Theory of Consumer Behaviour

THEORY OF CONSUMER BEHAVIOUR

Utility

  • Definition: The property of a commodity that satisfies a want or need of a consumer.

  • It refers to the want-satisfying power of a commodity.

  • A commodity possesses utility only if it satisfies a want.

  • Utility differs from person to person, place to place, and time to time.

  • The satisfaction that a consumer derives from the consumption of commodities is termed utility.

  • Example: If a consumer eats 5 oranges, the total satisfaction derived is the total utility. If they consume a 6th orange, the additional satisfaction is the marginal utility of the 6th orange.

Total Utility and Marginal Utility

  • Total Utility: The total satisfaction obtained from consuming a certain quantity of a commodity.

  • Marginal Utility: The extra satisfaction obtained from consuming one additional unit of a commodity.

Mathematical Representation of Utility

  • Total Utility (TU):

    • For 1 unit: TU1 = U1

    • For 2 units: TU2 = U1 + U_2

    • For 3 units: TU3 = U1 + U2 + U3

    • For n units: TUn = U1 + U2 + U3 + …

  • Marginal Utility (MU):

    • For the 2nd unit: MU<em>2=TU</em>2−TU1</p></li><li><p>Forthe3rdunit:MU<em>2 = TU</em>2 - TU_1</p></li><li><p>For the 3rd unit:MU3 = TU3 - TU_2

    • For the nth unit: MU<em>n=TU</em>n−TU(n−1)</p></li></ul></li></ul><h4collapsed="false"seolevelmigrated="true">WaysofMeasuringUtility</h4><ol><li><p><strong>CardinalApproach:</strong></p><ul><li><p>Utilityismeasurable,similartopricesandquantities.</p></li><li><p>Wecanassignanumberofutilstoeachcommodity.</p></li><li><p><strong>Example:</strong>Anorange=5utils,Anapple=6utils.</p></li></ul></li><li><p><strong>OrdinalApproach:</strong></p><ul><li><p>Utilityisnotmeasurablelikepricesandquantities.</p></li><li><p>Onecanordertheutilitiesfromdifferentgoods.</p></li><li><p>Wecandetermineiftheutilityofanorangeislessthan,equalto,orgreaterthantheutilityofanapple.</p></li></ul></li></ol><h4collapsed="false"seolevelmigrated="true">AssumptionsofCardinalUtilityAnalysis</h4><ol><li><p><strong>UtilityisCardinal:</strong>Utilitycanbemeasurednumerically.</p></li><li><p><strong>RationalConsumer:</strong>Consumersprefermoregoodsandservicestoderivemaximumutilityandhaveperfectknowledgeofgoodsandservices.</p></li><li><p><strong>LimitedMoneyIncome:</strong>Consumershavealimitedincometospendongoodsandservices.</p></li><li><p><strong>UnchangedTastesandPreferences:</strong>Consumerpreferencesremainconstant.</p></li><li><p><strong>NoTimeGap:</strong>Nobreakbetweentheconsumptionofsuccessiveunits.</p></li><li><p><strong>UtilityisAdditive:</strong>Theutilityderivedfromconsumingallgoodsandservicesisadditive.</p></li></ol><h4collapsed="false"seolevelmigrated="true">AdditiveUtility</h4><ul><li><p>Theutilityderivedfromtheconsumptionofallgoodsandservicesisadditiveinnature.</p></li><li><p>Utilityfunctionofabasket′n′,comprisingvariousgoodsandservicesisrepresentedas:<br>MU<em>n = TU</em>n - TU_(n-1)</p></li></ul></li></ul><h4 collapsed="false" seolevelmigrated="true">Ways of Measuring Utility</h4><ol><li><p><strong>Cardinal Approach:</strong></p><ul><li><p>Utility is measurable, similar to prices and quantities.</p></li><li><p>We can assign a number of utils to each commodity.</p></li><li><p><strong>Example:</strong> An orange = 5 utils, An apple = 6 utils.</p></li></ul></li><li><p><strong>Ordinal Approach:</strong></p><ul><li><p>Utility is not measurable like prices and quantities.</p></li><li><p>One can order the utilities from different goods.</p></li><li><p>We can determine if the utility of an orange is less than, equal to, or greater than the utility of an apple.</p></li></ul></li></ol><h4 collapsed="false" seolevelmigrated="true">Assumptions of Cardinal Utility Analysis</h4><ol><li><p><strong>Utility is Cardinal:</strong> Utility can be measured numerically.</p></li><li><p><strong>Rational Consumer:</strong> Consumers prefer more goods and services to derive maximum utility and have perfect knowledge of goods and services.</p></li><li><p><strong>Limited Money Income:</strong> Consumers have a limited income to spend on goods and services.</p></li><li><p><strong>Unchanged Tastes and Preferences:</strong> Consumer preferences remain constant.</p></li><li><p><strong>No Time Gap:</strong> No break between the consumption of successive units.</p></li><li><p><strong>Utility is Additive:</strong> The utility derived from consuming all goods and services is additive.</p></li></ol><h4 collapsed="false" seolevelmigrated="true">Additive Utility</h4><ul><li><p>The utility derived from the consumption of all goods and services is additive in nature.</p></li><li><p>Utility function of a basket 'n', comprising various goods and services is represented as:<br>U = f(x1, x2, x3, …, xn)<br>Where<br>Wherex1, x2, x3, …, xnarethequantitiesofdifferentgoodsandservicesconsumed.</p></li><li><p>Thetotalutilityfunctionofnitemsisadditiveandcanbewrittenas:<br>are the quantities of different goods and services consumed.</p></li><li><p>The total utility function of n items is additive and can be written as:<br>TU = U1(x1) + U2(x2) + U3(x3) + … + Un(xn)</p></li></ul><h4collapsed="false"seolevelmigrated="true">LawofDiminishingMarginalUtility</h4><ul><li><p>Asaconsumerincreasestheconsumptionofaproduct,theutilitygainedfromsuccessiveunitsdecreases.</p></li><li><p>Therateofincreaseoftotalutilitydecreasesasmoreunitsareconsumed.</p></li><li><p><strong>Example:</strong>Athirstyindividualconsumessoftdrinks.</p><ul><li><p>Thefirstbottleyields9utils.</p></li><li><p>Thesecondbottlemayyieldonly7utils.</p></li><li><p>Theutilityofeachsuccessivebottledecreases.</p></li><li><p>Eventually,theconsumermaydevelopanaversiontosoftdrinks.</p></li></ul></li></ul><h4collapsed="false"seolevelmigrated="true">TotalUtilityandMarginalUtilityRelationship</h4><ul><li><p>AslongastheTotalUtility(TU)curvefacesup,TUincreasesatanincreasingrate,andMarginalUtility(MU)isrising.</p></li><li><p>AttheinflectionpointB,theTUcurvechangesdirection,andMUisatitsmaximum.</p></li><li><p>PastpointB,theTUcurvefacesdown;TUincreasesatadecreasingrate,andMUisfalling.</p></li><li><p>AtpointD,TUismaximum,soMUiszero.</p></li><li><p>PastpointD,theTUcurvefalls,andMUisnegative.</p></li></ul><h4collapsed="false"seolevelmigrated="true">ConsumerEquilibrium</h4><p>Aconsumerisinequilibriumwhen:</p><ol><li><p>Satisfactionismaximized.</p></li><li><p>Entireincomeisspent.</p></li><li><p>Optimumallocationofexpenditureisattained.</p></li><li><p>Optimumquantityofeachcommodityisconsumed.</p></li></ol><p>Theconsumerisinequilibriumwhenthesatisfactionofthelastdollarspentonvariouscommoditiesisthesame.</p><h4collapsed="false"seolevelmigrated="true">CardinalUtilityAnalysisandConsumerEquilibrium</h4><ul><li><p>Thepriceaconsumeriswillingtopayforeachunitreflectsthemarginalutilityoftheproduct.</p></li><li><p></p></li></ul><h4 collapsed="false" seolevelmigrated="true">Law of Diminishing Marginal Utility</h4><ul><li><p>As a consumer increases the consumption of a product, the utility gained from successive units decreases.</p></li><li><p>The rate of increase of total utility decreases as more units are consumed.</p></li><li><p><strong>Example:</strong> A thirsty individual consumes soft drinks.</p><ul><li><p>The first bottle yields 9 utils.</p></li><li><p>The second bottle may yield only 7 utils.</p></li><li><p>The utility of each successive bottle decreases.</p></li><li><p>Eventually, the consumer may develop an aversion to soft drinks.</p></li></ul></li></ul><h4 collapsed="false" seolevelmigrated="true">Total Utility and Marginal Utility Relationship</h4><ul><li><p>As long as the Total Utility (TU) curve faces up, TU increases at an increasing rate, and Marginal Utility (MU) is rising.</p></li><li><p>At the inflection point B, the TU curve changes direction, and MU is at its maximum.</p></li><li><p>Past point B, the TU curve faces down; TU increases at a decreasing rate, and MU is falling.</p></li><li><p>At point D, TU is maximum, so MU is zero.</p></li><li><p>Past point D, the TU curve falls, and MU is negative.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Consumer Equilibrium</h4><p>A consumer is in equilibrium when:</p><ol><li><p>Satisfaction is maximized.</p></li><li><p>Entire income is spent.</p></li><li><p>Optimum allocation of expenditure is attained.</p></li><li><p>Optimum quantity of each commodity is consumed.</p></li></ol><p>The consumer is in equilibrium when the satisfaction of the last dollar spent on various commodities is the same.</p><h4 collapsed="false" seolevelmigrated="true">Cardinal Utility Analysis and Consumer Equilibrium</h4><ul><li><p>The price a consumer is willing to pay for each unit reflects the marginal utility of the product.</p></li><li><p>MUx = Px(forgoodx)</p></li><li><p>Theconsumerwillbeinequilibriumwhen:<br>(for good x)</p></li><li><p>The consumer will be in equilibrium when:<br>\frac{MU1}{P1} = \frac{MU2}{P2} = \frac{MU3}{P3} = …</p></li></ul><h4collapsed="false"seolevelmigrated="true">LawofEqui−MarginalUtility</h4><ul><li><p>Aconsumermaximizestotalutilitybyoptimallydistributingincomeamongvariouscommodities.</p></li><li><p>Themarginalutilityderivedperunitofexpenditure(perrupee)isthesameforallcommodities.</p></li><li><p></p></li></ul><h4 collapsed="false" seolevelmigrated="true">Law of Equi-Marginal Utility</h4><ul><li><p>A consumer maximizes total utility by optimally distributing income among various commodities.</p></li><li><p>The marginal utility derived per unit of expenditure (per rupee) is the same for all commodities.</p></li><li><p>\frac{MU1}{P1} = \frac{MU2}{P2} = \frac{MU3}{P3} = …</p></li></ul><h4collapsed="false"seolevelmigrated="true">IndifferenceCurveAnalysis</h4><ul><li><p>ProposedbyJ.R.HicksandR.G.Allen.</p></li><li><p>Utilityisconsideredordinal(rankablebutnotmeasurable).</p></li></ul><h5collapsed="false"seolevelmigrated="true">AssumptionsofIndifferenceCurveAnalysis</h5><ol><li><p><strong>OrdinalUtility:</strong>Utilityissubjectiveandrankablebutnotmeasurable.</p></li><li><p><strong>RationalConsumer:</strong>Consumersarerational.</p></li><li><p><strong>ConstantIncome:</strong>Theconsumer′sincomeisconstant.</p></li><li><p><strong>UnchangedPreferences:</strong>Tastesandpreferencesremainunchanged.</p></li><li><p><strong>Transitivity:</strong>IfaconsumerprefersAtoBandBtoC,thentheypreferAtoC.</p></li></ol><h4collapsed="false"seolevelmigrated="true">IndifferenceCurve</h4><ul><li><p>Combinationsofgoodsandservicesthatprovidethesametotalsatisfaction.</p></li><li><p>Thelocusofpoints,eachrepresentingadifferentcombinationoftwogoods,whichprovidethesamelevelofutilitytotheconsumer.</p></li></ul><h4collapsed="false"seolevelmigrated="true">MarginalRateofSubstitution(MRS)</h4><ul><li><p>Therateatwhichonecommoditycanbesubstitutedforanotherwhilemaintainingthesamelevelofutility.</p></li><li><p></p></li></ul><h4 collapsed="false" seolevelmigrated="true">Indifference Curve Analysis</h4><ul><li><p>Proposed by J.R. Hicks and R.G. Allen.</p></li><li><p>Utility is considered ordinal (rankable but not measurable).</p></li></ul><h5 collapsed="false" seolevelmigrated="true">Assumptions of Indifference Curve Analysis</h5><ol><li><p><strong>Ordinal Utility:</strong> Utility is subjective and rankable but not measurable.</p></li><li><p><strong>Rational Consumer:</strong> Consumers are rational.</p></li><li><p><strong>Constant Income:</strong> The consumer's income is constant.</p></li><li><p><strong>Unchanged Preferences:</strong> Tastes and preferences remain unchanged.</p></li><li><p><strong>Transitivity:</strong> If a consumer prefers A to B and B to C, then they prefer A to C.</p></li></ol><h4 collapsed="false" seolevelmigrated="true">Indifference Curve</h4><ul><li><p>Combinations of goods and services that provide the same total satisfaction.</p></li><li><p>The locus of points, each representing a different combination of two goods, which provide the same level of utility to the consumer.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Marginal Rate of Substitution (MRS)</h4><ul><li><p>The rate at which one commodity can be substituted for another while maintaining the same level of utility.</p></li><li><p>MRS = \frac{\Delta y}{\Delta x}</p></li><li><p>Sincequantityofonecommodityincreaseswhiletheotherdecreases,MRSisalwaysnegative.Theslopeoftheindifferencecurveisnegative.</p></li></ul><h4collapsed="false"seolevelmigrated="true">IndifferenceMap</h4><ul><li><p>Asetofindifferencecurvesdepictingaconsumer’spreferences.</p></li><li><p>Higherindifferencecurvesrepresenthigherlevelsofsatisfaction.</p></li><li><p>Combinationsonhigherindifferencecurvesarepreferredtothoseonlowerones.</p></li></ul><h4collapsed="false"seolevelmigrated="true">CharacteristicsofIndifferenceCurves</h4><ol><li><p><strong>DownwardSloping:</strong>Demandforonecommoditymustdecreaseifthedemandfortheotherincreasestomaintainthesameutilitylevel.</p></li><li><p><strong>ConvextotheOrigin:</strong>DuetothediminishingMRS.</p></li><li><p><strong>HigherCurves,HigherUtility:</strong>Higherutilityisderivedfromincreasedquantityofeitherorbothgoods.</p></li><li><p><strong>Non−Intersecting:</strong>Indifferencecurvescannotintersectbecausethesamecombinationofgoodscannotyieldtwodifferentutilitylevels.</p></li></ol><h4collapsed="false"seolevelmigrated="true">LawofDiminishingMRS</h4><ul><li><p>Theconvexnatureoftheindifferencecurveisduetothedecreasingrateofsubstitutionasmoreunitsofacommodityareconsumed.</p></li><li><p>Thequantityofacommodityaconsumeriswillingtosacrificeforanadditionalunitdecreasesastheycontinuesubstituting.</p></li></ul><h4collapsed="false"seolevelmigrated="true">BudgetLine</h4><ul><li><p>Representsallcombinationsoftwoproductsthatcanbepurchasedforagivenincome.</p></li><li><p>IfgoodsXandYareavailableatprices</p></li><li><p>Since quantity of one commodity increases while the other decreases, MRS is always negative. The slope of the indifference curve is negative.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Indifference Map</h4><ul><li><p>A set of indifference curves depicting a consumer’s preferences.</p></li><li><p>Higher indifference curves represent higher levels of satisfaction.</p></li><li><p>Combinations on higher indifference curves are preferred to those on lower ones.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Characteristics of Indifference Curves</h4><ol><li><p><strong>Downward Sloping:</strong> Demand for one commodity must decrease if the demand for the other increases to maintain the same utility level.</p></li><li><p><strong>Convex to the Origin:</strong> Due to the diminishing MRS.</p></li><li><p><strong>Higher Curves, Higher Utility:</strong> Higher utility is derived from increased quantity of either or both goods.</p></li><li><p><strong>Non-Intersecting:</strong> Indifference curves cannot intersect because the same combination of goods cannot yield two different utility levels.</p></li></ol><h4 collapsed="false" seolevelmigrated="true">Law of Diminishing MRS</h4><ul><li><p>The convex nature of the indifference curve is due to the decreasing rate of substitution as more units of a commodity are consumed.</p></li><li><p>The quantity of a commodity a consumer is willing to sacrifice for an additional unit decreases as they continue substituting.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Budget Line</h4><ul><li><p>Represents all combinations of two products that can be purchased for a given income.</p></li><li><p>If goods X and Y are available at pricesP1andandP2andinquantitiesand in quantitiesQ1andandQ2,foragivenbudgetB:<br>, for a given budget B:<br>B = P1 \times Q1 + P2 \times Q2</p></li><li><p>Anincreaseinincomeincreasesthebudget,allowingtheconsumertobuymore,increasingutility.</p></li></ul><h4collapsed="false"seolevelmigrated="true">ConsumerEquilibrium(OrdinalUtilityMethod)</h4><ul><li><p>Theamountofgoodsandservicesaconsumerbuysgiventheirincomeandmarketprices.</p></li><li><p>Theaimistomaximizesatisfactionfromtheavailableincome.</p></li><li><p>Aconsumerisinequilibriumwherethepricelineistangenttothehighestattainableindifferencecurve.</p></li></ul><h5collapsed="false"seolevelmigrated="true">ConditionsforEquilibrium</h5><ol><li><p>Agivenpricelineshouldbetangenttoanindifferencecurve,orthemarginalrateofsubstitutionofgoodXforgoodY(MRSxy)mustequalthepriceratioofthetwogoods:<br></p></li><li><p>An increase in income increases the budget, allowing the consumer to buy more, increasing utility.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Consumer Equilibrium (Ordinal Utility Method)</h4><ul><li><p>The amount of goods and services a consumer buys given their income and market prices.</p></li><li><p>The aim is to maximize satisfaction from the available income.</p></li><li><p>A consumer is in equilibrium where the price line is tangent to the highest attainable indifference curve.</p></li></ul><h5 collapsed="false" seolevelmigrated="true">Conditions for Equilibrium</h5><ol><li><p>A given price line should be tangent to an indifference curve, or the marginal rate of substitution of good X for good Y (MRSxy) must equal the price ratio of the two goods:<br>MRS{xy} = \frac{Px}{P_y}</p></li><li><p>Theindifferencecurvemustbeconvextotheoriginatthepointoftangency(second−ordercondition).</p></li></ol><h4collapsed="false"seolevelmigrated="true">ConsumerSurplus</h4><ul><li><p><strong>WillingnesstoPay:</strong>Themaximumamountabuyerwillpayforagood.</p></li><li><p>Consumersbuyatpriceslessthantheirwillingnesstopayandrefusetobuyaboveit.</p></li><li><p><strong>ConsumerSurplus:</strong>Thedifferencebetweenthewillingnesstopayandtheactualamountpaid.</p></li><li><p>Itmeasuresthebenefitbuyersreceive.</p></li><li><p>Graphically,it′stheareaabovethepricelineandbelowthedemandcurve.</p></li></ul><h4collapsed="false"seolevelmigrated="true">ConsumerSurplusChangewithPrice</h4><ul><li><p>Aspricedecreasesfrom</p></li><li><p>The indifference curve must be convex to the origin at the point of tangency (second-order condition).</p></li></ol><h4 collapsed="false" seolevelmigrated="true">Consumer Surplus</h4><ul><li><p><strong>Willingness to Pay:</strong> The maximum amount a buyer will pay for a good.</p></li><li><p>Consumers buy at prices less than their willingness to pay and refuse to buy above it.</p></li><li><p><strong>Consumer Surplus:</strong> The difference between the willingness to pay and the actual amount paid.</p></li><li><p>It measures the benefit buyers receive.</p></li><li><p>Graphically, it's the area above the price line and below the demand curve.</p></li></ul><h4 collapsed="false" seolevelmigrated="true">Consumer Surplus Change with Price</h4><ul><li><p>As price decreases fromP1totoP2,consumersurplusincreasesfromarea, consumer surplus increases from areaAP1Btoareato areaAP2C.</p></li><li><p>Theincreaseinconsumersurplusisthearea.</p></li><li><p>The increase in consumer surplus is the areaP1BCP2$$.

    Producer Surplus

    • Measured as the price received by the seller minus the price they are willing to sell at.

    • The minimum price a producer is willing to sell at equals their cost of production per unit.

    • Graphically, it's the area above the supply curve and below the price line.