Consumer Theory Basics

Meaning and Definition of Utility

• Utility: The satisfaction or pleasure a consumer derives from consuming a good or service.
• Subjective and varies across individuals and time.
• Measured in hypothetical units called “utils”.
• Two main interpretations:
  • Cardinal utility: Assumes utility is measurable (e.g., 1 apple gives 10 utils).
  • Ordinal utility: Assumes only ranking of preferences is possible (e.g., apple preferred to orange).

Law of Diminishing Marginal Utility (DMU)

• Statement: As successive units of a good are consumed, the marginal utility (MU) from each additional unit declines, ceteris paribus.
• Mathematical form: $MU_n = \frac{\Delta TU}{\Delta Q}$ where $TU$ is total utility.
• Assumptions:
  • Homogeneous units consumed continuously.
  • Consumer tastes, income, prices remain constant.
  • Rational behaviour.
• Explanation/Illustration:
  • First slice of pizza gives high MU; fifth slice gives lower MU.
  • Total utility increases at a decreasing rate, reaches maximum, then declines.
• Exceptions/Limitations:
  • Rare collectibles (MU may rise initially).
  • Addictive goods (MU may increase for initial units).
  • Ill-defined or large consumption intervals.
• Practical significance:
  • Basis for downward-sloping demand curve.
  • Guides taxation policy (higher marginal utility of income for the poor).

Consumer Equilibrium

• Point where a consumer maximises utility given budget and prices.
• Under cardinal approach (one commodity): equilibrium at $MU = P$.
• Two-commodity (ordinal) approach: equilibrium where the indifference curve is tangent to the budget line.
  • Mathematical condition: $\frac{MU<em>x}{P</em>x} = \frac{MU<em>y}{P</em>y}$ and entire income spent.
• Implications:
  • No incentive to reallocate spending.
  • Explains consumer choice and demand derivation.

Consumer Budget

• Budget (money income): total monetary resources available for spending, denoted $M$.
• Budget constraint / budget line equation: $P<em>x X + P</em>y Y = M$ where $P<em>x, P</em>y$ are prices of goods $X, Y$.
• Slope: $-\frac{P<em>x}{P</em>y}$ (rate at which the market allows substitution between goods).
• Intercepts:
  • $X$-axis intercept $= \frac{M}{P_x}$ (all income on good $X$).
  • $Y$-axis intercept $= \frac{M}{P_y}$ (all income on good $Y$).

Changes in Budget

• Income change (prices constant): shifts budget line parallelly.
  • Increase in $M$ → outward shift; consumer can reach higher indifference curves.
  • Decrease in $M$ → inward shift.
• Price change (income constant): pivots budget line.
  • Fall in $P_x$ → flatter slope; intercept on $X$-axis increases.
  • Rise in $P_x$ → steeper slope.
• Analytical implications:
  • Income effect: movement to new equilibrium due solely to income change.
  • Substitution effect: reallocation due to relative price change.

Summary Notes

• Utility is subjective satisfaction and underpins consumer behaviour.
• DMU explains why marginal benefits decline and underlies the demand curve’s shape.
• Consumer equilibrium occurs when the ratio of marginal utilities equals the ratio of prices.
• The budget line represents all affordable bundles; its position and slope are governed by income and prices.
• Shifts or pivots of the budget line capture income and substitution effects respectively.