THEORY OF CONSUMER

BEHAVIOUR
LEARNING OBJECTIVES

• To understand the economic

aspects of consumer behaviour
through cardinal and ordinal
approaches
• To study Cardinal Utility theory
• To study Ordinal Utility theory, i.e.
Indifference Curve Analysis
Introduction to Consumer Behaviour

• In economics the study of consumer behaviour

occupies an important place

• The problem of a consumer consists of three

things: (a) the object, (b) the constraints, and (c)
the decision variable

• Object – To maximize total utility (Satisfaction)

• Constraint – Limited Resources (Income)

• Decision Variable – the quantity purchased using

limited resources
 Cardinal Utility Approach
• Developed by Alfred Marshall
• The numbers 1, 2, 3, 4, 5… are cardinal numbers.
In contrast, the numbers
• Utility is the want satisfying power of a commodity
or a service. It is a subjective concept and it resides
in the mind of the consume
• The concept of cardinal utility assumes that the
measurement of utility of different commodities is
possible. For example, the consumption of an apple
may give 50 units of utility whereas an orange may
give only 40 units
• Total utility is the sum of the utilities obtained from all units of
a commodity consumed. The more of a commodity consumed
per unit of time, the greater will be the total utility or
satisfaction from it up to a certain point

• At some point total utility will reach a maximum and this is

called the saturation point beyond which there is no
satisfaction from the consumption. After attaining the
saturation point, if there is more consumption, it will cause the
total utility to decrease. Symbolically, total utility can be
expressed as:
 Total Utility…

n
TU n = ∑ Xi
i =1
Where TU n = total utility of n units
X i = utility of the ith unit
∑ = the notation of the sum total
(sigma)
n = total number of units consumed
 Total Utility and Marginal Utility…

• Marginal utility is defined as the change in total utility

caused by the consumption of one more unit of a
commodity per unit of time. Mathematically, marginal
utility of nTh unit is the difference between total utility of n
units and total utility of n-1 units of the commodity.
Symbolically:
• MU n = TU n – TU n-1
• MU n = marginal utility of n units
• TU n = total utility of n units
• TUn-1 = total utility of n-1 units
 LAW OF DIMINISHING MARGINAL UTILITY
• The Law of Diminishing Marginal Utility is a
generalization formulated from the observation of human
nature. As we get more and more of a commodity, the
satisfaction from it diminishes at some point of time.
According to Alfred Marshall the additional benefit(
marginal utility ) 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 tendency towards diminishing utilities from successive
doses of the same commodity is operative in all types of
commodities and services. The rate of diminishing utility
may be slow for some commodities, or rapid for others, but
the tendency to diminish is operative.
 Law of DMU…Assumptions

• The units of the commodity must be relevantly defined. A

unit must be complete for its use.
• The tastes and preferences of the consumer are given
and unchanged.
• The units of the commodity are homogeneous – in size,
quality etc.
• There is no time-lag between the consumption of the two
units of a commodity.
• The income of the consumer, the price, and the
substitutes are given.
• This law was developed by Alfred
Marshall. He defined this law as “If a person has
a thing which he can put to several uses, he
will distribute it among these uses in such a
way that it has the same marginal utility in
all. For, if it had a greater marginal utility in
one use than another, he would gain by
taking away some of it from the second use
and applying it to the first”. Thus a consumer
attains maximum total utility from his available
resources (income) only when the marginal utilities
of all goods consumed are equal
Symbolically,
MU1 = MU2 = MU3 = ... MUn
MU1/P1 = MU2/P2 = MU3/P3 = MUn/Pn
• The weakness of Alfred Marshall’s approach was related to its
cardinal measurement of utility

• The technique of indifference curves was originally developed

by F.Y.Edgeworth and later elaborated by J.R.Hicks and Allen

• Consumer can simply compare the utility of different

combinations of goods within the constraints of his income. A
consumer possesses a definite scale of preferences for goods
and services. Each scale of preference consists of a number
of alternative combinations of two or more goods, which give
the consumer same level of satisfaction. Therefore, the
consumer is indifferent towards these combinations
 INDIFFERENCE CURVE – DEFINITION,
MEANING
• An indifference curve is a locus or path indicating different
combinations of two commodities, X and Y, which yield an
equal level of satisfaction

• For convenience it is assumed that there are only two

commodities under consumption

• An indifference schedule may be defined as a schedule of

various combinations of the two commodities that will
equally be acceptable to the consumer
 INDIFFERENCE SCHEDULE…
Combinations Quantity of X Quantity of Y Total
Satisfaction

I 1X + 20Y = Z
II 2X + 12Y = Z
III 3X + 7Y = Z
IV 4X + 4Y = Z
V 5X + 3Y = Z
 PROPERTIES OR CHARACTERISTICS OF INDIFFERENCE
CURVES

• Indifference curves have a negative slope.

• Indifference curves are convex to the origin. It implies that the

consumer is prepared to sacrifice decreasing quantities of Y
for each given increment in the quantity of X.

• Indifference curves never intersect. Each curve represents a

particular level of satisfaction.

• Indifference curves need not be parallel to each other. This is

because the MRS between two commodities need not be the
same in all indifference curves.

• A higher indifference curve is always preferred to a lower one.

 INDIFFERENCE MAP…

• A family of indifference curves is known as indifference

map. The higher the indifference curve, the more will be
the level of satisfaction
 MARGINAL RATE OF SUBSTITUTION - MRS

• The marginal rate of substitution of X for Y (MRSxy) is defined as

the amount of Y the consumer is willing to give up to get an
additional unit of X. As the consumer gets more and more units of X,
he is willing to surrender less units of Y for each additional unit of X.
this is because, the relative importance of X in terms of Y goes on
diminishing. This feature of the consumer’s behaviour is known as
the principle of diminishing marginal rate of substitution

• A consumer gets the same level of satisfaction along a given

indifference curve. It means that an increase in the quantity of
commodity X is always accompanied by a similar decrease in the
quantity of commodity Y. Thus, the marginal rate of substitution
must be negative. Symbolically,

• MRSxy = − ∆Y ∕ ∆X
• Where ∆X represents change in X and ∆Y change in Y. The above
equation represents the slope of the indifference curve at a
particular point
 Budget constraint line or the Price line

• A consumer would like to go to the highest indifference

curve to gain maximum satisfaction. However, in the real
world, the power of decision making is confined to the
given constraints of the consumer. The constraints are
referred to as the opportunity factors which consist of
three elements: (i) given money income, (ii) price of
commodity X, (iii) price of commodity Y. There may be a
number of combinations of X and Y which can be
purchased by the given budget constraint. A budget or
price line is an illustration of the various combinations of
two commodities (X and Y) which can be purchased by
the given money income
• Determination of the rate of exchange: The first
application of indifference curves relates to the determination
of the rate of exchange between two commodities bartered by
two individuals.
• Determination of the tax policy: With the help of
indifference curves it is possible to show that direct taxes are
better than indirect taxes.
• Explaining the effects of subsidies: Subsidy is
generally provided by the government to help the low-income
groups in such a way that they are able to purchase goods at
a price lower than the market price. The question whether the
benefit to the consumers is more than the cost of the subsidy
to the government can be answered with the help of
indifference curve analysis.
• Explaining the effects of Rationing: Indifference
curves can be used to analyze the various methods of
rationing.
 USES OF INDIFFERENCE CURVES…
• Explaining the theory of Index Numbers: Index number
indicates the changes in the price level, and thus enables us to
compare the standards of living in two different periods or
situations. Here it is assumed that the consumer’s preference
between the two goods remains the same, i.e., the same
indifference curves apply for both periods.
• Explaining changes in tastes and preferences: The
slope of an indifference curve explains the relative preferences and
tastes of the consumer between two commodities.
• Measurement of Consumer’s Surplus: Indifference curve
analysis is also of much help in the measurement of consumer’s
surplus which is of paramount importance in various welfare policy
decisions.