CHAPTER 2

THEORY OF CONSUMER BEHAVIOR

Q1. What are the two main factors that determine a consumer’s choice in
finding the best combination of goods for maximum satisfaction?

The consumer faces a challenge in deciding how to allocate their income across
different goods, a concept economists call the “problem of choice.” The primary goal
for any consumer is to find a combination of goods that provides maximum
satisfaction. This “best” combination is determined by two main factors: consumer
preferences and budget constraints.

Consumer preferences represent the individual’s likes and dislikes, while the
budget constraint is defined by the consumer’s income and the prices of goods.

This chapter discusses two major approaches to understanding consumer behaviour:

1. Cardinal Utility Analysis

2. Ordinal Utility Analysis

Key Terms Used

1. Consumer The one who takes decisions about what to buy for the satisfaction of
wants, both as an individual or as a member of a household, is called a consumer.
2. Utility The want satisfying power of a good is called utility.
3. Cardinal Measurement of Utility It is that concept of utility which advocates
that utility can be measured in terms of units like 2, 4, 6, 8, etc. In other words,
utility is measurable in standard numerical units, known as ‘utils’.
4. Ordinal Measurement of Utility According to this utility cannot be measured in
numerical units, a consumer can (at best) rank his preferences in the sets of most
preferred to least preferred sets.
5. Total Utility (TU) It is the sum total of Marginal Utilities derived from the
consumption of all the units of a commodity.
 TU = MUX + MU2 +….+MU„ or LMU
6. Marginal Utility (MU) It refers to additional utility on account of the
consumption of an additional unit of a commodity. MU = TUn − TUn−1 Where,
MU = Marginal Utility
TUn = Total Utility at ’n’ units TUn−1 = Total Utility at (n – 1) units.

Relationship between Total Utility (TU) and Marginal Utility (MU)

(i) When MU is positive (+), TU rises.
(ii) When MU is zero (0), TU is maximum.
(iii) When MU is negative (-), TU starts declining.

1. Define utility.
The wants satisfying power of a good is called utility.
2. Define Marginal Utility (MU).
Marginal utility can be defined as the addition to the total utility by consuming one
additional unit. This is the utility derived from the consumption of last unit. Marginal
utility is the change in total utility by consuming one more unit of commodity. This
can be written as
ΔTU
Marginal utility (MU) =
ΔQ
Where ΔTU = Change in total utility and ΔQ = change in the number of units
consumed.



This can be also expressed as MU = TUn - TUn-1

Where, TUn is the utility derived from the consumption of n units and TUn-1 is the
utility derived from the consumption of n-1 units.

Q. How does Cardinal Utility Analysis measure consumer satisfaction?

Cardinal Utility Analysis quantifies the satisfaction or utility a consumer derives from
consuming goods by assigning numerical values to it. For example, wearing a shirt
might provide 50 units of utility, while drinking coffee gives 30 units. This method
expresses satisfaction in measurable terms

Q. Explain the Law of Diminishing Marginal Utility with the help of

utility schedule and graph.

The law of diminishing marginal utility is central to the cardinal utility analysis of
consumer behavior. The law states that marginal utility of a good diminishes as an
individual consume more units of a commodity. The law states that when an
individual consumes more units of a particular commodity, the intensity of his wants
goes on falling. This law can be explained with the help of table 2.3.

Quantity Consumed Total Utility Marginal Utility

1 20 20
2 35 15
3 46 11
4 54 8
5 59 5
6 61 2
7 61 0
8 59 -2
It can be seen from the above table that, total utility increases with increase in
consumption of each additional unit but at the diminishing rate, i.e. marginal utility
diminishes with increase in consumption of units. Total utility is at its maximum
when marginal utility is zero. After that, marginal utility becomes negative and total
utility starts to diminish.

The downward sloping marginal utility curve in figure 2.10 also shows the
diminishing rate in total utility.
What is demand and what is a demand curve?

Demand: The quantity of a commodity that a consumer is willing to buy and is able
to afford, given prices of goods and the income of the consumer, is called demand for
that commodity.

Demand Function
Mathematically, a function states the relationship between two or more variables.
Demand for a commodity is determined by several factors, such as, price of the
commodity, income of the consumer, prices of related commodities, consumer's
taste and preferences etc. Therefore, demand function explains the relationship
between quantity demanded and these determinants. This can be mathematically
written as

Q = f (Px, Pr, Y, T)

Where,

Q = quantity demanded
P = price of the commodity
Pr = prices of related goods
Y = income of the consumer
T = taste and preferences

Demand curve: A graphic representation of various quantities of a commodity that a

consumer is willing to buy at different prices of the same commodity, while holding
constant:

• Prices of other related commodities

• Income of the consumer

Figure 2.2 presents hypothetical demand curve of an individual for commodity x at

its different prices. Quantity is measured along the horizontal axis and price is
measured along the vertical axis.
Q. What is Law of Demand?

The Law of Demand states that there is a negative relationship between the price of a
commodity and the quantity demanded. As prices decrease, individuals buy more of
the commodity, and as prices increase, they buy less.

This is explained by the Law of Diminishing Marginal Utility, which suggests that
each additional unit of a commodity provides less satisfaction, leading individuals to
pay less for successive units, resulting in a downward-sloping demand curve.

Hence, the law of diminishing marginal utility explains why demand curves have a
negative slope.

Ordinal Utility Approach- The Indifference Curve Analysis

Question:
What does the Ordinal Utility Approach use to analyze consumer behavior?

The Ordinal Utility Approach, developed by J.R. Hicks and R.G.D. Allen in 1934,
analyzes consumer behavior using indifference curves. This theory assumes utility is
not measurable but can be ranked based on satisfaction. Key assumptions include:
1. Rationality: Consumers aim to maximize satisfaction within their income and
market conditions.
2. Utility is ordinal: Consumers rank preferences rather than measure exact utility.
3. Diminishing Marginal Rate of Substitution (MRS): Indifference curves are
convex to the origin, reflecting diminishing MRS.
4. Consistency and Transitivity of Choice: Consumer preferences are stable and
logically consistent.
5. Non-Satiety: Consumers are willing to consume more of both goods.

Indifference curve

Question: What does an indifference curve represent?

An indifference curve can be defined as the locus of points of different

combinations of two commodities which give same level of satisfaction or utility
to the consumer. Since all the combinations give the same amount of satisfaction,
the consumer prefers them equally. When such combinations are plotted graphically it
results in to a curve, called indifference curve. It is also known as iso-utility curve or
equal utility curve.

For example, let us suppose that a consumer forms five combinations a, b, c, d and e
of two commodities, X and Y. All these combinations yield the consumer the same
level of satisfaction (U). The consumer is, therefore, indifferent to the choice between
them.
 Figure 2.15 Indifference Curve

Q. What is indifference map

A set of indifference curves which rank the preferences of the consumer is called an
indifference map. A higher indifference curve shows higher level of satisfaction and
combinations of goods on a lower indifference curve yield a lower utility. An
indifference map is shown in figure 2.16.

 Figure 2.16 Indifference Map

Q. What is Marginal Rate of Substitution (MRS)

The slope of an indifference curve at anyone point is called the marginal rate of
substitution between the two commodities. 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. It is the rate at which one commodity is substituted for
another commodity.

MUx MUy
MRSxy = or MRSyx =
MUy MUx

Q. What is the Law of Diminishing Marginal Rate of Substitution?

The law of diminishing marginal rate of substitution states that when a consumer
substitutes one commodity (say X) for another (Y), the marginal rate of substitution
decreases as the stock of X increases and that of Y decreases. This diminishing
marginal rate of substitution gives convexity to the indifference curve.

 Q. What are the key properties of an indifference curve?

1. Indifference curve has negative slope: The negatives slope of an indifference

curve implies the trade-off between quantities of two commodities which are
substitute for one another. Therefore, if quantity of one commodity decreases,
quantity of other commodity must increase if the consumer is to stay on the
same level of satisfaction.

Good Y

Good X

2. Higher indifference curve represents a higher level of satisfaction: An

upper indifference curve contains large quantity of one or both of the goods
than the lower one. A larger quantity is supposed to yield a greater satisfaction
than the smaller quantity.

 Good Y

Good X

3. Indifference curves are convex to origin: The convexity of indifference

curve implies that as the consumer substitutes X for Y, the marginal rate of
substitution (MRS) diminishes.

4. Indifference curves do not intersect each other: If two indifference curves

intersect or tangent, these would imply two different levels of satisfaction
which is impossible.


 5. Indifference curves never touch the axis: A rational consumer has no
preference or addiction to any particular commodity.

Budget Line or Budget constraint

Q. Budget Line or Budget constraint

A budget line or price line shows the possible combinations of two commodities
which can be purchased by spending the entire income of the consumer, given
the prices of commodities.

Suppose that the income of the consumer is Rs. 100 and prices of the two
commodities x and y are Rs.10 and Rs 20 respectively. Therefore, M =100, Px =10
and Py = 20. Thus, if the consumer spend his entire money income on commodity x,
he can purchase 10 units of it. Similarly, he can purchase 5 units of y by using his
entire money income.

M 100
Qx = = = 10
Px 10

M 100
Qy = = =5
Py 20

 Px
The slope of the budget line is the ratio of the prices of two commodities =
Py

Consumer's Equilibrium: Indifference Curve Approach

Q. What conditions must be satisfied for a consumer to be in equilibrium

according to the indifference curve approach?

The consumer is in equilibrium when he maximises his utility, given his income
and the market prices of the commodities. According to indifference curve
analysis, two conditions must be satisfied for the consumer to be in equilibrium.

1) First condition or necessary condition: The marginal rate of substitution is

equal to the ratio of commodity prices. The marginal rate of substitution is the
slope of the indifference curve and ratio of commodity prices is the slope of the
budget line. Therefore, at the equilibrium point, the slope of the indifference
curve should be equal to the slope of the budget line. Mathematically, it can be
written as,


 MUx Px
MRSxy = =
MUy Py

2) Second condition or supplementary condition: Indifference curve should be

convex to the origin

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 which is convex to the origin. The equilibrium conditions are
satisfied at point E as shown in the figure 2.19.

The consumer maximises his satisfaction by purchasing ox and oy amount of x

Px
and y respectively. At point e MRSxy = .
Py

Q. How do changes in income and the price of goods affect the budget set
of a consumer?

1. Changes in Income:

• Income Increases: The budget line shifts outward (to the right), allowing the
consumer to afford more of both goods, increasing purchasing power.
• Income Decreases: The budget line shifts inward (to the left), reducing the
consumer’s purchasing power and the available consumption bundles.

2. Changes in the Price of Goods:

• Increase in Price (e.g., bananas): The budget line pivots inward, becoming
steeper around the vertical intercept, showing that the consumer can afford
fewer units of the good.

• Decrease in Price (e.g., bananas): The budget line pivots outward, becoming
flatter, indicating the consumer can afford more of the good.
 Q. Differentiate between cardinal utility and ordinal utility

Cardinal Utility v/s Ordinal Utility


Q. What does it mean for a consumer to be rational in economics?

In economics, a rational consumer is one who makes the best choices based on their
preferences and aims to maximize satisfaction. They have clear preferences and
choose from available bundles of goods to get the most satisfaction

Q. Where is the optimal point for a consumer on the budget line?

The optimal point for a consumer is where the budget line is tangent to the highest
possible indifference curve they can afford. A point below the budget line is not
optimal, as there are better options on the line. A point above the budget line cannot
be chosen, as it exceeds the consumer’s budget. The best bundle is at the point where
the budget line touches the highest indifference curve within the budget.
Linear Demand

A linear demand curve can be represented by the equation:

d(p) = a – bp

• a is the horizontal intercept (the quantity demanded when the price is zero),
• b is the slope of the demand curve (the rate at which demand decreases as price
increases).

a
At a price of zero, the demand for the good is a. At a price equal to , demand
b
becomes zero. The slope tells us how much the demand changes with respect to price.
Figure 2.15 illustrates a linear demand curve.


Q. How does the demand for normal and inferior goods change with income?

The demand for goods depends on the consumer’s income:

• Normal Goods: Demand increases as income increases and decreases as income

decreases. For example, higher-quality food items.

• Inferior Goods: Demand decreases as income increases and increases as income

decreases. For example, low-quality cereals.

A good can shift between being normal and inferior depending on income levels. For
instance, low-quality cereals may initially see increased demand with a slight rise in
income but later see decreased demand as consumers switch to better-quality
alternatives at higher income levels.

Substitutes and Complements

How does the demand for a good change with the price of its substitutes and
complements?

The relationship between the price of related goods and demand depends on whether
the goods are substitutes or complements:

1. Complementary Goods:
These are used together (e.g., tea and sugar). If the price of one increases, the demand
for the other decreases, and vice versa.

2. Substitute Goods:
These can replace each other (e.g., tea and coffee). If the price of one increases, the
demand for the other increases, and vice versa.
Thus, complementary goods have an inverse demand-price relationship, while
substitute goods have a direct demand-price relationship.

Shifts in the Demand Curve

Q. What causes shifts in the demand curve, and what do these shifts signify?

The demand curve shifts when factors other than the price of the good change,
altering the quantity demanded at every price level. These shifts can either move the
curve to the right (increase in demand) or to the left (decrease in demand).

Factors Causing Shifts:

1. Changes in Income:

• Normal Goods: Increased income leads to higher demand (rightward shift).

Example: buying more cars.
• Inferior Goods: Increased income reduces demand (leftward shift). Example:
replacing low-cost goods with premium brands.

2. Changes in the Price of Related Goods:

• Substitutes: Higher prices for substitutes increase demand for the original good
(rightward shift). Example: If tea becomes expensive, coffee demand rises.
• Complements: Higher prices for complementary goods decrease demand for the
original good (leftward shift). Example: Expensive smartphones lead to lower
demand for accessories.

3. Changes in Tastes and Preferences:

• Favorable changes increase demand (rightward shift). Example: Ice cream

demand rises in summer.
• Unfavorable changes reduce demand (leftward shift). Example: Health concerns
lower demand for cold drinks.
Conclusion:

Shifts in the demand curve highlight how factors beyond price, such as income,
related goods, and preferences, influence consumer behavior, increasing or
decreasing demand across all price levels.

Movements along the Demand Curve

Q. What causes movement along the demand curve?

• Movement along the demand curve occurs when there is a change in the price of
the good itself. At higher prices, the quantity demanded decreases, leading to a
movement upward along the curve. Conversely, at lower prices, the quantity
demanded increases, causing a movement downward along the curve.

• This change in quantity demanded due to a price change is referred to as expansion

(when quantity demanded increases) or contraction (when quantity demanded
decreases).
 What is Market Demand?

Market demand for a product at a specific price is the sum of the individual demands
of all consumers at that price. In other words, it’s the combined quantity of the good
that all buyers in the market are willing and able to purchase at a given price.

Elasticity of Demand

Price elasticity of demand measures how much the quantity demanded of a good
responds to a change in its price. It tells us whether the demand for a good is sensitive
or not to price changes.

The formula for price elasticity of demand is:

% change in quantity demanded

Price elasticity of demand(eD) =
% change in price

 ELASTICITY OF DEMAND

The concept of elasticity of demand measures the change in quantity demanded

due to change in its determinants. Corresponding to the important determinants of
quantity demanded such as its own price, income of the consumer and price of related
commodities, there are three kinds of elasticity of demand - price elasticity, income
elasticity and cross elasticity.

I. PRICE ELASTICITY OF DEMAND

Q. What is Price Elasticity of Demand? And what are the different types

The price elasticity of demand is defined as the degree of responsiveness of quantity

demanded to change in its price.

This can be written in the form of an equation as,

propor tionate change in quantit y demanded

Ep =
propor tionate change in price

The general formula for calculating price elasticity of demand is

ΔQ ΔP
Ep = ÷
Q P

ΔQ P
= ×
Q ΔP

ΔQ P
= ×
ΔP Q


Where, Ep = Price elasticity of demand, ΔQ = Change in quantity demanded, ΔP =
Change in price, P = Original price, Q = Original quantity. The value of coefficient of
elasticity ranges from zero to infinity.

Degrees of Price Elasticity of Demand

1. Perfectly Inelastic Demand (Ed=0): The case of zero value of coefficient of

elasticity is called perfectly inelastic demand. It implies that a change in the price
of a commodity has no impact on the quantity demanded. The price elasticity is
zero in the case necessities. The demand curve for a perfectly inelastic good is a
vertical line.

2. Relatively Inelastic Demand (0 < Ed<1): A demand curve is considered inelastic

when- quantity demanded does not change as much as the change in price. When
price increases by 20 percent and demand decreases by 10 percent, demand is said
to inelastic. The coefficient value varies in between zero and one. The demand
curve will be a steeper one for inelastic demand.
3. Unitary Elastic Demand (Ed=1): Unitary demand occurs when a given change in
price causes an equally proportionate change in quantity demanded. When price
increases by 20 percent and quantity demanded decreases by 20 percent, demand
is said to be unitary elastic. The value of coefficient of elasticity is equal to one.
4. Relatively Elastic Demand (1< Ed<∞): When a given proportionate change in
price causes more than proportionate change in quantity demanded, it is called
elastic demand. For example, 20 percent change in price causes 30 percent change
in quantity demanded. The demand curve will be flatter in this case. The value of
coefficient of elasticity lies in between one and infinity.

5. Perfectly Elastic Demand (Ed=∞): In perfectly elastic demand, the coefficient

value it infinity which represents the infinite change in quantity demanded with
respect to even a small change in price. The demand curve is then horizontal
straight line
 Measurement of Price Elasticity of Demand

Mainly, there are three methods for measuring elasticity of demand - Percentage
Method, Total Expenditure Method and Geometric Method.

1. Percentage Method

According to this method, elasticity of demand is the ratio of proportionate change in

quantity demanded of a commodity to proportionate change in its own price. It can be
measured using the formula.

propor tionate change in quantit y demanded

Ep =
propor tionate change in price

The general formula for calculating price elasticity of demand is

ΔQ ΔP
Ep = ÷
Q P

ΔQ P
= ×
Q ΔP

ΔQ P
= ×
ΔP Q

Where, Ep = Price elasticity of demand, ΔQ = Change in quantity demanded, ΔP =

Change in price, P = Original price, Q = Original quantity. The value of coefficient of
elasticity ranges from zero to infinity.

Let us suppose that the price of the commodity falls from Rs. 50 to Rs. 40 and as a
result quantity demanded increases from 10 kg to 12 kg. Here ΔP = 50-40 = 10, ΔQ
= 8-10 = -2, P = 50 and Q = 10.




 ΔQ P
Ep = ×
ΔP Q

−2 50
= × = -1
10 10

2. Total Outlay (Expenditure) Method

Q. How does the price elasticity of demand affect total expenditure when the
price of a good changes?

Total expenditure on a good is the product of its price and quantity demanded. The
impact of a price change on total expenditure depends on the price elasticity of
demand:

1. When Price Increases:

• Elastic Demand: Total expenditure decreases because the percentage drop in

demand is greater than the price increase.
• Inelastic Demand: Total expenditure increases because the percentage drop in
demand is smaller than the price increase.
• Unitary Elastic Demand: Total expenditure remains the same as the percentage
change in price equals the change in demand.

2. When Price Decreases:

• Elastic Demand: Total expenditure increases because the percentage increase in

demand is greater than the price decrease.
• Inelastic Demand: Total expenditure decreases because the percentage increase in
demand is smaller than the price decrease.
• Unitary Elastic Demand: Total expenditure remains unchanged as the percentage
changes in price and demand are equal.

In this method elasticity is measured by taking into account the change in total outlay
on commodity before and after the change in its price. Total outlay of a commodity is
equal to quantity demanded of commodity multiplied by its price

3. Geometric Method

The geometric method measures elasticity on a demand curve at a point and in

between two points. The method of measuring elasticity at a point is called point
method and in between two points on a demand curve is called are method.

a) Point Method: This method was introduced by Alfred Marshall. In this method,
elasticity (along a linear demand function) is measured by taking the ratio of lower
segment to upper segment.

It is easy to find elasticity at any point along the straight line demand curve. If lower
segment is equal to upper segment, the ratio is equal to one showing unitary elastic
demand. This can be explained using the figure 2.8

L ower Segment
Ep =
Upper Segment
Factors Determining Price Elasticity of Demand for a Good

Q. What factors influence the price elasticity of demand for a good

The price elasticity of demand depends on two main factors:

1. Nature of the Good:

• Necessities: Demand is inelastic because they are essential (e.g., food). Price
changes have little impact on quantity demanded.

• Luxuries: Demand is elastic as they are non-essential, and even a small price
increase can significantly reduce demand.

2. Availability of Close Substitutes:

• When substitutes are available, demand becomes elastic as consumers can

switch to cheaper alternatives.

• If substitutes are unavailable, demand is inelastic as consumers have limited

options despite price increases.