Exercise and notes

Chapter 2 Consumer behaviour

1.1 Cardinal approach

1.2 Ordinal approach
1.3 Substitution, income and net effects of a price change
1.4 Attribute approach
Theory and calculation

1. 1 Cardinal approach
Utility is a measurable and quantifiable entity. According to cardinal approach, a person can
express utility or satisfaction he derives from the goods in the quantitative cardinal terms. Thus,
a person can say that he derives utility equal to 10 units from the consumption of a unit of good
A, and 20 units from the consumption of a unit of good B.
Moreover, the cardinal measurement of utility implies that a person can compare utilities
derived from goods in respect of size, that is, how much one level of utility is greater than
another. A person can say that the utility he gets from the consumption of one unit of good B
is double the utility he obtains from the consumption of one unit of good A.

For example, Table 3.1 indicates that one hamburger per day (or, more generally, one unit of
good X per period of time) gives the consumer a total utility (TU) of 10 utils, where a util is an
arbitrary unit of utility. Total utility increases with each additional hamburger consumed until
the fifth one, which leaves total utility unchanged. This is the saturation point. Consuming the
sixth hamburger then leads to a decline in total utility because of storage or disposal problems.1
The third column of Table 3.1 gives the extra or marginal utility resulting from the consumption
of each additional hamburger. Marginal utility is positive but declines until the fifth hamburger,
for which it is zero, and becomes negative for the sixth hamburger.
Draw the TUx and Mux based on the information above:
Note that the TU rises by smaller and smaller amounts (the shaded areas) and so the MU
declines. The consumer reaches saturation after consuming the fourth hamburger. Thus, TU
remains unchanged with the consumption of the fifth hamburger and MU is zero. After the fifth
hamburger, TU declines and so MU is negative. The negative slope or downward-to-the-right
inclination of the MU curve reflects the law of diminishing marginal utility. Utility schedules
reflect tastes of a particular individual; that is, they are unique to the individual and reflect his
or her own particular subjective preferences and perceptions. Different individuals may have
different tastes and different utility schedules. Utility schedules remain unchanged so long as
the individual’s tastes remain the same

Law of diminishing marginal utility = Each additional unit of a good eventually gives less
and less extra utility.

Suppose there are only two goods X and Y on which a consumer has to spend a given income.
The consumer’s behaviour will be governed by two factors
first, the marginal utilities of the goods and
Secondly, the prices of two goods. Suppose the prices of the goods are given for the consumer.
The consumer will distribute his money income between the goods in such a way that the utility
derived from the last money spent on each good is equal. In other words, consumer is in
equilibrium position when marginal utility of money expenditure on each good is the same.
Now, the marginal utility of money expenditure on a good is equal to the marginal utility of a
good divided by the price of the good.

In symbols,

MUm= MUx/ Px

Where,
MUm is marginal utility of money expenditure and
MUmis the marginal utility of X and Px is the price of X.
Consumer will spend his money income on different goods in such a way that marginal utility
of money expenditure on each good is equal.
That is, consumer is in equilibrium in respect of the purchases of two goods X and V when

MUx/ Px= MUy/ Py

Now, if MUx/ Pxand MUy/ Py are not equal

and MUx/ Pxis greater than MUy / Py= the consumer will substitute good X for good Y.
As a result of this substitution, the marginal utility of good X will fall and marginal utility of
good y will rise. The consumer will continue substituting good X for good Y until MUx/
Pxbecomes equal to MUy/ Py.
When MUx/ Pxbecomes equal to MUy/ Pythe consumer will be in equilibrium.
But the equality of MUx / Px with MUy / Py can be achieved not only at one level but at different
levels of expenditure. The question is how far does a consumer go in purchasing the goods he
wants.

This is determined by the size of his money income. With a given income and money
expenditure a RM has a certain utility for him: this utility is the marginal utility of money to
him.

Since the law of diminishing marginal utility applies to money income also, the greater the size
of his money income the smaller the marginal utility of money to him. Now, the consumer will
go on purchasing goods until the marginal utility of money expenditure on each good becomes
equal to the marginal utility of money to him.

Thus, the consumer will be in equilibrium when the following equation holds good:

MUx/ Px= MUy/ Py= MU m

Where MUmis marginal utility of money expenditure (that is, the utility of the last rupee spent
on each good).
If there are more than two goods on which the consumer is spending his income, the above
equation must hold good for all of them.

Thus

MUx / Px = MUy / Py = …….. = MUm

Exercise:
1.2 Ordinal approach- indifference curve and budget line

Indifference curves: definition

A consumer’s tastes and equilibrium can also be shown by indifference curves. 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.
Exercise:
 Budget line

The budget constraint line shows all the different combinations of the two commodities that a
consumer can purchase, given his or her money income and the prices of the two commodities.
EXAMPLE: Suppose that Px= Py = $1, that a consumer’s money income is $10 per time period
and that it is all spent on X and Y. The budget line for this consumer is then given by line KL
in Fig. 4-4. If the consumer spent all of her income on commodity Y, she could purchase 10
units of Y. This defines point K. If she spent all of her income on commodity X, she could
purchase 10 units of X. This defines point L. By joining point K to point L by a straight line
we define budget line KL. Budget line KL shows all the different combinations of X and Y that
this individual can purchase given her money income
Exercise: