Last Updated on: 4th September 2024, 02:08 pm
Consumer Behaviour Theory
Consumer Behaviour Theory in Economics
In this Part, we discus about various aspects of Consumer Behaviour, to maximize his satisfaction level, within his Budget Constraints
Utility
Diminishing Marginal Utility
Equi-Marginal Utility
Marginal Rate of Substitution
Consumer Surplus
Indifference Curve
Budget Line
Consumer Equilibrium
Indifference Map
Meaning of Utility in Economics
In Economic terms, Utility is the benefit or satisfaction derived by consumer, on consumption of a commodity.
Utility is want satisfying power of a commodity. For example,Rice has the power to satisfy hunger; water fulfills our thirst. Liquor,satisfies the wants of drunkards. Utility is subjective. It varies from person to person.
Marginal Utility : Marginal utility is the additional utility derived from consumption of additional unit of a commodity. Marginal utility approach was proposed by Alfred Marshall. Marginal utility curve of a consumer is also his demand curve.
Total Utility : Total utility is the sum of utilities derived from the consumption of different units.
| Number of Oranges | Total Utility | Marginal Utility |
| 1 | 40 | 40 |
| 2 | 65 | 25 |
| 3 | 85 | 20 |
| 4 | 100 | 15 |
| 5 | 110 | 10 |
| 6 | 115 | 5 |
| 7 | 115 | 0 |
| 8 | 110 | -5 |
| 9 | 100 | -10 |
| 10 | 85 | -15 |
Characteristics of Marginal Utility
- Marginal utility, before the point of satiety (full satisfaction), remains positive, but diminishes with the consumption of every additional unit of a commodity.
- Upto the point of satiety, the total utility increase with each additional unit of consumption.
- At the point of satiety, the marginal utility falls to zero and the total utility does not increase further from this point onward. So, the total utility becomes maximum when the marginal utility falls to zero.
Basic Assumption of Utility
- Cardinal measurability: Utility is a cardinal concept. Utility is measured by the amount of money the consumer is willing to sacrifice, for another unit of a commodity. Cardinal theory of utility is proposed by Marshall.
- Constancy: The marginal utility of money remains constant throughout.
- Independence: The total utility derived by consumer for all commodities purchased by him is the sum total of the utilities of different commodities.
- Rationality: Every consumer is rational. He seeks maximisation of his utility within the constraint of available resources, as explained under Law of Diminishing Utility & Law of Equi-marginal Utility
Law of Diminishing Utility in Economics
The want of a human being for a particular commodity diminishes as its consumption increases. The Law of Diminishing Utility is a generalisation drawn from the characteristics of human wants. The want of a thirsty man for water may be intense, but after he takes one glass, his intensity of desire for another glass becomes less.
Law of Diminishing Marginal Utilityis called Gosen’s first law.
Diminishing Marginal Utility
The desire for a particular commodity or service can usually be satisfied in full (i.e., it is satiable). We cannot consume an infinite quantity of a commodity or services. The first few units consumed gives a positive marginal utility. As consumption increases, a time comes when no further utility is obtained. At this stage, marginal utility is zero. Between this stage, and the stage of a positive marginal utility, there is a downward variation of marginal utility.
Limitations of law of diminishing marginal utility
Like other economic laws, the law of Diminishing Marginal Utility is subject to certain limitations.
- Constancy of Attributes: The law is true only when all other things, in respect of the consumer (e.g. habits, tastes, temperament, income) remain uncharged.
- Initial stages and small increments: The law may not apply in the initial stages for very small increments of the commodity. For example, if a thirsty man is offered water in teaspoons, the utility he gets from the second teaspoon of water may conceivably be greater than that from the first one.
- Substitutes and complements: The utility of a commodity also depends on the supply of its substitutes and complements. For example, if more coffee (at cheaper prices) is available, the utility of tea may fall. If petrol becomes scarce, the utility of automobiles will sharply decline.
- Possession of other people: Utility of a commodity sometimes depend on the amount of the commodity which other people possess. For example, in a rich locality, if every householder except one, has two cars, the intensity of his desire for a second car may be higher than that for the first car.
Law of equi-marginal utility
A consumer will maximize his utility when he spends money in such a way that the utility derived from last rupee spent is equal.
For more than one commodity, the consumer maximizes his total utility by allocating his given money income among various commodities in such a way that the marginal utility of money spent on each commodity is equal
So, the ratio between marginal utility & price becomes the same for every commodity.
MUx / Px = MUy / Py = MUz / Pz = ……. = MUn / Pn
This equality is known as Law of equi-marginal utility
Law of equi-marginal Utility is also known as the law of Substitution, or the law of Economy in Expenditure, or the Law of maximum satisfaction, propounded by German Economist H.H. Gossen.
For single commodity, consumer, maximizes utility where MU = P (MU represents value of Marginal Utility of a commodity & P Represents Price of the commodity)
Example : If utility of last rupee spent on wheat is twice the utility of last rupee spent on rice, then a person will increase the utility spent as last rupee by switching from rice to wheat. As the consumption of wheat increases, its utility diminishes. The person will continue switching from rice to wheat till the state of equilibrium. At this stage, Marginal Utility of Wheat / Price of Wheat = Marginal Utility of Rice / Price of Rice.
Marginal Rate of Substitution of Commodity
Marginal rate of substitution (MRS) is the rate at which one commodity is substituted by the other, to derive same amount of utility. So, it is the rate at which the consumer is prepared to exchange goods x and goods y.
| Combination | Apples | Oranges | MRS |
| M | 1 | 12 | 5 |
| N | 2 | 7 | 4 |
| O | 3 | 3 | 2 |
| P | 4 | 1 | – |
The Table explains the Marginal Rate of Substitutions (MRS). Initially, at combination N, the consumer takes up 5 units of orange to get an additional unit of apple. Here, the MRS in 5.
Similarly, at combination O, the consumer is willing to spare 4 unit of oranges and at combination P, he is willing to agree to spare 2 units of oranges. Thus, MRS goes on Diminishing, referred as Diminishing Marginal Rate of substitution (DMRS)
Declining Marginal Rate of Substitution of Utility
As the consumer goes on increasing consumption of Apples, the intensity of desire for it declines. Thus, the stock of oranges reduce and the intensity of desire of it increases. Therefore, the consumer seeks to sacrifice less and less quantity of oranges, for every increase in the apples.
It is assumed that the goods (Apples & Orange) are imperfect substitutes of each other. Had they have been perfect substitutes, the increase and decrease would affect each other and MRS would remain same.
Consumer Surplus in Economics
Consumer’s surplus is measured by the difference between the maximum price, which the consumer is willing to pay for a commodity, and that which he actually does pay.
Consumer Surplus = (What a consumer is ready to pay) – (what he actually pays)
| No. Of units | Marginal utility (Ready to pay) | Market Price (Actual paid) | Consumer surplus |
| 1 | 38 | 30 | 8 |
| 2 | 35 | 30 | 5 |
| 3 | 34 | 30 | 4 |
| 4 | 32 | 30 | 2 |
| 5 | 30 | 30 | 0 |
| 6 | 27 | 30 | -3 |
| 7 | 25 | 30 | -5 |
Consumer Surplus
Consumer Surplus Graph
Assumptions of Consumer Surplus Concept
Consumer surplus concept is based on assumptions that utility is measurable, the marginal utility of money remains same, the utility of a commodity depends on its supply, the commodity has no close substitute.
Limitations to concept of Consumer’s Surplus
- The Consumer’s Surplus obtained from a commodity is affected by the availability of substitutes.
- Consumer’s Surplus cannot be measured precisely,as Marginal Utilities of different units of a commodity consumed by a person, cannot be measured accurately.
- The assumption that Marginal Utility of money is constant is unrealistic. As more purchases are made, and the consumer’s stock of money diminishes, the Marginal Utility of money also will undergo a change.
- Rule of consumer’s surplus does not apply in case of prestigious goods (e.g. diamond).
Indifference Curve
An indifference curve shows all the combinations of two goods, giving the same level of satisfaction to the consumer.
J.R. Hicks and R.G.D. Allen proposed the concept of indifference curve analysis.
| Combination | Commodity X | Commodity Y | MRS |
| A | 1 | 20 | – |
| B | 2 | 12 | 8:1 |
| C | 3 | 8 | 4:1 |
| D | 4 | 6 | 2:1 |
The Table shows two commodities X and Y. A person consumes 20 units of Y and 1 unit of X (represented by Combination 1:20). To maintain same level of satisfaction, he is willing to sacrifice 8 units of Y for an additional unit of goods X (represented b combination 2:12). This way, we may various combination of commodities giving same level of satisfaction.
Indifference Curve Graph
Properties of Indifference Curve
- An indifference curve is always convex to the origin due to the diminishing marginal utility.
- As a consumer increases one unit of a commodity, he reduces the consumption of the other commodity to maintain the same level of satisfaction. So, Indifference curve has a negative slope:
- The consumer seeks to sacrifice lesser quantity of Y for every increment in the quantity of X. So, it shows Diminishing Marginal Rates of substitutes
- A higher indifference curve will give higher level of satisfaction, than the lower one.
- Two Indifferent Curves do not intersect, but they may not be parallel to each other.
- Indifference Map is group of more than one ICs.
Indifference Curve Analysis
Every consumer has a scale of preference between alternative combinations of two or more things, giving the consumer the same amount of satisfaction. Consumer is rational and aware of his preference. Since all the alternative combinations of the two goods give the consumer the same satisfaction, he may choose any one alternative being indifferent about to the other combinations.
Budget Line
A Budget line (also known as Consumption Possibility Curve) represents the different possibilities of two goods, which the consumer can afford with his limited income.
Example
A consumer has Rs.200 to spend on Egg roll and cold drinks which cost Rs.10 and Rs.20 respectively.
He has 3 alternative possibilities before him. He may buy only 10 cold drinks, or buy only 20 Egg roll, or may buy both Egg roll and cold drinks in various combinations:
| Egg roll @10 | 6 | 8 | 10 | 12 | 4 | 2 |
| Cold drinks @20 | 7 | 6 | 5 | 4 | 8 | 9 |
Consumers Equilibrium
A consumer equilibrium occurs when the consumer is deriving maximum possible satisfaction from the goods and is in no position to rearrange his purchases of goods.
Assumptions of Consumers Equilibrium
Consumers Equilibrium concept is based on assumptions that the consumer has different selection for various combinations of two goods X and Y obtaining same amount of satisfaction. He has a fixed money income which he has to spend wholly on goods X and Y. Prices of goods X and Y are fixed.
Consumers Equilibrium Graph
The Consumers Equilibriumgraph shows the combination of two goods X and Y the consumer will buy to be in equilibrium, (the indifference map) and budget line together.
Indifference Map
The indifference map depicts the consumer’s preference scale between various combinations of two goods. The Indifference Curve of products (IC1, IC3) with respect to budget line (PL) shows various combinations the consumer can afford to buy with his limited resources (money is having)
Indifference Map
Interpretation of Indifference Map
Every combination on budget line PL costs the same. Thus combinations R, S, Q, T and H cost the same to the consumer.
The consumer aims to maximise his satisfaction. To do that, he will try to reach highest indifference curve. But since there is a budget constraint, he will be forced to remain on the given budget line.
Suppose he chooses R, which lies on a lower indifference curve (IC1). But he can very well afford S, Q or T lying on higher indifference curve. Similarly he has other combinations On IC1, like H.
This way he can choose other points like S, T etc. on other lines, lying on budget line. Now we find that Q is the best choice because this combination lies not only on his budget line but also puts him on highest possible indifference curves matching his money income.
Thus the consumer will be at equilibrium at point Q on IC3. At this point, his budget line PL is tangent to the indifference curve IC3. In this equilibrium position (at Q), the consumer will buy OM of X and ON of Y.
Marginal Rate of Substitution
At the tangency point Q, the slopes of the price line PL and indifference curve IC3 are equal. The slope of the indifference curve shows the Marginal Rate of Substitution of X for Y (MRSxy) which is equal to MUx/MUy, while the slope of the price line indicates the ratio between the prices of two goods Px/Py
Equilibrium Point
At equilibrium point Q, MRSxy = MUx/MUy = Px/Py, Where, MRSxy is Marginal rate of Substitution of X for Y, MUx and MUy are Marginal Utility of X and Y, Px & Py are price of product X & Y respectively.
Condition for Equilibrium
Price line must be tangent to the indifference curve, or the marginal rate of substitution of goods X and Y must be equal to the ratio between the prices of the two goods.
Click here to see PDF
