitution

Marginal rate of substitution shows that how much of one

commodity is substituted for how much of another. Above table
shows when our consumer has 15 apples and 1 mango, he will be
prepared to sacrifice 4 apples for 1 mango to get same level of
satisfaction. Here the marginal rate of substitution of mangoes for
apple is 4:1. Another period consumer is ready to sacrifice only 3
apples for 1 mango because his little more want has been fulfilled.
So the marginal rate of substitution diminishes.

Reasons for diminishing marginal rate of substitution

1 Although human wants are unlimited but particular want can be

satiable means when consumer increases the consumption of
particular good his interest on that good decreases.

2 Another reason for diminishing marginal rate of substitution is

imperfect substitute of goods. For example in case of perfect
substitute goods increases in the stock of one commodity and
decreases in the quantity of another commodity would make no
difference. Hence marginal rate of substitution will not diminish.

Properties of indifference curve

1 An indifference curve has negative slope represents if quantity

of one commodity decreases then quantity of other must increase
to stay on same level of satisfaction.

2 The farther away from the origin an indifference curve

represents the higher level of satisfaction and vice versa.
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3 Indifference curves do not intersect each other. If they intersect

the intersection point lies on two indifference curves means one
combination gives two level of satisfaction is not true.

4 The indifference curves are convex to the origin. It means

marginal rate of substitution must decreases.

Budget line

We know that higher the indifference curve represents higher

level of satisfaction so our rational consumer wants to achieve
highest possible indifference in order to obtain highest possible
satisfaction.

In this situation consumer is governed by budget or money

income which sets the limit to maximized satisfaction. The budget
constraint can be algebraically written as follows.

Y = PxQx+PyQY

Where, Y = income

Px and Py are the per unit prices of X and Y goods.

Qx and Qy are the quantities of commodities.

Budget line can be derived with help of numerical example. Let

our consumer has Rs 600 and per unit prices of apple and mango
are Rs 2 and Rs 3 respectively.

If he spends all on apple he will get 300 unit of apple and 0 unit of
mango.

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If he spends all on mango he will get 0 unit of apple and 200 unit
of mango.

If we plot above combination of apple and mango on diagram and

join them we will get budget line.

The budget line represents various combinations of apple and

mango which can be purchased with given money income.

Budget line shifts when,

If income (Y) increases shifts to right and vice versa.

If relative price of commodities changes.

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Equilibrium

Assumptions

1 Consumer has map of indifference curve showing different level

of satisfaction.

2 Money income is given.

3 Price of goods in market is given.

4 goods are homogeneous and divisible.

5 Consumer is rational.

If we super impose indifference map on budget curve. Only one

indifference curve will be tangent to budget line.

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IC2 is tangent to budget line MN at point E is the equilibrium

point. OP and OQ are the equilibrium quantity of apple and
mango. IC3 is desirable but cannot be achievable due to money
income shown by budget line. A and B are the affordable
combinations from the point of view of budget but lies on lower
indifference represents lower level of satisfaction. So E is the
equilibrium combination of apple and mango which gives
maximum satisfaction or maximum possible satisfaction.

For equilibrium two conditions must be fulfilled,

1 The price line and indifference curve must be tangent to each

other means slope of both curve must be equilibrium.
MUx
Slope of IC = MUy (Marginal utility ratio)
Px
Slope of budget line = Py (price ratio)
MUx Px

MUy Py

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2 At equilibrium point IC must be convex to origin. It means at the

nearer to the equilibrium point marginal rate of substitution is
falling or right to the equilibrium point MRSx,y diminishes.

Change in equilibrium

Income effect

Income effect explains about what happens to consumer’s

equilibrium when income of consumer changes relative prices of
goods remaining the same. As a result of change in income of
consumer his satisfaction will be either more or less for he has
now larger or smaller income to spend.

In the figure above A, B and C are the successive equilibrium

points. When income increases budget line shifts from M1N1 to
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M2N2 and M3N3 and tangent to indifference curve IC1, IC2 and
IC3. Above figure shows when income increases demand for both
goods increases in case of both normal goods. When income
increases from M1N1 to M2N2 demand for X and Y goods
increases from OX1 to OX2 and OY1 to OY2 respectively.

In case of inferior goods shape of ICC ( income consumption curve

) will be as follows.

Price effect

Price effect explains how the consumer’s equilibrium shifts as a

result of change in the price of one good while his income and
price of other good remain same.

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Above figure shows as the price of X falls budget line shifts to right
from its initial position AB to AC and AD. Due to increase in
purchasing power of the given money income consumer can
purchase more of X and Y goods. The new equilibrium occurs right
to the original equilibrium (for normal goods). If we join
successive equilibrium points E1, E2 and E3 we will get PCC(price
consumption curve).

Substitution effect

Substitution effect explains what happens to the consumer’s

equilibrium when relative prices of goods changes while his
income remains same.

Decomposition of income and substitution effect from price

effect

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Above figure shows E1 is the initial equilibrium where initial

budget line AB and initial indifference curve IC1 are tangent. If
price of X decreases budget line shifts from AB to AC and higher
indifference IC2 is tangent at E3 is the new equilibrium point. The
shift in equilibrium from E1 to E3 increases the demand for X good
from OX1 to OX3 is total price effect. This price effect can be split
into two effects substitution and income effect. The substitution
effect is the increase in quantity bought as the price of commodity
falls after adjusting income(reducing income) so as to keep the
real purchasing power of consumer the same as before.

The amount by which the money income is reduced so that the

consumer should be neither better off nor wrose off than before
is called compansating variation in income. It means the reduction
on income must bring consumer to initial indifference curve. The
compansating budget line DE is parallel to budget line AC and
tangent to inotial indifference curve IC1 at E2 to the right of initial
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equilibrium(slope of DE >slope of AB). Movement from E1 to E2 is

substitution effect of price change. so consumer will buy more to
substitute X for Y because now X is cheaper and price of Y remains
same. In the figure above,

Total price effect = X1X3

Substitution effect = X1X2

Income effect = X2X3

Total price effect( X1X3) = Substitution effect (X1X2) +

Income effect (X2X3)

1 Substitution effect: Substitution effect is always positive when

price of commodity falls because more quantity of cheaper good
is purchaged and substituted tfor others whose price have not
fallan.

2 Income effect:

a) Income effect is positive for normal goods

b) Income effect is negative for inferior or giffen good

i) Oridinary inferior good: Negative income effect is

weaker than positive substitution effect so total
price effect is positve.

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ii) Giffen good: Negative income effect is stronger than

positive substitution effect so total price effect is
negative.

Conclusion

1) If both effects are positive price effect will be positive.

2) if positive substitution effect > negative income effect total

effect will be positve.

3) if positive substitution effect < negative income effect total

effect will be negative.

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