The Theory of Consumer

Behaviour
Dr. Rekha V.
Assistant Professor
Department of Economics
Maharaja’s College Ernakulam
Utility
• Utility denotes “Pleasure”, “Satisfaction”, a Sense of fulfillment of desire
• Utility → “Want satisfying power” of a commodity
• Alfred Marshal in his book ‘Principles of Economics’ 1890 has given the
detailed concept of utility
• Rather than a psychological phenomenon, utility is a scientific construct
that economists use to understand how rational consumers make
decisions.
• Consumer demand functions are derived from the assumption that people
choose the bundle of consumption goods that give them the greatest
satisfaction or utility
Features of Utility
• Utility is subjective
It deals with the Mental Satisfaction of a Man. For Example, alcohol has utility for a
drunkard but for a teetotaler, it has no Utility.
• Utility is relative
Utility of a Commodity never remains the same. It varies with time, place and
person. For example, cooler/AC has utility in summer but not during winter.
• Utility is not essentially useful
A commodity having utility need not be useful. E.G., Smoking is not healthy, but it
satisfies the want of an addict thus have utility for him/her.
• Utility is ethically neutral
Utility has nothing to do with ethics. Use of alcohol may not be good from the
moral point of view, but as these intoxicants satisfy wants of the drunkards, they
have utility.
Total Utility & Marginal Utility
• Total utility is the overall satisfaction that a consumer derives from
the consumption of particular goods and services.
• Marginal utility is the change in total utility obtained by consuming
one additional (marginal) unit of a good or service
change in total utility
Marginal utility =
change in quantity
• Although the total utility increases, the extra or marginal utility
received from consuming each additional unit of the commodity
usually decreases
Total Utility & Marginal utility
• “The additional benefit which a person derives from a given
increase in stock of a thing diminishes with every increase in the stock
that he already has” - Marshall
Law of diminishing marginal utility
• The law of diminishing marginal utility states that, as the amount of a good consumed increases,
the marginal utility of that good tends to decline. It is the MU not the TU that falls with increase
in the consumption of a good. The law means TU increases at a decreasing rate. When saturation
point is reached, MU of a good becomes zero.
• When MU is positive, TU increases
• When MU is zero, TU is maximum
• When MU is negative, TU begins to fall
• Significance of the law:
✓ Because of diminishing MU the demand curve slopes downward
✓ MU of money is generally never zero or negative. Since money represents purchasing power over
all other goods and there is not enough money to satisfy people’s unlimited wants
✓ Role in fiscal policy: Imposition of progressive tax and spending the tax proceeds on social
services for the poor people
 Concepts of Utility
• The Utility Derived from the
Initial Utility Consumption of Ist Unit
of Commodity.

• The Aggregate of Utilities

obtained from the Consumption of
Total Utility Different Units of Commodity.
• TUn= U1+U2+U3+U4+…..+Un

• Change in Total Utility resulting

from the change in
Marginal Utility Consumption.
• MU = TUn- TUn-1
7
Types of Marginal Utility
Positive • With Consumption of an
Marginal Additional Unit of a Commodity,
Total Utility Increases.
Utility
• With Consumption of an
Zero Marginal Additional Unit of a
Commodity, Total Utility
Utility Remains Same.

Negative •merWith Consumption of an

Additional Unit of a
Marginal Commodity, Total Utility
Utility decrease 8
 Approaches to Consumer Behaviour
9

Cardinal • Propounded by
Marshall
Utility • Known as Marshalling
Approach Approach

Ordinal • Propounded by Hicks

& Allen
Utility • Known as Indifference
Approach Curve Analysis
Cardinal Approach vs Ordinal Approach
• Utility can be measured in monetary units by the amount of money
the consumer is willing to sacrifice for another unit of a commodity
• A utility function that describes by how much one market basket is
preferred to another is called a cardinal utility function.
• Utility function that generates a ranking of market baskets is called an
ordinal utility function. The ranking associated with the ordinal utility
function places market baskets in the order of most to least
preferred.
Cardinal Utility Analysis
• Formulated by Alfred Marshall-Utility of a commodity equals the money the consumer is willing
to pay for it
Based on certain assumptions:
• Rationality: Consumer spends his income on different goods and services so as to attain
maximum satisfaction
• Cardinal measurability of utility: Utility is a measurable & quantifiable entity
• Constant marginal utility of money: Money is the measuring rod of utility, must be constant
• Diminishing marginal utility: The utility gained from successive units of a commodity diminishes.
Consumer Equilibrium: Single Commodity Case
• Consumer is in equilibrium when the marginal utility of x is equated
to the market price
MUx= Px
• If Mux > Px, the consumer can increase his welfare by purchasing more units of X. If Mux < Px
the consumer can increase his total satisfaction by buying less of X.
Criticisms
• Utility is a subjective concept which cannot be measured objectively.
• The assumption of constant utility of money is unrealistic.
• The law of diminishing marginal utility is a psychological law which must not be taken for granted.
Equal marginal utility: Multi Commodity case
• Equimarginal principle: 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.
• 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. The
consumer can derive maximum satisfaction only when marginal utility per rupee
spent on good X is the same as the marginal utility per rupee spent on another
good Y. When this condition is met, the consumer does not find any interest in
changing his expenditure pattern.
Equal marginal utility: Multi Commodity case
• Equimarginal principle: The fundamental condition of maximum satisfaction or
utility is the equi-marginal principle. The consumer is said to be in equilibrium
when he is able to spend personal income in such a way that the utility or
satisfaction of the last dollar spent on the various commodities is the same.
𝑀𝑈𝑋 𝑀𝑈𝑌
= ………= 𝑀𝑈𝑀
𝑃𝑥 𝑃𝑌
• Consumer reaches his equi. When the MU derived from each rupee spent on the
two commodities X and Y are the same.
𝑀𝑈𝑋 𝑀𝑈𝑌
• If > , 𝑡ℎ𝑒𝑛 𝑡ℎ𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑤𝑖𝑙𝑙 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑒 𝑔𝑜𝑜𝑑 𝑋 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 𝑌. 𝐴𝑠 𝑎
𝑃𝑥 𝑃𝑌
𝑀𝑈𝑋 𝑀𝑈𝑌
r𝑒𝑠𝑢lt, MU of good X falls and MU of good Y . It will continue till =
𝑃𝑥 𝑃𝑌
In Table 2.6, 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. 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. 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.
Limitations of equi-marginal principle
• The law of equi-marginal utility is based on the measurability of utility
in cardinal numbers. But utility is a subjective concept and, hence, not
quantifiable.
• This law cannot be applied in the case of indivisible commodities like
motor car, refrigerator, etc. Since these commodities are not divisible
into smaller units, the law may seem to be inoperative. (No time gap
between the consumption of diff. units)
• Assumption of constant marginal utility of money is not possible
Indifference Curve-Assumptions
• Rationality: The consumer is assumed to be rational- he/she aims at the
maximization of his/her utility, given income and market prices.
• Utility is ordinal: It is taken as axiomatically true that the consumer can rank his
preferences (order the various 'baskets of goods') according to the satisfaction of
each basket.
• Consistency and transitivity of choice: It is assumed that the consumer is
consistent in his choice, that is, if in one period he chooses bundle A over B, he
will not choose B over A in another period if both bundles are available to him. If
A > B, then B A
• Similarly, it is assumed that consumer's choices are characterised by transitivity: if
bundle A is preferred to B, and B is preferred to C, then bundle A, is preferred to
C. If A > B, and B > C, then A > C
Indifference Curve
• An indifference curve shows the various combinations of commodity
X and commodity Y which yield equal utility or satisfaction to the
consumer. A higher indifference curve shows a greater amount of
satisfaction and a lower one, less satisfaction. Thus, indifference
curves show an ordinal rather than a cardinal measure of utility.
• Indifference curves are downward sloping. When the amount of X
increases along an indifference curve, the amount of Y decreases. The
fact that indifference curves slope downward follows directly from
our assumption that more of a good is better than less.
 Total An indifference map shows all the
Spending indifference curves which rank the
$20 preferences of the consumer. Combinations
of goods situated on an indifference curve
$20 yield the same utility. Combinations of goods
$20 lying on a higher indifference curve yield
higher level of satisfaction and are preferred.
$20 Combinations of goods on a lower
$20 indifference curve yield a lower utility.

30

25

20

15

10

0
0 5 10 15 20
Marginal Rate of Substitution (MRS)
• 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 (and still remain on the same indifference curve). As the individual
moves down an indifference curve, the MRSxy diminishes. In this figure, the MRS between
clothing (C) and food (F ) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D
and E) to 1 (between E and G). When the MRS diminishes along an indifference curve, the curve is
convex.
Properties of indifference curves
• Negatively sloped: An indifference curve has a negative slope, which denotes that
if the quantity of one commodity (y) decreases, the quantity of the other (x) must
increase, if the consumer is to stay on the same level of satisfaction
• Convex to the origin: The indifference curves are convex to the origin. This
implies that the slope of an indifference curve decreases (in absolute terms) as
we move along the curve from the left downwards to the right, the marginal rate
of substitution of the commodities is diminishing.
• Neither intersect or be tangent with one another: Indifference curves do not
intersect. If they did, the point of their intersection would imply two different
levels of satisfaction, which is impossible.
• Higher the indifference curve represent a higher level of satisfaction.
Budget Constraint
• Constraints that consumer face as a result of limited incomes. Income acts
as a constraint in the attempt for maximising utility.
• The budget line indicates all combinations of food and clothing for which
the total amount of money spent is equal to income.
• A budget line shows all possible combination of two commodities that
could be pursued with a given amount of income.
𝑃𝑥 𝑋 + 𝑃𝑦 𝑌 = 𝑀 {𝑃𝐹 𝐹 + 𝑃𝑐 𝐶 = 𝐼}
The slope of the budget line is equal to the ratio of the prices of two goods.
𝑃𝑥
Slope =
𝑃𝑦
 Suppose, for example, that our consumer has a
weekly income of $80, the price of food is $1 per unit,
and the price of clothing is $2 per unit. Table 3.2
shows various combinations of food and clothing that
she can purchase each week with her $80.

Basket Budget Allocation

A 1 × 0 + 2 × 40 = 80

B 1 × 20 + 2 × 30 = 80

D 1 × 40 + 2 × 20 = 80

E 1 × 60 + 2 × 10 = 80

G 1 × 80 + 2 × 0 = 80
Consumer Equilibrium
• The consumer is in equilibrium when he maximises his utility, given his
income and the market prices. Two conditions must be fulfilled for the
consumer to be in equilibrium.
• The first condition is that the marginal rate of substitution be equal to the
ratio of commodity prices

This is a necessary but not sufficient condition for equilibrium. The second
condition is that the indifference curves be convex to the origin. This
condition is fulfilled by the axiom of diminishing MRSx,y which states that the
slope of the indifference curve decreases (in absolute terms) as we move
along the curve from the left downwards to the right.
Graphical Representation
• Given the indifference map of the consumer and his budget line, the
equilibrium is defined by the point of tangency of the budget line
with the highest possible indifference curve (point e). At the point of
tangency the slope of the budget line and of the indifference curve.

At the point of tangency ‘e’, the consumer

maximises his utility by buying x* and y*
of the two commodities.