UNIT 4: CONSUMER
BEHAVIOUR
(UTILITY
ANALYSIS)
OBJECTIVES
After studying this unit, you will be able to:
Discuss the concepts of cardinal and ordinal utility
State the concepts of equi marginal utility
Analyse the indifference curve
Explain the concept of consumer equilibrium and
consumer surplus
4.1 CARDINAL AND ORDINAL
UTILITY
Utility is an economic term referring to the total satisfaction received from consuming a good or
service. For example, satisfaction you get by consuming a cup of tea is the utility of that cup of tea. If this
measure is given, one may think of increasing or decreasing utility, and thereby explain economic behavior
in terms of attempts to increase one’s utility. Changes in utility are sometimes expressed in fictional units
called utils. There are mainly two kinds of measurement of utility implemented by economists: cardinal
utility and ordinal utility.
Utility was originally viewed as a measurable quantity, so that it would be possible to measure the
utility of each individual in the society with respect to each good available in the society, and to add these
together to yield the total utility of all people with respect to all goods in the society. Society could then
aim to maximise the total utility of all people in society, or equivalently the average utility per person. This
conception of utility as a measurable quantity that could be aggregated (summed up) across individuals is
called cardinal utility.
Cardinal utility quantitatively measures the preference of an individual towards a certaincommodity.
Numbers assigned to different goods or services can be compared
4.1.1 MARGINAL UTILITY
ANALYSIS
Marginal utility is an additional utility obtained from the
consumption or use of an additional unit of a good. It can be
put in other words as the change in total utility divided by the
change in uantity. Marginal utility indicates an extra
satisfaction from consuming an extra unit. Marginal utility
needs to be contrasted with the related term total utility.
Marginal utility is the additional amount of satisfaction
obtained from consuming one additional unit of a good. Total
utility is the overall amount of satisfaction obtained from
consuming several units of a good. While the maximization of
total utility represents the ultimate goal of consumption, the
analysis of consumer behaviour gives greater emphasis on the
marginal utility.
4.1.2 THE LAW OF DIMINISHING
MARGINAL UTILITY: MARSHILLIAN
APPROACH
Marginal utility refers to the change in
satisfaction which results when a little
more or little less of that good is
consumed.
The law of diminishing marginal utility
says that with the increase in the
consumption of a good there is a
decrease in the marginal utility that
person derives from consuming each
additional unit of that product.
ASSUMPTIONS
1. Cardinal measure of utility: Utility is a measurable and
quantifiable concept. A person can specify that he gets five units
of utility by consuming one unit of good A etc. Utility is an
imaginary unit of measuring utility.
2. Independent utilities: Utility is additive; the utilities derived from
different independent goods can be added to get the measure of
total utility.
3. Constant marginal utility of money: The marginal utility of
money remains constant for a particular consumer when he
spends money on various goods. All other commodities except
money are subject to the law of diminishing marginal utility.
4.2 LAW OF EQUI-MARGINAL
UTILITY
The Law of Equi-Marginal Utility is an extension to the
law of diminishing marginal utility. The principle of equi-
marginal utility explains the behavior of a consumer in
distributing his limited income among various goods and
services. This law states that how a consumer allocates
his money income between various goods so as to
obtain maximum satisfaction.
ASSUMPTIONS
The principle of equi-marginal utility is based on the following
assumptions:
1. The wants of a consumer remain unchanged.
2. He has a fixed income.
3. The prices of all goods are given and known to a consumer.
4. He is one of the many buyers in the sense that he is powerless to
alter the market price.
5. He can spend his income in small amounts.
6. He acts rationally in the sense that he want maximum
satisfaction.
7. Utility is measured cardinally. This means that utility, or use of a
good, can be expressed in terms of "units" or "utils". This utility is not
only comparable but also quantifiable.
PRINCIPLE
Suppose there are two goods 'x' and 'y' on which the consumer has
to spend his given income.
The consumer's behavior is based on two factors:
1. Marginal Utilities of goods 'x' and 'y'
2. The prices of goods 'x' and 'y'
4.3 INDIFFERENCE CURVES
AND ITS PROPERTIES
An indifference curve may be defined as the locus of points. Each point
represents a different combination of two substitute goods, which
yields the same utility or level of satisfaction to the consumer.
Therefore, he/she is indifferent between any two combinations of goods
when it comes to making a choice between them. Such a situation arises
because he/she consumes a large number of goods and services and
often finds that one commodity can be substituted for another. This
gives him/her an opportunity to substitute one commodity for another,
if need arises and to make various combinations of two substitutable
goods which give him/her the same level of satisfaction. If a consumer
faced with such combinations, he/she would be indifferent
between the combinations.
4.3.1 ASSUMPTIONS
The following assumptions about the consumer psychology are implicit
in indifference curve analysis:
1. Transitivity: If a consumer is indifferent to two combinations of two
goods, then he is unaware of the third combination also.
2. Diminishing marginal rate of substitution: The rarer the availability of
a good, the greater is its substitution value. For example, water has a
high substitution value as it is a scarce resource.
3. Rationality: The consumer aims to maximise his total satisfaction
and has got complete market information.
4. Ordinal utility: Utility in this approach is not measurable. A consumer
can only specify his preference for a particular combination of two
goods, he cannot specify how much.
4.3.2 PROPERTIES OF
INDIFFERENCE CURVE
Indifference curves have the four basic characteristics:
1. Indifference curves have a negative slope
2. Indifference curves are convex to the origin
3. Indifference curves do not intersect nor are
they tangent to one another
4. Upper indifference curves indicate a higher
level of satisfaction.
INDIFFERENCE
CURVES HAVE A
NEGATIVE SLOPE
The negative slope of indifference curve
implies-
1. that the two commodities can be
substituted for each other
2. that if the quantity of one commodity
decreases, quantity of the other commodity
must increase so that the consumer stays at
the same level of satisfaction.
INDIFFERENCE CURVES
ARE CONVEX TO ORIGIN
Indifference curves are not only negatively sloped but are also convex to
the origin. The convexity of the indifference curves implies two properties:
1. The two commodities are imperfect substitutes for one another
2. The Marginal Rate of Substitution (MRS) between the two goods
decreases as a consumer moves along an indifference curve. This
characteristic of indifference curves is based on the assumption of
diminishing marginal rate of substitution.
The assumption of diminishing MRS, as mentioned above, states an observed fact that if a
consumer substitutes one commodity (X) for another (Y), his willingness to sacrifice more units
of Y for one additional unit of X decreases, as quantity of Y decreases. There are two reasons for
this:
1. Two commodities are not perfect substitutes for one another.
2. MU of a commodity increases as its quantity decreases and vice versa.
INDIFFERENCE CURVES CAN
NEITHER INTERSECT NOR BE
TANGENT TO ONE ANOTHER
If two indifference curves intersect or are tangent with one another, it will reflect two rather
impossible conclusions:
2. that two different
1. that two equal
combinations – one
combinations of two
being larger than the
goods yield two other-yield the same
different levels of level of
satisfaction satisfaction.
UPPER INDIFFERENCE CURVES REPRESENT A
HIGHER LEVEL OF SATISFACTION
An indifference curve placed above and to the right of
another represents a higher level of satisfaction than
the lower one. In Figure 4.4, indifference curve IC2 is
placed above the curve IC1. It represents, therefore, a
higher level of satisfaction.
The reason is that an upper indifference curve
contains all along its length a larger quantity of one or
both the goods than the lower indifference curve. And a
larger quantity of a commodity is supposed to yield a
greater satisfaction than the smaller quantity of it,
provided MU>0. For instance, consider the indifference
curves IC1 and IC2 in, Figure 4.4.
4.3.3 BUDGET LINE
The budget line is also known as the price line, the
consumption possibility line or the price opportunity
line. It represents different combinations of two
goods X and Y which the consumer
can buy by spending all his income.
4.4 CONSUMER'S
EQUILIBRIUM WITH
CARDINAL APPROACH
Law of Equi-marginal Utility or the principle of Equi-marginal utility says that the
consumer would maximise his utility if he allocates his expenditure on various goods
he consumes such that the utility of the last rupee spent on each good is equal.
4.5 THE CONSUMER'S EQUILIBRIUM
WITH ORDINAL APPROACH
If we superimpose the indifference map and budget line as in Figure shown above, we
find that a consumer has to decide to purchase a particular combination (C) as it falls
on his budget line, though a different combination (D) would be more desirable as it will
give a higher level of satisfaction. At his point of equilibrium C, the price line is
touching the indifference line tangentially meaning that the slopes are equal. The
slope of indifference curve indicates the marginal rate of substitution between X and
Y, and the slope of budget line indicates the ratio of price of X to that of Y. Thus the
principle of consumer's equilibrium works out; the marginal rate of substitution
between X and Y must be proportional to the ratio of price of X to that of Y.
MRSxy = Px/Py
4.5 THE CONSUMER'S EQUILIBRIUM
WITH ORDINAL APPROACH
4.5.1 CHANGES IN PRICE
According to the price consumption curve, if the price of X falls, the
new budget or price line becomes M-L1, as more of X can be brought out
of the given budget and thus C1 becomes the new equilibrium point. If the
price of X falls again, the price of Y and budget remaining same, the new
equilibrium point shifts to C11. The line connecting such successive
equilibrium points at C, C1 and C11 is called PCC or price consumption
curve.
4.5.1 CHANGES IN PRICE
4.5.2 PCC AND DEMAND CURVE
The individual consumer demand curve for the
commodity X can be derived from the price
consumption curve. For example, when the price
of X is given by the slope of ML, the amount of X
demanded is OX11; when the price of X is given
by slope ML1 OX1
amount of X is purchased; and OX is purchased
at a price of X denoted by the slope of ML11.
Thus the price consumption relations when taken
out and plotted separately in Figure 4.7 gives the
demand curve, D.
4.5.2 PCC AND DEMAND CURVE
4.5.3 INCOME OF THE CONSUMER
When the price of the commodity X changes, the real income position of
the consumer also changes and this has a considerable effect on the consumer's
demand.
The traditional marginal utility analysis ignored this income-effect assumption
of constant marginal utility of money spent. The indifference analysis considers
this income effect, because it is an important determinant of demand.
Figure 4.8 shows three parallel budget lines corresponding to three different
levels of the consumer's income which he spends on goods X and Y, the points E1,
E2, and E3 being the three equilibrium points. The curve joining such equilibrium
points is known as the Income Consumption Curve (ICC). The slope of the budget
line depends on the price ratio and hence remains constant.
4.5.3 INCOME OF THE CONSUMER
In case both commodities X and Y are normal
goods the income consumption curve can take
Notes one of the shapesshown in Figure 4.9.
In case X is a normal good but Y an inferior good the
income consumption curve would take the shape depicted
as ICC1 in Figure 4.10. This implies that as the income of the
consumer increases he buys more of both X and Y up to a
point and beyond that he buys more of X and less of Y. The
curve ICC2 in Figure 4.10 depicts the case when X is an
inferior good and Y is a normal good.
4.5.4 PRICE OF RELATED GOODS
Almost all the goods that a consumer purchases in a
market are "related goods" either by way of
complementarity or substitutability. X and Y are
compliments if the rise in demand of X increases
the demand for Y, e.g., pen and ink, bread and butter, etc.
X and Y are substitutes, if the rise in demand for x
reduces the demand for Y, e.g., tea and coffee.
4.6 CONSUMER SURPLUS
Consumer surplus is the satisfaction
that a consumer obtains from a good
over and above the price paid. This is
the difference between the
maximum demand price that buyers
are willing to pay and the price that
they actually pay. A related notion
from the supply side of the market is
producer surplus.
A DIAGRAMMATIC REPRESENTATION
The demand curve shows the
quantum of demand at various
potential prices, just as the supply
curve shows the supply level to the
market at various potential prices.
For example, at too high a price like
OP1, there is no demand and at too
low a price OP2 , there is no supply.
Consumablequantities are indicated
by the demand curve and
marketable supplies are indicated by
the
supply curve.
When OP gets settled as the actual equilibrium price, we can work
out the area of:
1. Consumer’s Surplus: The upper triangle represents the
difference between the potential price and actual price paid by the
buyers for all the units between O and Q.
2. Producer’s Surplus: The lower triangle represents the difference
between the potential price and actual price charged by the
supplier for all the units between O and Q.
THANK YOU!
Bico, Kathleen Joie J.
Bruce, Ralion Lenard
