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Unit 3: Consumer behaviour

The basis of consumer behaviour is that people tend to choose those goods and services they value
highly. Based on this premise, economists developed the notion of utility to describe the
consumption patterns adopted by the consumers. Utility is the power of a commodity or service to
satisfy human wants. Utility is thus the satisfaction which is derived by the consumer by
consuming the goods and services. Any commodity or service which can satisfy a human want is
said to have utility.
The utility can be studied through two different approaches;
1. Cardinal approach
2. Ordinal approach

The cardinal approach of utility measurement

According to the cardinal utility approach, the utility is measurable, and the consumers can express
their satisfaction in cardinal or quantitative numbers, such as 1,2,3, and so on. The utility is
measured on a hypothetical unit called “Utils”. The unit of utility is utils. For eg: An apple may
yield to a consumer a utility of 20 utils whereas an orange yields him a utility of 10 utils. Therefore,
it is clear that the consumer gets twice as much utility from an apple as that from an orange.

Assumptions of the cardinal utility approach

1. Rationality: It is assumed that the consumers are rational, and they satisfy their wants in the
order of their preference. They will purchase those commodities first which yields the highest
utility and those at last which yields them the lowest utility.

2. Limited resources (money): The consumer has limited money to spend on the purchase of
goods and services and thus this makes the consumer buy those commodities first which is a
necessity.

3. Maximization of satisfaction: Every consumer aims to maximize his/her satisfaction with the
amount of money he/she spends on goods and services.

4. Utility is cardinally measurable: It is assumed that the utility is measurable, and the utility
derived from one unit of the commodity is equal to the amount of money, which a consumer is
ready to pay for it, i.e. 1 Util = 1 unit of money.

5. Diminishing marginal utility: The utility gained falls as more and more units of a commodity
are consumed.

6. Constant marginal utility of money: The marginal utility of money remains constant
irrespective of the level of a consumer’s income.
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7. Utility is additive: Utility is not only cardinally measurable but can be added together to obtain
the total utility. For instance, a consumer consumes X1, X2, and X3 units of good X and derives
U1, U2 and U3 utils, respectively. Then the total utility = U1 + U2 + U3

The ordinal approach of utility measurement

According to the ordinal utility approach, consumers can't express the utility of various
commodities they consume in absolute terms, like 1 util, 2 utils, or 3 utils but it is possible to
express the utility in relative terms. The consumers can rank commodities in the order of their
preferences as 1st, 2nd, 3rd and so on. The ordinal utility approach is based on the fact that the
utility cannot be measured in absolute quantity but can only be compared.

Assumptions of the ordinal utility analysis

1. Rationality: It is assumed that the consumers are rational and aim at maximizing their level of
satisfaction for given income and prices of goods and services.

2. Utility is ordinal: Utility is not absolutely (cardinally) measurable. Consumers are required
only to order or rank their preference for various bundles of commodities.

3. Transitivity and consistency of choice: The consumer’s choice is expected to be either

transitive or consistent. The transitivity of choice means, that if the consumer prefers commodity
X to Y and Y to Z, then he must prefer commodity X to Z. The consistency of choice means that
if a consumer prefers commodity X to Y at one point in time, he will not prefer commodity Y to
X in another period.

4. Nonsatiety: It is assumed that the consumer has not reached the saturation point of any
commodity and hence, he prefers larger quantities of all commodities.

5. Diminishing marginal rate of substitution (MRS): The marginal rate of substitution refers to
the rate at which the consumer is ready to substitute one commodity (A) for another commodity
(B) in such a way that his total satisfaction remains unchanged. The ordinal approach assumes that
MRS goes on diminishing if the consumer continues to substitute A for B.

Total and marginal utility

Total utility (TU): It is the total satisfaction a consumer gets from consuming some specific
quantities of a commodity at a particular time. As the consumer consumes more of a good per
period, his/her total utility increases. However, there is a saturation point for that commodity
beyond which the consumer will not be capable of enjoying any greater satisfaction from it.

Marginal utility (MU): It is the extra utility a consumer derives from an additional unit of the
product. In other words, marginal utility is the change in total utility that results from the
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consumption of one more unit of a product. Graphically, it is the slope of total utility.

Mathematically, marginal utility (MU) = , where, TU is the change in total utility, and Q is

the change in the units of product consumed.

Law of diminishing marginal utility

Marshall has stated the law of diminishing marginal utility 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”. In other words, the law simply states that other things being equal,
the marginal utility derived from successive units of a given commodity goes on decreasing. This
law is founded based on facts;

i. The utility derived from a commodity depends on the intensity or urgency of the need for that
commodity

ii. as more and more quantities of a commodity are consumed, the needs get satisfied and therefore
the intensity of the need decreases.

E.g.: Suppose a person is very hungry and is offered some sandwiches to eat. The utility he/she
derives from the first piece of sandwich would be maximum. When he/she eats the second piece,
he/she derives a lower satisfaction. As he/she goes on eating more and more sandwiches,
satisfaction/utility derived from the successive units goes on decreasing. If the sandwiches are
eaten continuously, a point is reached when the hunger is fully satisfied and it gives zero utility.
Eating sandwiches anymore will give a negative utility in the form of discomfort or stomachache.

Sandwiches Total utility (TU) Marginal utility (MU)

1 40 40

2 70 30

3 90 20

4 100 10

5 100 0

6 90 -10
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120

100

80 Total utility (TU)

60
Utility

40

20

0
0 1 2 3 4 5 6 7
-20
Units of sandwiches

Fig: Law of diminishing marginal utility

Assumptions of the law of diminishing marginal utility

1. The consumer is rational.

2. The unit of the goods consumed must be standard. For example: a cup of tea, a pair of shoes, a
bottle of cold drink but not like a sip of tea, a bite of apple etc.

3. The consumer's taste and preferences remain unchanged.

4. The consumer consumes identical or homogenous products. The commodity to be consumed

should have similar quality, colour, design, etc.

5. There is no time gap between the consumption of the two units of the commodity.

6. The mental condition of the consumer remains normal.

7. The income of the consumer remains the same. Any rise in the money income of the consumer
may influence the taste and preference of the consumer towards the particular commodity.

8. The price of the substitute goods remains constant.

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Exceptions to the law of diminishing marginal utility

1. Hobbies: In the case of certain hobbies like stamp collection or old coins, every additional unit
gives more pleasure. MU goes on increasing with the acquisition of every unit.

2. Drunkards: It is believed that every dose of liquor Increases the utility of a drunkard.

3. Miser: In the case of a miser, greed increases with the acquisition of every additional unit of
money.

4. Reading: The habit of reading more books gives more knowledge and in turn greater
satisfaction.

5. The utility of a commodity to a person depends on the quantity of that commodity possessed by
others. Suppose in a particular locality, a person has two cars and his rival has only one car. Then
the latter’s desire for the second car will be higher than that of the first car.

Indifference curve

The indifference curve (IC) is a curve that represents all those combinations of goods that give the
same level of satisfaction to the consumers. All the combinations of goods lying on the IC are
equally preferred by the consumer. The rational consumer is indifferent between any of these
combinations of goods. IC are also called iso-utility or equal utility curves.

Combination Commodities Utility

x y

A 25 5 U

B 15 7 U

C 10 12 U

D 6 20 U

E 4 30 U

Table: Indifference schedule of commodity X and Y

The table represents five different combinations; A, B, C, D and E of two commodities X and Y
that yield the same level of satisfaction (U). When these points are plotted and joined by a curve,
the resulting curve is known as the indifference curve.
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Indifference schedule/set: Indifference schedule is the tabular statement that shows the different
combinations of two commodities yielding the same level of satisfaction.

Indifference map: It refers to the set of indifference curves of different satisfaction levels. The
higher IC yields a higher level of satisfaction than the lower IC in the indifference map.

35
30 A
25
Commodity X

20
15
10
5
0
0 10 20 30

Commodity Y

Fig: Indifference curve

Commodity X

IC3

Commodity Y

Fig: Indifference map

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Properties of indifference curve

1. Indifference curves slope downward to the right: This means that when the quantity of one
good in the combination is increased, the quantity of another good has to be necessarily reduced
so that the total satisfaction remains constant.

2. Indifference curves are convex to the origin: Indifference curves are convex to the origin
because of the diminishing marginal rate of substitution, meaning that as a consumer acquires more
of one good, they are willing to give up increasingly smaller amounts of the other good to maintain
the same level of satisfaction.

3. Higher indifference curves represent a higher level of satisfaction than the lower ones: The
further away from the origin an indifferent curve lies, the higher the level of utility it denotes.

4. Indifference curves cannot intersect each other: In the figure, the consumer prefers
combination B to combination C. On the other hand, from IC 1, the consumer is indifferent between
A and C, and from the indifference curve IC 2, the consumer is indifferent between A and B.
According to the principle of transitivity, the consumer is indifferent between B and C but this is
not true as B represents a higher level of satisfaction than C. Therefore, indifference curves never
cross each other.

Fig: Intersecting indifference curves

Price line/Budget line

The price or budget line shows all those combinations of two goods that can be purchased with
the consumer's income, given the prices of the goods. The points on or below the budget line are
feasible and affordable, while points outside the budget line are unaffordable. In the figure, the
points C and D are within the budget line of the consumers and they can purchase either C or D
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with their income. However, the consumer cannot purchase the combination E as it lies outside
the budget of the consumer.

Fig: Budget/Price line

Marginal rate of substitution (MRS)

The marginal rate of substitution is a rate at which consumers are willing to substitute one
commodity for another in such a way that the consumer remains on the same indifference curve.
The marginal rate of substitution of X for Y is defined as the number of units of commodity Y that
must be given up in exchange for an extra unit of commodity X so that the consumer maintains
the same level of satisfaction. The slope of the indifference curve gives the marginal rate of
substitution.

△
MRSXY = = –
△

Consumer equilibrium

It refers to the point at which a consumer maximizes their satisfaction or utility, given their budget
constraints and the price of the goods. Graphically, it is a point where the budget line is tangent to
the indifference curve of the highest order. At the point of consumer equilibrium, the slope of the
indifference curve and that of the budget line are equal. The slope of the indifference curve gives
MRSXY and that of the budget line gives the price ratio of goods (PX/PY).

At consumer equilibrium, the Slope of the indifference curve = Slope of the budget line

MRSXY = PX/PY

–  Y/ X = PX/PY
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Review questions

1. Differentiate ordinal and cardinal utility.

2. Who are consumers? What are the basic assumptions of cardinal utility analysis?

3. Define ordinal utility. What are the assumptions of the ordinal approach of utility measurement?

4. Explain the law of diminishing marginal utility. What are its assumptions and limitations?

5. What does the indifference curve represent? Explain its properties.

6. Graphically explain consumer equilibrium.

7. Write short notes on:

a) Indifference map

b) Consumer equilibrium

c) Marginal rate of substitution

d) Price line

e) Marginal utility

f) Total utility

8. Why do indifference curves never intersect each other?