Business Economics: Theory of Consumer Behaviour Study Notes

Learning Outcomes for Theory of Consumer Behaviour

After studying this unit, students should expect to be able to:

• Explain the meaning of utility.
• Describe the methodology consumers utilize to maximize satisfaction by allocating expenditures across different goods.
• Explain the Law of Diminishing Marginal Utility using specific examples.
• Describe the concept of Consumer Surplus and provide illustrative examples.
• Define the meaning of Indifference Curves and the Price Line (Budget Line).
• Demonstrate how Indifference Curves and Price Lines explain the state of Consumer Equilibrium.

Nature of Human Wants

In the field of economics, a "want" is defined as a wish, desire, or motive to own or use goods and services that provide satisfaction. These wants originate from physical, psychological, or social factors. Because resources are inherently limited, individuals must choose between urgent and less urgent wants.

Characteristics of Human Wants

• Unlimited in Number: Human beings possess an infinite number of wants; it is impossible to satisfy all of them.
• Varying Intensity: Wants are felt with different levels of urgency. Some are intense and immediate, while others are less so.
• Utility Dependence: The utility derived from a good depends on the intensity of the want it satisfies.
• Economic Definition of Utility: In general terms, utility is satisfaction. In an economic sense, utility is the "want-satisfying power" of a commodity.
• Satiability: While total human wants are unlimited, each individual specific want is capable of being satiated.
• Competitiveness: Wants compete with one another for satisfaction because resources are scarce relative to the total number of wants.
• Complementarity: Certain wants can only be satisfied by using a group of goods or more than one good simultaneously.
• Alternative Satisfaction: A specific want can often be satisfied through various alternative goods or methods.
• Subjectivity and Relativity: Wants and utility are subjective concepts that vary based on the individual, time, and place.
• Recurrence: Some wants recur periodically (e.g., hunger), while others occur only once.
• Habit and Custom Formation: Repeatedly satisfying a want can lead to the formation of habits or customs.
• External Influences: Wants are shaped by factors such as income, personal taste, fashion trends, advertisements, and prevailing social norms.
• Multiple Causes: Wants arise from physical instincts, psychological needs, social obligations, and the economic status of the individual.
• Psychological Nature: Utility is a psychological concept. It is distinct from "usefulness" and is independent of moral or ethical considerations.

Classification of Wants

Economics categorizes human wants into three distinct types: Necessaries, Comforts, and Luxuries.

1. Necessaries

Necessaries are essential for living and are further subdivided into three groups:

• Necessaries for Life or Existence: Items required to meet basic physiological needs and maintain life, such as a minimum amount of food, clothing, and shelter.
• Necessaries for Efficiency: Items required beyond basic survival to maintain energy, longevity, and work efficiency. This includes nourishing food, clean water, adequate clothing, education, recreation, and a comfortable dwelling.
• Conventional Necessaries: Items that become necessary due to social customs, conventions, or the pressure of habit. They are not strictly required for survival or efficiency but are compelled by social environment.

2. Comforts

Comforts are goods that make life pleasant and satisfying. They are less urgent than necessaries. Examples include:

• Tasty and wholesome food.
• Better quality housing.
• Clothing suitable for different occasions.
• Audio-visual equipment.
• Labour-saving devices.

3. Luxuries

Luxuries are expensive, superfluous items that are not essential for living. They often serve vanity or social status. Examples include:

• Expensive designer clothing.
• Exclusive vintage cars.
• High-end, classy furniture.

Note on Fluidity: These categories are not rigid. A luxury for one person may be a comfort or necessity for another, or a luxury in the past (like certain technologies) may become a necessity today.

Fundamental Concepts of Utility

Two primary concepts of utility are used to analyze consumer behaviour:

• Total Utility (TU): The sum of all utilities derived from the consumption of all units of a commodity at a given time. It is the sum of marginal utilities up to the specific unit consumed.     $TU = \sum MU$
• Marginal Utility (MU): The additional satisfaction or utility gained from consuming one extra unit of a commodity.     $MU = TU_n - TU_{n-1}$     Alternatively:     $MU = \frac{\Delta TU}{\Delta N}$

Relationship Between TU and MU

The following schedule illustrates the relationship between Total Utility and Marginal Utility:

Key Observations on the TU-MU Relationship:

• At the first unit of consumption, $TU = MU$.
• When Total Utility is increasing at a decreasing rate, Marginal Utility is decreasing but remains positive.
• When Total Utility reaches its maximum and remains constant (Point of Satiety), Marginal Utility is zero ($MU = 0$).
• When Total Utility begins to decrease, Marginal Utility becomes negative.

The Law of Diminishing Marginal Utility

This law is based on the logic that while total wants are unlimited, any specific want can be satisfied. As a consumer consumes more units of a good, the intensity of their desire for that good diminishes.

Definition: As a consumer takes more units of a good, the extra satisfaction (Marginal Utility) derived from each additional unit falls. Note that it is the marginal utility that declines, not necessarily the total utility initially.

Example: Consumption of Tea

In this example, the $11^{th}$ cup yields negative marginal utility ($-4$), possibly indicating that over-consumption causes sickness.

Assumptions of the Law

1. Homogeneity: Units must be identical in all respects (taste, quality, etc.). Consumer traits like habits and income must also remain unchanged.
2. Standard Units: Consumption must involve standard units (e.g., a cup of water, not a spoonful).
3. Continuity: There must be no time interval or gap between the consumption of successive units.
4. Exceptions for Prestige/Accumulation: The law may not apply to items like gold or cash, where more quantity might increase the desire for more.
5. Related Goods: The shape of the utility curve is influenced by the presence or absence of substitutes or complements.

Consumer Surplus

The concept of Consumer Surplus was propounded by Alfred Marshall. It is a measure of the welfare or net gain that buyers receive from participating in a market.

Definition and Calculation

Marshall defined Consumer Surplus as: "The excess of the price which a consumer would be willing to pay rather than go without a thing over that which he actually does pay."

$\text{Consumer Surplus} = \text{What a consumer is ready to pay} - \text{What he actually pays}$

Derivation from the Law of Diminishing Marginal Utility

• Consumers are willing to pay more for goods from which they derive higher utility.
• The demand curve is determined by the consumer's willingness to pay based on utility.
• As consumption increases, marginal utility (and thus willingness to pay) falls.
• Consumer equilibrium occurs when $MU = \text{Price}$.
• Since the market price is usually the same for all units, the consumer gains "extra utility" on all units prior to the marginal (last) unit.

Measurement Illustration (Price = $20$)

Total Consumer Surplus ($1$ to $6$ units) = $10 + 8 + 6 + 4 + 2 + 0 = 30$.

Graphical Representation and Changes

• Graphically, Consumer Surplus is the triangular area below the demand (MU) curve and above the price line.
• Impact of Price Changes: A rise in price reduces consumer surplus; a fall in price increases it.
• Components of Increase (when price falls):     a) Increase in surplus for existing buyers (rectangle effect).     b) Surplus available to new buyers entering the market (triangle effect).

Applications and Limitations

Practical Applications:

• Business Firms: Helps identify customer segments likely to repeat purchases and aids in cost-benefit analysis for investments.
• Price Discrimination: Firms can identify groups with high willingness to pay to set differentiated prices.
• Government Policy: Finance ministers use it to decide on taxes; commodities with high consumer surplus can be taxed with minimal welfare loss to citizens.

Limitations:

• Difficulty in precisely measuring marginal utility.
• In the case of necessaries, the surplus is technically infinite.
• Influenced by the availability of substitutes.
• Prestige goods (e.g., diamonds) do not follow simple utility scales.
• The marginal utility of money changes as consumption happens (Marshall assumed it was constant, which is unrealistic).
• Modern economists argue utility cannot be measured quantitatively in monetary terms.

Indifference Curve Analysis (Ordinal Approach)

Developed by Hicks and Allen, this approach is more realistic than the cardinal approach because it believes human satisfaction (a psychological phenomenon) cannot be measured in monetary units. Instead, it relies on the ordering of preferences (Ordinal concept).

Assumptions Underlying the Approach

1. Full Information: The consumer knows their own tastes and the economic environment.
2. Rationality: The consumer acts to reach more preferred consumption bundles.
3. Ordinal Expressibility: Consumers can rank bundles (first, second, etc.) but cannot say by "how much" they prefer one over another.
4. Transitivity: If $A > B$ and $B > C$, then $A > C$.
5. Non-Satiation (More is Better): A bundle with more of a commodity is preferred to a bundle with less.

The Indifference Curve (IC)

An Indifference Curve (also called "iso-utility" or "equal utility" curve) represents all combinations of two goods that provide the same level of satisfaction to a consumer.

Indifference Schedule Example:

Indifference Map: A collection or set of indifference curves representing different levels of satisfaction. Curves farther from the origin represent higher utility.

Marginal Rate of Substitution (MRS)

The MRS is the rate at which a consumer is willing to exchange one good for another while maintaining the same level of satisfaction (moving along an IC).

$MRS_{xy} = \frac{MU_x}{MU_y}$

Diminishing MRS: As the consumer acquires more of Good X (e.g., food) and gives up Good Y (e.g., clothing), the rate at which they are willing to substitute X for Y falls. This is because:

1. The want for a particular good is satiable.
2. Goods are imperfect substitutes for each other.

Properties of Indifference Curves

1. Downward Sloping to the Right: Commodities must be substituted for one another to maintain the same satisfaction level.
2. Convex to the Origin: This is due to the Diminishing Marginal Rate of Substitution.
   • Extreme Case 1: Perfect Substitutes: IC is a straight, parallel line with constant slope/MRS.
   • Extreme Case 2: Perfect Complements: IC is L-shaped (e.g., left and right shoes).
3. Non-Intersection: Two indifference curves can never cross as it would lead to a logical absurdity (where different levels of satisfaction are equal).
4. Higher IC = Higher Satisfaction: Higher curves contain more of at least one good.
5. Do Not Touch Axes: Since the analysis assumes the consumer wants a combination of both goods, the curve will not touch the X or Y axis.

The Budget Line (Price Line)

The budget line represents the constraint on a consumer's choices based on limited income and fixed prices.

Algebraic Equation:$P_X Q_X + P_Y Q_Y \leq B$ Where $B$ is the total money available. If the consumer spends their entire income: $P_X Q_X + P_Y Q_Y = B$

• Slope of Budget Line: Defined by the price ratio $\frac{P_X}{P_Y}$.
• Shifts: Occur due to changes in income (nominal), changes in prices, or a combination of both.

Consumer Equilibrium

A consumer is in equilibrium when they derive the maximum possible satisfaction given their constraints and have no desire to rearrange their purchases.

Conditions for Equilibrium

1. The point of equilibrium must be on the budget line.
2. The budget line must be tangent to the highest possible Indifference Curve.
3. At the point of tangency, the slope of the IC (MRS) must equal the slope of the budget line (price ratio):     $MRS_{xy} = \frac{P_X}{P_Y}$     Which can be written as:     $\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$

Superiority of Indifference Curve Analysis

Indifference curve analysis is considered superior to Marshall's utility analysis because:

• It avoids the assumption of quantifiable (cardinal) utility measurement.
• It allows for the simultaneous study of multiple commodities.
• It does not assume the marginal utility of money is constant.
• It successfully separates Income Effect from Substitution Effect.