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: MU2 = TU2 - TU_1

  • For the 3rd unit: MU3 = TU3 - TU_2

  • For the nth unit: MUn = TUn - TU_(n-1)

Ways of Measuring Utility

1. Cardinal Approach:

   • Utility is measurable, similar to prices and quantities.

   • We can assign a number of utils to each commodity.

   • Example: An orange = 5 utils, An apple = 6 utils.

2. Ordinal Approach:

   • Utility is not measurable like prices and quantities.

   • One can order the utilities from different goods.

   • We can determine if the utility of an orange is less than, equal to, or greater than the utility of an apple.

Assumptions of Cardinal Utility Analysis

1. Utility is Cardinal: Utility can be measured numerically.

2. Rational Consumer: Consumers prefer more goods and services to derive maximum utility and have perfect knowledge of goods and services.

3. Limited Money Income: Consumers have a limited income to spend on goods and services.

4. Unchanged Tastes and Preferences: Consumer preferences remain constant.

5. No Time Gap: No break between the consumption of successive units.

6. Utility is Additive: The utility derived from consuming all goods and services is additive.

Additive Utility

• The utility derived from the consumption of all goods and services is additive in nature.

• Utility function of a basket 'n', comprising various goods and services is represented as:
  U = f(x1, x2, x3, …, xn)
  Where x1, x2, x3, …, xn are the quantities of different goods and services consumed.

• The total utility function of n items is additive and can be written as:
  TU = U1(x1) + U2(x2) + U3(x3) + … + Un(xn)

Law of Diminishing Marginal Utility

• As a consumer increases the consumption of a product, the utility gained from successive units decreases.

• The rate of increase of total utility decreases as more units are consumed.

• Example: A thirsty individual consumes soft drinks.

  • The first bottle yields 9 utils.

  • The second bottle may yield only 7 utils.

  • The utility of each successive bottle decreases.

  • Eventually, the consumer may develop an aversion to soft drinks.

Total Utility and Marginal Utility Relationship

• As long as the Total Utility (TU) curve faces up, TU increases at an increasing rate, and Marginal Utility (MU) is rising.

• At the inflection point B, the TU curve changes direction, and MU is at its maximum.

• Past point B, the TU curve faces down; TU increases at a decreasing rate, and MU is falling.

• At point D, TU is maximum, so MU is zero.

• Past point D, the TU curve falls, and MU is negative.

Consumer Equilibrium

A consumer is in equilibrium when:

1. Satisfaction is maximized.

2. Entire income is spent.

3. Optimum allocation of expenditure is attained.

4. Optimum quantity of each commodity is consumed.

The consumer is in equilibrium when the satisfaction of the last dollar spent on various commodities is the same.

Cardinal Utility Analysis and Consumer Equilibrium

• The price a consumer is willing to pay for each unit reflects the marginal utility of the product.

• MUx = Px (for good x)

• The consumer will be in equilibrium when:
  \frac{MU1}{P1} = \frac{MU2}{P2} = \frac{MU3}{P3} = …

Law of Equi-Marginal Utility

• A consumer maximizes total utility by optimally distributing income among various commodities.

• The marginal utility derived per unit of expenditure (per rupee) is the same for all commodities.

• \frac{MU1}{P1} = \frac{MU2}{P2} = \frac{MU3}{P3} = …

Indifference Curve Analysis

• Proposed by J.R. Hicks and R.G. Allen.

• Utility is considered ordinal (rankable but not measurable).

Assumptions of Indifference Curve Analysis

1. Ordinal Utility: Utility is subjective and rankable but not measurable.

2. Rational Consumer: Consumers are rational.

3. Constant Income: The consumer's income is constant.

4. Unchanged Preferences: Tastes and preferences remain unchanged.

5. Transitivity: If a consumer prefers A to B and B to C, then they prefer A to C.

Indifference Curve

• Combinations of goods and services that provide the same total satisfaction.

• The locus of points, each representing a different combination of two goods, which provide the same level of utility to the consumer.

Marginal Rate of Substitution (MRS)

• The rate at which one commodity can be substituted for another while maintaining the same level of utility.

• MRS = \frac{\Delta y}{\Delta x}

• Since quantity of one commodity increases while the other decreases, MRS is always negative. The slope of the indifference curve is negative.

Indifference Map

• A set of indifference curves depicting a consumer’s preferences.

• Higher indifference curves represent higher levels of satisfaction.

• Combinations on higher indifference curves are preferred to those on lower ones.

Characteristics of Indifference Curves

1. Downward Sloping: Demand for one commodity must decrease if the demand for the other increases to maintain the same utility level.

2. Convex to the Origin: Due to the diminishing MRS.

3. Higher Curves, Higher Utility: Higher utility is derived from increased quantity of either or both goods.

4. Non-Intersecting: Indifference curves cannot intersect because the same combination of goods cannot yield two different utility levels.

Law of Diminishing MRS

• The convex nature of the indifference curve is due to the decreasing rate of substitution as more units of a commodity are consumed.

• The quantity of a commodity a consumer is willing to sacrifice for an additional unit decreases as they continue substituting.

Budget Line

• Represents all combinations of two products that can be purchased for a given income.

• If goods X and Y are available at prices P1 and P2 and in quantities Q1 and Q2, for a given budget B:
  B = P1 \times Q1 + P2 \times Q2

• An increase in income increases the budget, allowing the consumer to buy more, increasing utility.

Consumer Equilibrium (Ordinal Utility Method)

• The amount of goods and services a consumer buys given their income and market prices.

• The aim is to maximize satisfaction from the available income.

• A consumer is in equilibrium where the price line is tangent to the highest attainable indifference curve.

Conditions for Equilibrium

1. 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:
   MRS{xy} = \frac{Px}{P_y}

2. The indifference curve must be convex to the origin at the point of tangency (second-order condition).

Consumer Surplus

• Willingness to Pay: The maximum amount a buyer will pay for a good.

• Consumers buy at prices less than their willingness to pay and refuse to buy above it.

• Consumer Surplus: The difference between the willingness to pay and the actual amount paid.

• It measures the benefit buyers receive.

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

Consumer Surplus Change with Price

• As price decreases from P1 to P2, consumer surplus increases from area AP1B to area AP2C.

• The increase in consumer surplus is the area P1BCP2$$.

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.