Chapter 2

Theory of Consumer Behavior

 Meaning of Utility
 The level of satisfaction or happiness that
consumer receives from the consumption of
goods and services is called utility.
 It is the human want satisfying power of goods
and services.
 It is a subjective entity and varies from person
to person, time to time and place to place.
 Approaches to Utility Analysis:

1. Cardinal Approach:
 Developed by neo-classical economists
(Alfred Marshall)
 Utility can be measured in cardinal numbers
1,2,3 etc.
 Utility is measurable and additive
 Also known as marginal utility analysis.
 The measuring unit of utility is ‘Utils’
 Cont………..
2. Ordinal Approach:
 The modern economists have rejected the
concept of cardinal utility and have instead
employed the concept of ordinal utility
analysis for analyzing consumer behavior.
 This method assumes that utility cannot be
measured in number but it can be ranked like
first, second, more or less.
 Cont…………
 The ordinal utility implies that the consumer is
capable of simply comparing the different levels of
satisfaction.
 For example, a consumer may not be able to tell
that a orange gives 10 utilities and an apple
gives 20 utilities. But he always tells that apple
gives more utility than orange
(comparing/ordering/raking the utilities derived
from the consumption of orange and apple).
 Cont………….
 Utility being a psychological feeling is not
quantifiable (can not be expressed in number).
  According to the ordinal utility hypothesis, while
the consumer may not be able to indicate the exact
amounts of utilities that he derives from
commodities or any combination of them.
 But he is capable of judging whether the
satisfaction obtained from a combination of goods
is equal to, lower than, or higher than another.
 Concepts of Total and Marginal Utility
Total Utility:
 it refers to the total satisfaction derived by the
consumer from the consumption of a given
quantity of goods.
 In other words, it is the aggregate of marginal
utilities.
 Mathematically,
TU= MU1+MU2+…………..+MUn
n
TU=∑MU i
i=1
 Marginal Utility (MU)
 The additional made to the total utility by consuming one
more unit of a commodity (extra utility obtained by
consuming one more unit).
MU= =
MU=TUn-TUn-1
∆=Change
TU= Total utility
MU= Marginal utility
TUn= Total utility of nth units
TUn-1= Total utility of (n-1)th commodity
 Types of Marginal Utility
1. Positive marginal utility: When total utility
increases with the consumption of additional units of
the commodity, then the marginal utility derives in a
positive form even if it is decreasing.
2. Zero utility: No addition to the total utility by
consumption of an additional unit (total utility
becomes maximum).
3. Negative utility: When the total utility decreases
with each successive unit of the commodity, the
marginal utility becomes negative.
 Law of Diminishing Marginal Utility

a. Introduction
 This is an important law in economics.
 It is equally applicable in all parts of
economics.
 This law was propounded by a famous
economist HH Gossen in 1854 AD.
 Therefore it is also called as Gossen’s first law.
 Finally this law was fully developed by Alfred
Marshall (Neo-classical economist).
 Cont………..
b. Statement:
 This law says that the additional level of
satisfaction goes on diminishing with every
increase in units of consumption within same
period of time.
 In other words, when consumer consumes
more and more units of the same commodity,
the successive level of satisfaction diminishes.
 Cont…………..
b. Assumptions
 The consumer should be rational,
 Cardinal measurement of utility,
 Constant Marginal utility of money,
 Homogeneous units of goods,
 No change in taste and preferences of the consumer,
 No time gap in consumption,
 Utility is additive: U= f (x1, x2 …xn) and U=U1(x1)
+U2(x2)+ U3(xn)
 d. Tabular Explanation
Units of Total Utility Marginal  Both MU and TU obtained from the
goods (Q) (TU) Utility (MU) consumption of first unit of a
0 0 - commodity are equal (i.e. 10 utils).
 TU increases but at diminishing rate
1 10 10 when the units of the commodity
consumed increases gradually (i.e. 2nd ,
2 18 18-10=8 3rd 4th and 5th units are consumed) but
MU decreases .
3 24 24-18=6  TU becomes maximum when 6th unit is
consumed but MU becomes zero. This
4 28 28-24=4 indicates the point of satiety.
 Thereafter (beyond the point of
5 30 30-28=2 satiety), TU starts to decline and MU
become negative if another additional
6 (point of 30 30-30=0 unit is consumed.
satiety)
7 28 28-30=-2
 e. Graphical Explanation
32  The MU curve is downward sloping
30 which indicates that MU derived
28
TU from the additional level of
26
24 satisfaction goes on diminishing
22 with every increase in units of
20 consumption within same period of
18
time.
16
TU, MU

14
 MU curve lies on X-axis and even
12 falls below the X-axis which
10 indicates zero and negative utility
8
respectively.
6
4
 As long as MU is positive the TU
2 increases at a diminishing rate,
0 becomes maximum when MU is
1 2 3 4 5 6 7
-2
zero and starts to fall as MU is
Quantity MU
negative. Hence it is a bell-shaped
curve.
 Limitations of the Law

 Irrational consumer 
 Rare and curious goods like old coins
 Goods of entertainments like watching movies, popular TV
programs, popular games like football etc.
 Habitual goods like cigarettes, alcohols, drugs etc.
 Unequal size and quality
 Time gap in consumption
 Change in taste and preference
 Utility can not be measured in cardinal number
 Marginal unity of money does not remain constant.
Consumer’s Equilibrium (one commodity
model)
 Let a consumer with certain money income
and commodity X.
 Since both his money income and commodity
X have utility for him, he can either spend his
money income on commodity X or retain it in
the form of asset.
 If MUx > MUm as asset, utility maximizing
consumer will exchange his money income for
commodity X until MUx= Px(MUm).
MUx is the marginal utility curve of X good. It
Cont..
slopes downwards to the right indicating that when a
consumer consumes more and more units of the
same commodity, utility obtained from each
successive units goes on diminishing.
The horizontal line Px(MUm) shows the constant
marginal utility weighted by the price of the
commodity X.
e Point be the equilibrium point of the consumer
where MUx=Px(MUm). This equilibrium indicates
that he maximizes utility by consuming OQ1 units.
At points above e, MUx> Px(MUm). So if the
consumer exchanges his money income for
commodity X, he increases his satisfaction per unit
of commodity.
At points below e, Mux<Px(MUm). So consumer
can therefore increase his satisfaction by reducing
his purchase.
Derivation of Demand Curve
 Initially a consumer is in equilibrium at
point e1 where a consumer purchases
OQ1 quantity at price P1. This
combination shown in lower pane of
figure by point A.
 If price falls from P1 to P2, a consumer
gets new equilibrium at point e2 where
he purchases OQ2 quantity. This
combination is denoted by point C in
lower panel of figure.
 Similarly, if price rises from P1 to P3, a
consumer gets new equilibrium at point
e3 and he purchases OQ3 quantity. This
combination is presented by point B in
D the lower panel of figure.
 If points A, B, and C are joined, the
demand curve DD is derived. It slopes
downward from left to the right
D indicating an inverse relationship
between price and demand.
Law of Substitution/Law of Equi-marginal
Utility
a. Introduction
 This law was propounded by a famous
economist HH Gossen in 1854 AD.
 Therefore it is also called as Gossen’s second
law of utility.
 Finally this law was fully developed by Alfred
Marshall (Neo-classical economists).
 Cont..
b. Statement:
This law states that in order to maximize the utility, the
consumer allocates his/her money income on various
goods in such a way that the ratio of marginal utility to
price of each goods be equal to the marginal utility of
money.
Mathematically,
Suppose consumer consumes only two goods namely X
and Y.
=MUm
M=Qx. Px +Qy.PY
 Cont..
 c. Assumptions:
 This law is based on the following assumptions:
 The consumer is rational.
 The utility can be measured in cardinal numbers.
 The marginal utility of money remains constant.
 No change in the price of goods/ prices remain same.
 It is based on two commodity.
 Law of diminishing MU operates on consumption.
 Consumer has a given money income and has to spend his whole
income on consumption of selected goods.
 Goods are divisible and all units of the commodities are
homogeneous.
 Wants are comparable, substitutable and complementary
d. Tabular Explanation

 As shown in above
table, a consumer is in
equilibrium by
purchasing 6th unit of
good x and 4th unit of
good y
 24=6x2+4x3=24 (all
income is spent)
 Mux/Px= MUy/Py= 5
e. Graphically
 As shown in graph , a
consumer is in equilibrium
by purchasing 6th unit of
good x and 4th unit of good y.
=5
 Other combinations besides
6th unit of good x and 4th unit
of good y will not maximize
consumer's equilibrium.
 For example, loss in utility
by consuming one more unit
of good x ( i.e 6th unit to
7th )is less than loss in utility
by consuming one less unit
of good Y (4th unit to 3rd
unit)which is shown by
shaded area.
 Limitations
1. Irrational consumer.
2. Cardinal measurement is impossible.
3. Marginal utility money does not remain same.
4. Price does not remain same
5. Indivisibility.
6. Consumer’s ignorance
 Indifference Curve/ preference curve
a. Meaning:
An indifference curve is a locus representing various combinations of
two goods which yields the same level of satisfaction (utility) to the
consumer.
b. Assumptions:
1. The consumer must be rational: he aim at the maximization of his
utility at his given income and market prices of goods and
services and he has full knowledge of all relevant information.
2. Two wants are satiable (possible to satisfy or sate) at a time.
3. Ordinal measurement of utility.
4. The total utility depends on the quantities of the commodities
consumed. i.e U=f(q1,q2,…..qn)
 Cont..
5. Consumer has non-satiety in nature: the
consumer prefers more goods to less of it.
6. Consumer has definite scale of preferences for
goods and services.
7. Operation of diminishing marginal rate of
substitution
8. Consistency: if one period a consumer chooses
bundle A over B, he will not choose B over A in
another period if both bundles are available to him
i.e.if A> B, then no B>A.
9. Transitivity: A>B, B>C, then A>C
c. Indifference Schedule: A schedule
of various combinations of the two goods that will
give the same level of utility to the consumer.
Combin X Y U MRSXY  All the combinations ( i.e. A,
ations B, C, D and E ) give the same
level of utility to the
A 1 12 U0 -
consumer.
B 2 8 U0 4/1  The consumer is indifferent as
to whether he gets A
C 3 5 U0 3/1
combination of 1 unit of X +
D 4 3 U0 2/1 12 units of Y, or the
combination B of 2 units of X
E 5 2 UO 1/1
+ 8 units of Y, or the E
combination of 5 units of X +
2 units of Y.
 The quantity of X is
increasing while that of Y is
decreasing to attain the same
level of satisfaction.
Indifference Curve: A graphical
representation of indifference schedule

A(1,12)
In figure, IC is
indifference curve which
shows that 1 of X and 12
B(2,9)
of Y per unit of time
C(3,5)
(combination A) gives
the consumer the same
D(4,3)
E(5,2)
level of satisfaction as 2
IC=U0 of X and 8 of Y
(combination B) and so
on.
Indifference Map

it is a set of
indifference curves
In the figure, a set of
four indifference
curves i.e. 1C1, 1C2,
1C3 & IC4, is
indifference map of
four indifference
curves.
.

Properties of Indifference Curve

 1. IC Always Slopes Downwards From Left to
Right:
 According to figure, any points lying
Y
on IC yield same level of satisfaction
i.e. TUA=TUB=TUC=TUD
 The consumer should sacrifice units of
Y in order to get more units of X to
maintain the same level of utility.
Y Good  The negative slope (downward sloping
Y
) of indifference curve shows that two
goods are substituted for one other
without change in the level of
satisfaction

X
X GoodX
 These possibilities are impossible

Y Y
Y
Go Go
Goo
of od
d

X Good X Good X Good

More units of Y good are More unit of X good are More units of both X
consumed consumed and Y are consumed
2. IC is Convex to the Origin

 Due to diminishing
MRSXY, IC is
convex to the origin.
 In figure, slope from
A to B(i.e. )> slope
from B to C (i.e. =)
and so on.
 3. Higher IC yields higher level of satisfaction
than lower one:

 It is because that the

higher IC contains
more units of both
Y goods or more units
good
of at least one good
than lower IC.
 TU(IC3)> TU(IC2)
>TU(IC1)

X good
 4. Indifference curves do not intersect each other:

 If two indifference curves intersect

each other, it would imply that an
D
indifference curve indicates two
E different levels of satisfaction or two
different combinations- one being
larger than other- yield same level of
satisfaction.
 TU(IC1)=TU(IC2) at the intersect
point. But TU(IC1) >TU(IC2) at the
left side of intersect point , whereas
TU(IC1)< TU(IC2) at the right side.
 This violets the assumptions of
consistency and transitivity.
Marginal Rate of Substitution (MRS)

 It is the rate at which units of two goods are

substituted each other to maintain the same
level of satisfaction.
 MRSXY: MRS of X for Y represents the
amount of Y which the consumer has to give
up for the gain of additional units of X so that
his level of satisfaction remains the same.
 MRSXY= Slope of IC
 Law of Diminishing Marginal Rate of
Substitution
a. Statement:
The amount of Y which the consumer has to give up for the gain
of additional units of X goes on diminishing.
b. Causes:
1. Changes in intensity of want: As the consumer has more and
more units of a good, the intensity of his wants for that good
goes on diminishing.
2. Imperfect substitution: Goods are not prefect substitutes of
each other (utility given by X good is different from the utility
given by Y good)
3. Assumption of MRS: The increase in the quantity of one good
does not increase the want satisfying power of the other.
 Budget Line
Meaning
A budget line is a locus representing various combinations of
two goods that can be purchased by spending fixed income
at a given prices.
Mathematically,
 M=QxPx+QyPy
Where,
Px= price of X good
Py= price of Y good
Qx= quantity of X good
Qy= quantity of Y good
 Graphically
 In the given figure, AB is a budget
line which measures the purchasing
power or afford capacity of the
consumer.
 It is a straight line and slopes
downward from left to the right
C which indicates that in order to
purchase more unit of one
commodity the purchase of another
D
one should be reduced.
 This is because the consumer has a
fixed income
 Slope of budget line=
Shift in budget line due to change in price
of X keeping M and Py constant
 In the figure, AB is a
initial budget line.
 Other things remaining
the same, If the price of
X good falls then the
budget line shits
rightward from AB to
AC.
 Similarly, the budget line
shits leftward from AB to
AD due to fall rise in
price of X good.
Shift in budget line due to change in
Money Income (M) keeping Px and Py
Constant
 AB is a initial budget line.
 Other things remaining the
same, if the income of the
consumer increases then the
budget line shifts rightwards
from AB to CD parallelly.
 Other things remaining the
same, if the income of the
consumer decreases then the
budget line shifts leftwards
from AB to EF parallelly.
  Numeric Question
Q. Let a consumer selects two goods i.e. X and Y for
consumption having prices with Rs. 800 and Rs. 400 and fixed
income with Rs. 4000.
a. Derive budget line.
b. Identify his equilibrium point where he allocates entire
budget equally on two goods.
c. Let price of X good falls to Rs 400, sketch the new budget
line/ constraint.
d. When he spends Rs. 1600 on X good and Rs. 2400 on Y
good after fall in price of X good. Show the new equilibrium
to the consumer.
e. Derive price demand curve.
 Consumer’s Equilibrium
a. Statement
A consumer’s equilibrium is defined as a point
where he/she has maximized the level of his/her
satisfaction, given his/her resources and other
condition.
 b. Assumptions
 Consumer must be rational.
 Consumer must have budget line and
indifference curve
 Prices of two goods remain unchanged
 Consumer has to maximize utility by spending
fixed budget on two goods
 c. Conditions of Consumer’s Equilibrium

The following two conditions must be satisfied to be a

consumer’s equilibrium
1. Necessary Condition/ First Order Condition:
The budget line should be tangent to the indifference
curved
i.e slope of IC =Slope of budget line
(MRSXY = )
2. Sufficient Condition/Second Order Condition
IC should be convex to the origin.
d. Explanation: Consumer’s equilibrium can be
explained with the help of indifference curve and
budget line graphically. As shown in the figure, consumer is in equilibrium
at point E where two conditions for equilibrium
(AB ) budget line is tangent to the IC2 and IC2 is
convex to the origin) are satisfied.
 Consumer gets maximum satisfaction by spending
total budget on combination E which contains 0X1
units of X good and 0Y1 units of X goods.
 Consumer can not attain equilibrium at higher
indifference curve IC3 because any points lying on
IC3 are unattainable because of budget constraint
(Although IC3 is desirable, it is unattainable due to
budget constraint )
 The points P and Q lie on the IC2 but they are
lying outside the budget line AB and unattainable.
Therefore, they can not be equilibrium points.
 Similarly, points R and S also can not be
equilibrium points because they lie at lower
indifference curve IC1 and give lower level of
satisfaction than by IC2.
 Price Effect
 Ceteris paribus, the price effect shows the change
in quantity demanded for a commodity due to
change in its price.
 Symbolically,
 PE=
Where,
Qx= quantity of X Good
 Px= price of X Good
 PY= Price of Y good (constant)
 M= Money income (constant)
 1. Price Effect of Substitute Goods
b. Substitute Goods:
 They are those goods which can be used in place of the other.
 For example, tea and coffee.
 A rise in price of one commodity will cause the demand for the
other to rise, other things remaining the same.
 For example, a rise in price of tea will cause a rise in the
demand for coffee and vice versa.
 In case of substitute goods, price of one commodity and
demand for another one are positively related/ as price of one
commodity goes up demand for another one also goes up and
vice-versa.
Graphically
 e2 is the initial equilibrium point to the consumer
where AB budget line is tangent to the IC2 and IC2
is convex to the origin and consumer purchases
0X2 units of X good and E2X2 units of Y good.
 Les us assume that price of X good falls, price of Y
good and his money income remains unchanged.
 This increases the purchasing power of the
consumer for X goods and budget line shits
rightwards from AB to AC and the consumer will
be in equilibrium at point e3 on higher indifference
curve and consumes Ox3 units of X good and e3X3
units of Y good. He increases his demand for X and
reduces demand for Y good (0X3>0X2 and
E3x3<E2X2).
 This is because X good becomes cheaper than
before and consumer substitutes X good for Y good.
 Level of satisfaction has increased as a
consequence of the fall in the price of X good.
 Cont..
 Similarly, let us assume that price of X good rises, price of Y good and his
money income remains unchanged.
This decreases the purchasing power of the consumer for X goods and budget
line shits leftwards from AB to AD and the consumer will be in equilibrium at
point e1 on lower indifference curve and consumes Ox1 units of X good and
e1X1 units of Y good. He decreases his demand for Y and increases demand
for Y good (0X1<0X2 and e1x1>e2X2).
This is because Y good becomes cheaper than before and consumer substitutes
Y good for X good.
Level of satisfaction has decreased as a consequence of the rise in the price of
X good.
Price consumption curve PCC is obtained by joining three consumer’s
equilibrium points e1, e2 and e3. it slopes downwards from left to the right
indicating negative price effect.
PCC is a locus of various consumer’s equilibrium points at various level of
prices of the commodity, other things remaining the same.
2. Price Effect of Complementary Goods
 They (car and petrol) are those goods which are
consumed/demanded together/jointly to satisfy a particular
want (travel). They are jointly demanded. For example, ink
and pen. A fall in price of one commodity will cause the
demand for the other to rise, other things remaining the
same. For example, a rise in price of pen will cause a fall
in the demand for ink and vice versa.
 In case of complementary goods, price of one commodity
and demand for another one are negatively related/ as price
of one commodity goes up demand for another one goes
down and vice-versa.
Graphically

explain the graph as in

substitute goods
 3. Price Effect of Giffen Goods
 Those inferior goods in which there is a
positive relationship between price and
demand are called Giffen goods.
 Income Effect
 Ceteris paribus, the income effect shows the change
in quantity demanded for a commodity due to
change in income of the consumer.
 Symbolically,
 Income effect (IE)=
Qx= quantity of X Good (constant)
 Px= price of X Good
 PY= Price of Y good (constant)
 M= Money income
 1. Income Effect for Normal
Goods/Positive Income Effect:

 Those goods whose demand increases as

income of the consumer rises and decreases as
income falls (positive income effect and
negative price effect)
 For example, branded clothes, television, car
etc.
 As shown in the figure, initially consumer is in
equilibrium at point e1 where two conditions of

Cont..
consumer’s equilibrium are fulfilled (IC1 is tangent to
the budget line AB and IC1 is convex to the origin). By
consuming OX1 units of X and OY1 units of Y, the
consumer maximizes his/her utility.
 Let us suppose that the income of consumer increases,
at constant price of X and Y, budget line of the
consumer shifts rightwards from AB to CD and tangent
to new indifference curve IC2 at point e2 thereby
purchasing OX2 units of X and OY2 units of Y.
consumer increases his demand for both goods.
 Let us suppose that the income of consumer decreases,
at constant price of X and Y, budget line of the
consumer shifts leftwards from AB to EF and tangent to
new indifference curve IC3 at point e3 thereby
purchasing OX3 units of X and OY3 units of Y.
consumer decreases his demand for both goods.
 By joining consumer’s equilibrium points e1, e2 and e3.
income consumption curve (ICC: a locus of equilibrium
points at various levels of consumer’s equilibrium
which slopes upwards to the right indicating positive
income effect) is derived.
2. Negative Income Effect/ Inferior Goods
 There is an inverse relationship income of the
consumers and the demand for inferior goods,
other things remaining the same. (If demand
for a commodity decreases as a result of
increase in income of the consumer, then such
commodity is called inferior goods and vice
versa)
 Explain the graph as in positive income effect.
 Here, Y being an inferior goods and X is
superior goods, demand for X increases to X2
and that of Y decreases to OY2 as income
increases and demand for X decreases to OX3
and that of Y increases to OY3 as income
decreases
 ICC slopes downwards to the right in case of
inferior indicating negative income effect.
 3. Substitution Effect
 The substitution effect is a change in the
quantity demanded of a commodity which
results from a change in its price, relative to
the prices of other commodities.
 It happens when the consumer’s real income
or satisfaction level becomes constant.
 SE=
 Decomposition of Price Effect into
Income and Substitution Effects for
Normal Goods
 Define price effect
 Define income effect
 Define substitution effect
 Define normal goods
 PE= SE+ IE
 It can be explained with the help of indifference curve and
budget line (consumer’s equilibrium)
 Hicksian Approach: Consumer’s real income is so adjusted (by
way of taxation) after fall in price of X commodity that he
returns to his initial indifference curve no matter if his
consumption basket changes.
Graphically
 In the given figure, e1 is an initial equilibrium
point of the consumer where two conditions of
equilibrium (the budget line AB is tangent to
IC1 and IC1 is convex to the origin) are
satisfied. Here, he consumers OX1 units of X
and OY1units of Y.
1. PRICE EFFECT (PE)
 Let us assume that price of X falls at constant
price of Y and money income, the budget line
shifts rightward from AB to AC and tangent to
IC2 at point e2 thereby consuming OX2 units
of X and OY2 units of Y.
 Here, he increases units of X by X1X2 units
and reduces Y1Y2 units of Y.
 This process of adjustment on the consumption
of X and Y is called price effect (movement
from e1 to e3).
 Here price effect is negative because demand
for X increases as price of it falls.
 Cont..
2. SUBSTITUTION EFFECT (SE)
 The real income of the consumer increases by BC due to fall in price of
X.
 According to Hicksian approach, consumer’s real income (i.e. BC) is so
adjusted (by way of taxation) after fall in price of X commodity that he
returns to his initial indifference curve (IC1) no matter if his consumption
basket changes.
 When government increases income tax, the budget line AC shifts
parallely to DE and tangents to initial indifference curve IC1 at point e3
thereby consuming OX3 units of X and OY3 units of Y.
 Here, he reduces his demand for X by X2X3 units and for Y by Y2Y3.
 The movement from e2 to e3 is called substitution effect which is always
positive (as price of X falls, its demand also falls)
 Cont..
3. INCOME EFFECT (IE):
 If the money taken from consumer by the way of
taxation returns to him, a consumer goes back to e2 from
e3.
 This is called income effect (movement from e3 to e2)
which is positive because demand increases from OX3 to
OX2 due to increase in income.
 PE=SE+IE
 e1e2=e1e3+e2e3
 X1X2=X1X3+X2X3
 Decomposition of Price Effect into Income and
Substitution Effects for Inferior Goods

 Define price effect

 Define income effect
 Define substitution effect
 Define inferior goods
 PE= SE+ IE
 It can be explained with the help of indifference curve and
budget line
 Hicksian Approach: Consumer’s real income is so adjusted (by
way of taxation) after fall in price of X commodity that he
returns to his initial indifference curve no matter if his
consumption basket changes.
Cont..

Explain the graph as in

normal goods
PE ()=SE (+)+IE (-)
e1e2=e1e3+e2e3
X1X2=X1X3+X2X3
SE (+)(e1e3)>IE (-)(e3e2)
• Thank you
• Any questions ???