COURSE: ADVANCED MICRO ECONOMICS

TOPIC: THEORY OF CONSUMER BEHAVIOUR (UTILITY THEORY)

TUTOR: DOTMAN (08028703055)

Definition: Utility may be defined as the creation of satisfaction. Put different, utility is seen as the want-
satisfying power of a commodity i.e. it’s the quality possessed by a commodity or service to satisfy human
want. It may also be defined as value- in-use of a commodity.

Types of Utility

The following are the types of utility available:

1. Form utility: This type of utility is created or added by changing the shape or form of a particular good. For
example, a form utility is created when a carpenter makes a chair out of wood.
2. Place utility: This is utility created or added based on geographical location. If the commodity is not at a
particular place, its utility may diminish or totality absent. For example, watching a live football match at
the stadium.
3. Time utility: These are time bound utilities. They are present at a particular time and less or none at any
other time. For examples, selling a highly perishable good few days after harvest or production. Another
good example is watching a live programme or match.
4. Service utility: This type of utility is created or added when professionals like teachers, doctors, lawyer etc
satisfy human wants through their services.
5. Possession utility: This type of utility is created or derived when there is right ownership or possession of
a commodity. For example a hammer has a greater utility in the hand of a carpenter than in the hand of a
tailor.
6. Knowledge utility: This occurs when the utility of a commodity increases as a result of the increase in the
knowledge of its use. For example, knowing that your mobile phone can perform banking services. This
type of utility is usually created through advertisement.
7. Natural utility: It’s created or added by the free gift of nature. For example, water, air, sunshine, beach etc

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Properties of Utility
The following attributes make utility what it is:
1. Utility is abstract: Utility cannot be seen, touched nor felt with hands. For example, the argumentative
power of a lawyer is abstract.
2. Utility relative: A good may possess different utility at different times or at different places or for different
persons. For example, a fan has greater utility in summer than in winter; the reverse is also true for an
umbrella.
3. Utility subjective: This means that the satisfaction derived from a commodity differs from persons to
persons. One man’s food is another man’s poison.
4. Utility and pleasure: Utility is free from pleasure or pain. This means that a commodity capable of creating
or adding utility may not give pleasure when consumed. For example, an injection creates utility but gives
no pleasure. There is no relationship between utility and pleasure.
5. Utility and satisfaction: There is a cause-effect relationship between the two. Utility is the power of a
commodity to satisfy human wants, whereas satisfaction is the result of utility. Utility is the present even
before consumption but satisfaction is after consumption.
6. Utility and usefulness: If a good possesses want-satisfying power, it has utility but its consumption may be
useful or harmful. Utility is also free from usefulness. For example, wine has utility but it’s harmful to
health.

Approaches to Utility Theory

There are two basic approaches to the problem of utilities, the cardinal approach and the ordinal approach.

A. THE CARDINAL APPROACH

The cardinal utility theory also known as the marginal utility theory or the neo-classical utility theory was
developed by the 19th century economists. Prominent among the theorists are; Hermann Heinrich Gossen,
(1854); William Stanley Jevons, (1871); Carl Menger, (1871); Leon Walras, (1874); Alfred Marshal, (1890).
They postulated that utility is measured in a cardinal sense i.e it can be quantified or measured numerically in
subjective units called utils.
The standard of measurement is money. If a consumer imagines that a mango has 8 utils and an apple 16 utils, it
implies that the utility of one apple is twice that of one mango.

Cardinalists’ Assumptions

The marginal utility analysis is based on the following set of assumptions:

1. Rationality: The consumer is assumed to be sensible and he aims at maximizing his utility subject to the
constraint imposed by his given income.
2. Cardinal utility: The utility of each commodity is measureable. Utility is measured by the monetary unit
that the consumer is prepared to sacrifice for the unit of the commodity.
3. Constant marginal utility of money: The essential feature of a standard unit of measurement is that it is
constant. Since money is used as the standard unit of measurement, it must therefore be assumed to be
constant irrespective of the level of income of the consumer.
4. Diminishing marginal utility: The marginal utility of a good diminishes as the consumer acquires larger
quantity of it.

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5. Utility is additive: The total utility of a bundle of goods depends on the individual commodities i.e. TU=F
(Q1, Q2......,Qn) given that there are n-number of commodities in a given bundle with quantity Q 1,Q2....Qn.
6. Perfect knowledge: The consumer is assumed to have full knowledge of the availability of the
commodities and their technical qualities.
7. He is also assumed to possess perfect knowledge of the choice of commodities open to him, their prices
and his choices are certain.

Basic Concepts of the Cardinalists

The following concepts are worth defining:
1. Total utility: This refers to the total amount of satisfaction obtained by a consumer from the consumption
of some quantities of goods and services i.e. TU =F(Q).
2. Marginal utility: This is the additional satisfaction a consumer derives from an additional unit of a
commodity, ceteris paribus.
It is the ratio of change in total utility to change in quantity consumed i.e.

MU = =

See class notes for graphical and tabular relationship.

Equilibrium of a consumer

A consumer is said to be at equilibrium when the utility he derives from the consumption of an item
justifies the price paid for such an item. He is said to maximize his welfare at this point, subject to his
income.

Consumer’s equilibrium can be under any of the following cases;

1. A single commodity case: Here, the consumer buys only one commodity. He is at equilibrium at the point
where the marginal utility derived from the consumption of a commodity is equal to the price paid i.e.

Where: = Marginal utility from commodity x

= Price of commodity x
See class notes for mathematical derivation of this point.
2 Two – or –More Commodities Case: If there are two or more commodities involved, the condition for the
equilibrium of the consumer is the equality of the ratios of the marginal utilities of the individual
commodities to their respective prices. That is;

= =-------- =

See class note for mathematical derivation.

Note, the equilibrium condition stated above is called the equimarginal principle. Other names for this principle
may include the following:

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 i. The proportionality rule,
ii. The law of maximum satisfaction,
iii. The law of indifference,
iv. Gossen’s second law.

Marshal (1890) defined it thus; ‘’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’’

See class notes for solution to disequilibrium point.

Weakness or Limitations of the Cardinal Approach

The following are the weak points of the cardinal theory:

1. Utility is not measurable: the assumption of cardinal utility is extremely doubtful. the satisfaction from
various commodities cannot be measured objectively ,say in utils.
2. Unrealistic constant marginal utility of money: as income increases, the marginal utility of money changes
(decreases).A ₦500 note is worth more to a consumer when his income is low,say₦10,000 than when his income
is high, say ₦1,000,000.thus,money cannot be used as a measuring –rod.
3. Consumer irrationality: Most of our human purchases are casual, prompted by habit or taste and it cannot
be expected of the consumer to act rationally under these circumstances. Bandwagon effect, snob effect etc can
also make a consumer to be irrational.
4. Imperfect knowledge: in reality, most of the consumers are ignorant about other useful alternative of
spending their incomes.
5. The law of diminishing marginal utility has been established from introspection. It’s thus, a psychological law
which must be taken for granted.

B. ORDINAL APPROACH:

This school of thought postulated that utility is not measurable but it is an ordinal magnitude.
Consumer’s behaviour is explained in terms of his preferences or rankings for different combinations of two
goods, say x and y. The theory was developed by 20 th century economists such as: Slutsky (1915), Allen (1934),
Hicks (1939) and Watsan (1951).

Ordinalists’ Assumptions

In order to make their theory stand, the following axioms were made:

1. Rationality: The consumer aims at the maximization of his utility, given his income and market prices.

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2. Full knowledge: The consumer is assumed to possess complete information about the price of goods in
the market.
3. There are two goods, X and Y and he prefers more of x to less of y or more of y to less of x i.e. x and y are
normal goods.
4. The price of the two goods are given
5. Diminishing marginal rate of substitution: This means that the willingness to give up certain unit of one
commodity, say y, reduces over time.
6. Consistency: It is also assumed that the consumer is consistent in his choices, that is, if in one period he
chooses X over Y, he will not choose y over x in another period if both goods are available to him.

If X > Y, then Y > X

7. Transitivity of choice: If commodity x is preferred to y and Y is preferred to Z, then X is preferred to Z. If x >

y, Y > Z, then x > Z.
8. Consumer’s tastes, habits and income remain constant throughout the analysis.

Basic Concepts of the Ordinalists

The following concepts are worth explaining:

1. The Budget Line: it’s a line showing various combinations of two commodities the consumer can buy given
his money income and market prices of the two commodities.

The budget line is also called the budget constraint of the consumer and it sets limits to the maximization
behaviour of the consumer.

The income constraint, in the case of two commodities, say x and y, may be written thus:

M = P x Qx + P y Qy

The equation of the BL when graphically presented may be written as:

Qy = M - P y Qy

Py P y

See class notes for details and graphical illustrations.

Note, the slope of the BL is the ration of the prices of the two commodities.

2. Indifference Curve: An IC is the locus of points (particular combinations of goods) which yield the same
level of satisfaction to the consumer, so that he is indifferent as to the particular combination he
consumes.

Simply put, an IC joins together all points representing different combinations of two goods which yield the same
utility to the consumer.

Again, it’s the graphical representation of indifference schedule

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Note, an indifference map is a set of indifference curves which rank all consumers’ preferences.

See class notes for graphical illustrations and types.

Properties of Indifference Curves

a. An IC has a negative slope: This means that if the quantity of one commodity, say x, decreases, the
quantity of the other commodity, say y, must increase so that the consumer can stay on the same level of
satisfaction.
b. The further away from the origin an IC lies, the higher the level of satisfaction.
c. Two Indifference curves do not intersect. If two ICs intersect, it represents two different levels of
satisfaction and this is impossible.
d. ICs are convex to the origin: This explains the law of diminishing Marginal Rate of Commodity Substitution.
3. Marginal Rate of Substitution: It means the amount of one commodity that is required to compensate the
consumer for giving up an amount of another commodity such that he maintains the same level of utility.
MRS is the negative slope of IC. That is:

Slope of IC =

And; =

See class notes for proof.

Equilibrium of a Consumer
A consumer is at equilibrium (maximizing his utility) at the point where the budget line is tangential to
an IC.

At this point, the slopes of the BL ( ) and of the IC (MRSx,y = MUx ÷ MUy) are equal. That is, at

equilibrium:

See class note for graphical illustration and mathematical derivation.

Changes in Income and relative prices
A rise (fall) in the income of the consumer will lead to an outward (inward) parallel shift in the Budget
Line (BL).
On the other hand, a rise in the price of one of the commodities, say , will make the BL to pivot
inward. It pivots outwardly for a fall in price.
NB: These will hold, ceteris paribus.

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See class notes for graphical illustrations.
Price Consumption Curve
It a curve joining various points of tangency of successive BLs and higher ICs resulting from a
continuous rise/fall in the price of one commodity, ceteris paribus.
Note, it can be used to confirm the law of demand.
See class notes for details and graphical illustration.
Income Consumption Curve
ICC is also called the Engel curve, named after a 19th century German statistician, Ernest Engel. ICC is a
curve (line) joining various point of tangency of successive BLs and ICs resulting from a
continuous rise or fall in consumer’s income, ceteris paribus.
ICC shows the positive relationship between consumer’s income and demand for a normal good.
It’s also used to confirm the law of demand.
See class notes for details and graphical illustration.
Income and Substitution Effects
Income effect is the change in demand that would occur as the relative price changes leaving the
consumer’s money income unchanged and leading to a change in his real income. Substitution
effect, on the other hand, is the change in demand that would occur as the relative price
changes, after adjusting the consumer money income so as to keep his real income constant. The
adjustment is called compensating variation and the resultant budget line (BL) is called
compensated Budget Line.
Note, Slutsky’s theorem states that the substitution effect of a price change is always negative. See
class note for graphical illustrations.

Weakness of the Indifference Curve Analysis

1. Failure to explain the observed behaviour of the consumer.
2. Consumer irrationality.
3. Combinations of goods are not based on any principle.
4. Limited analysis of consumer’s behaviour.
5. Two-goods model unrealistic.
6. Failure to explain consumer’s behaviour in choice involving risk or uncertainty.
7. All commodities are not divisible.

PRACTICE QUESTIONS

1. Given the utility function U =10Q1Q2 and relative prices of P1 = ₦20, P2 = ₦10 and consumer
money income of ₦400. You are required to determine the units of each commodity to consume
at the equilibrium point.
2. Given the utility function, φ = Ax ayb subject to a budget constrained of PxX +PyY= B, prove that at
the point of constrained utility maximization the ratio of price Px÷P y must equal the ratio of
marginal utilities MUX ÷ MUY.
3. Prove the Marshalian demand function, stating its properties.

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4. A housewife has ₦220 to spend on fruit and yam. The unit price of fruit is ₦20 and per tuber of yam is
₦40. Total utilities are given below:

Qty TU of Fruits TU of Yam

1 100 400
2 180 760
3 240 1000
4 280 1120
5 300 1180
Determine the quantities of fruits and yam to buy at equilibrium.

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