CONSUMER BEHAVIOUR

Prof. Subhalaxmi Mohapatra

Faculty Member
IBS Dehradun
For class of 2010
Chapter objectives
To understand the basic principles of consumer choice and behavior.
To understand the process an individual adopts to choose a particular
good or set of goods, and the way he tries to draw maximum
satisfaction from the goods shall be analyzed.
To focus on the concept of total utility and marginal utility and
establish the relationship between the two concepts.
To discuss the different utility theories like diminishing marginal utility
theory and equi-marginal theory.
To focus on substitution and income effect. The concepts of
substitution and income effect shall be explained with the help of
indifference curve analysis.
The concepts of marginal rate of substitution, consumer equilibrium
and consumer surplus shall also be discussed in detail.
Relevance of the Topic

 We know that management is interested

in the market demand of the product
(which is the sum total of individual’s
consumer’s demand), hence we begin our
discussion with the individual market
demand.

 Since the behaviour of individual demand

depends upon the consumer behaviour, we
thus begin with the theory of consumer
behaviour.
Though in common usage the terms preference and choice are
synonymous, but in economic parlance, they are two distinct but
related terms.
Example: Rahul may have the desire to buy a particular car, but he
cannot buy it unless he has economic resources to buy it.
The extent of satisfaction that a person gets after consuming any
product or service is called as utility. In other words utility denotes
satisfaction. Utility refers to the ranking of different goods and
CHOICE AND UTILITY THEORY
services.
Utility is a subjective concept that cannot be measured. Utility can
just be compared. Given the limited resources, a consumer can
compare the utility of two goods or services from which he makes a
choice. Thus, utility helps a consumer to make better choices.
Utility

 Why do we purchase commodities?

 Ans. Consumption of these commodities give us
satisfaction
 The satisfaction which a consumer gets by having
or consuming goods or services is called utility
 The want satisfying power of commodity is
utility.
 Utility is a power or capacity of a commodity to
satisfy human wants.
 Same commodity gives different utility to
different consumers.
 Even for the same consumer, utility varies from
unit to unit, from time to time and from place to
place.
 We measure utility in units called “utils”
 There are two approaches by which utility can be measured.
 Cardinal utility approach: Cardinal approach is based on
Marshallian school of thought. It says that utility can be measured.
It has come out with a unit called util to measure the utility. Util
reveals how much of money a consumer is willing to pay for a given
unit of product.
 Independent variables: This approach assumes that utility
obtained from the consumption of one product is not dependent on
the utility derived from other products.
MEASUREMENT OF UTILITY
 Ordinal utility approach: This approach is based on the view that
utility cannot be measured at all; it can just be ranked in order of
preferences. This approach is based on the assumption that a
customer is consistent in ranking and preference is based on the
choice of products available.
Cardinal Utility Approach

Alfred Marshall (1890) introduced the Cardinal

Utility Theory also known as Marshallian
Utility Theory.

Utility is subjective not objective

 Assumptions of Utility Theory
It assumes that customers make a rational choice. Customers choose goods and services
that give them maximum satisfaction considering their tastes and preferences and the
resource constraints.
The second assumption is, consumers always prefer more quantity.
Example: If there are two options, option A (3 biscuits and 10 chocolates and option B (3
biscuits and 12 chocolates), then consumers will always prefer option B, since the quantity
is more.
The third assumption made is regarding the trade off that the customers would make.
Put in other words, a consumer will substitute some amount of one product for some
amount of another product in case of utility remaining constant.
Example:If there are two options, option A (3 biscuits and 10 chocolates) providing same
utility as option B (4 biscuits and 6 chocolates), then as per the assumption, the consumer
will prefer option B where the consumer is willing to loose 4 chocolates for 1 additional
biscuit, with no change in total utility. The fourth assumption stresses on the existence of
diminishing marginal rate of substitution. This assumption says that keeping utility
constant, when additional units of a product are consumed, the value of each additional
unit, measured by the amount of other product the consumer is willing to forego,
declines.
 Total Utility
Meaning:
Total utility can be defined as the amount of utility a person derives from the
consumption of a particular product in a given period.
The sum- total of satisfaction which a consumer derives by consuming the
various units of a commodity.
Nature of Total Utility:
The more units of a commodity he consumes, greater will be his total utility or
satisfaction from it up to a certain point.
As he keeps on increasing the consumption of the commodity , he eventually
reaches the point of saturation represented by the maximum total utility.
If further units of the commodity are consumed, his total utility starts declining
Marginal Utility

Defined as the change in total utility resulting from 1 unit change in the
consumption of the good.
MU x = ΔTU x / Δ Qx
MU x -- Marginal utility
ΔTU x – change in total utility
Δ Qx –change in quantity of good X respectively

MU of nth Unit = TU n - TU n-1

Another way of finding marginal utility is by differentiating total utility

function:
MUx = dTU x / dQx
Total utility and Marginal
utility In the given table, the behavior or total utility
schedule of person consuming ice-cream can be
Quantit observed.
y of
Margin It can be observed that total utility increases
ice- Total initially, later it become constant after reaching
al
cream utility a certain point. Subsequently it starts declining.
utility In the given case, it can be seen that when a
consu person starts consuming ice-cream, his total
med utility is increasing initially. When the person
had consumed 5th unit of ice-cream, total utility
0 0 - stopped increasing. On consumption of the 6th
1 6 6 unit, total utility started decreasing.
2 10 4 Marginal utility starts decreasing as the
3 13 3 consumer starts consuming more units of a
product. If you refer to the above table, the
4 14 1 marginal utility became zero, when the person
5 14 0 has consumed 5th unit. Subsequent consumption
leads to negative marginal utility.
6 12 -2
Relationship between Total
and Marginal Utility
● As consumption increases, total utility rises but marginal
utility falls.
● It may be observed that when total utility is maximum,
marginal utility falls to zero.
● When total utility starts falling, marginal utility becomes
negative.
● Marginal utility declines as consumer starts consuming
more units of a particular commodity. It can be noted in
the earlier example that, when the total utility reaches
its’ maximum, marginal utility becomes zero. The decline
in the total utility takes place when marginal utility
becomes negative. 
The Law of Diminishing Marginal Utility
 According to the Law of Diminishing Marginal Utility, “ for any individual
consumer the value that he attaches to successive units of a particular
commodity will diminish steadily as his total consumption of that
commodity increases, the consumption of all other goods being held
constant.” (R. G. Lipsey)
 When a consumer consumes additional units of a particular good at a point
of time, his desire for every successive unit becomes less intense,
consequently utility derived from each successive unit diminishes.
 According to law of diminishing marginal utility, the extra or marginal
utility declines as a person consumes more and more of any particular
good. The total utility grows at a slower rate, when a person consumes
more and more of a good. Total utility grows at a slower rate as the
marginal utility starts diminishing with each additional unit consumed. The
diminishing marginal utility is a result of the fact that a person’s
enjoyment of a good decline as more and more of the good is consumed.
 In the given case of ice-cream, a person’s total utility after consuming 1st
unit of ice-cream is 6 and the total utility after the consumption of second
unit of ice cream is 10, it means that utility from the second ice-cream is
4, which is lesser than the first. As he consumes more units of the same
product, his utility level goes down and he pays less for the same
commodity
Assumptions

1) Various units of the goods are homogeneous.

2) No time gap between consumption of the
different units
3) Tastes, preferences and fashions remain
unchanged
4) Consumer is rational ( i.e has complete
knowledge and maximizes utility)

If the above conditions holds good, law holds good

universally.
 Explains value paradox: The law helps in understanding the factors, which
determine the value of a product. In his book “The Wealth of Nations” Adam Smith
developed theory that explains why different products have different market
values. He introduced the ‘diamond-water’ paradox. He said though water is highly
essential commodity, it is priced lower, when compared to a less essential product
like diamond. He explained this through two concepts i.e. value in use and value in
exchange. The price of diamond is far higher, though diamond has a low value in
use but a high value in exchange while water has high value in use but low value in
exchange. Hence, it conveys that if the availability of a product is less, marginal
utility would be high.
 Explains the derivation of Law of demand: it helps in deriving the law of demand
and explain the downward sloping of the demand curve. It also helps to analyze
why prices fall.
 Explains the redistribution of income: Diminishing marginal utility helps the
government to frame fiscal policies. The value for money differs with every person. 
 Example: Assume two persons are earning Rs 50,000 and Rs 5,000 respectively, and both of them get a
salary hike of Rs 1000, the effect would be significant in the case of second person when compared to
the first person. Since, for a person earning 5,000 the income increase is 20 %, whereas, for the person
earning 50,000 it is just 2%. Hence the effect differs considerably. The same effect can be felt in the
imposition of tax. An increase in tax rate will not have much impact on a person who is getting higher
income than a person who is getting lesser income.
Maximizing Utility

 Equilibrium for one product: (consumption of all

other product remains constant)
The utility maximizing consumer will adjust
her purchases until the marginal utility of last
unit purchased equal to the price of a unit of
that product.
MU = P
Or, MU/P = 1
Equilibrium for many products:
To maximize utility, consumers allocate
expenditure among products so that equal
utility is derived from the last unit of money
spent on each.
MUx/Px = MUy/Py = -------------- =MUn/ Pn
Equimarginal Utility
Law of equimarginal utility states that the consumer will spend his money on
different products in such a way that the marginal utility of each product is
proportional to its price. As a result, the level of satisfaction would be the
same while consuming the two products. A consumer having a limited income
has to choose between ice-cream and a leather belt. If the leather belt costs
six times more than ice-cream, consumer would buy the leather belt only
when its marginal utility is at least six times more than the marginal utility of
ice-cream.
A consumer continues buying a product till its marginal utility is equal to its
price. Hence the demand curve for a single product is MUx = Px, if it is
assumed that the price of the product is fixed. The consumer goes on
consuming the product till he reaches a point where, MUx = Px.
If there is any change in the income level, there is going to be a change in the
marginal utility. The consumer goes on consuming or purchasing till the
marginal utility of his income or money is equal to both the products. Thus,
equilibrium can be achieved at MUx / Px = MUy / Py = MUm
Equimarginal Principle

Marginal utility of Egg and marginal utility of

shoes – are they equal?
If good A cost = 2 (good B)
Buy good A only when it gives twice marginal
utility compared to good B.
Every single good should bring same marginal
utility per RsS. Spent.
I should arrange my consumption so that every
single good brings me the same MU per rupees
expenditure.
Utility Maximizing Rule

In general, utility maximizing consumer spread

out their expenditure until the following
condition holds:
(MU x / Px ) = (MU y/ Py)

Another View:
(MU x / MU y) = (Px / Py)
Consumer
 Surplus
 The concept of consumer surplus was pioneered by Marshall.
According to him, “the excess of the price which a consumer would
be willing to pay rather than go without a thing over which he
actually does pay, is the economic measure of his surplus
satisfaction.” Thus, consumer surplus can be defined as the
difference between what consumers would like to pay for a
product and what they actually pay.
 Based on the consumer surplus, government frames the policies of
welfare and development for the rich and poor. Normally rich have
more consumer surplus. So to bridge the gap between the rich and
the poor, government designs it’s tax policies in such a way that
the least impact is felt on the poor.
 Consumer surplus helps a monopolist to retain a customer in the
long run. If the monopolist focuses on the short run, he may not be
able to retain the customer in the long run. Consumer surplus can
also be used to measure the health of an economy. A higher
consumer surplus means that the economy is stable.
 Consumer’s Surplus for an Individual
(Explanation see in the next slide)
3.00
Price of milk [£ per glass]

2.00

1.00 Market price

0.30

1 2 3 4 5 6 7 8 9 10

Glasses of milk consumed per week

 Consumer’s Surplus for an Individual

● Consumer’s surplus is the sum of the extra valuations placed on

each unit above the market price paid for each.
● For the 1st unit consumption of glass of milk, the price the
consumer is willing to pay is £3 but the actual price which he
pays is £0.30.
● Ms. Green pays the red area for the 8 glasses of milk she
consumes per week when the market price is £0.30 a glass.
● The total value she places on these 8 glasses of milk is the
entire shaded area (red and green).
● Hence her consumer’s surplus is the green area.
Ordinal Utility Theory: Indifference
Curve Approach
Introduction

Limitations of Cardinal Utility Approach

OUT deals with consumer’s behavior under the
assumption that utility from different units of a
good or between different goods need only be
rankable and not measurable.
If a consumer gets more utility from bundle A than
from bundle B, it means that the consumer will
rank bundle A above bundle B.
He need not know by how much quantity A is
preferred to B.
This approach was originally due to Vilfredo Pareto
and was further elaborated by John Hicks and
R.G.D. Allen.
Assumptions of the Theory

 1. Rationality: A consumer aims to maximize his

utility (subject to income and prices)
 2. Utility is Ordinal :The consumer can rank his
preferences (order the various ‘baskets of
goods’) according to the satisfaction of each
basket. He need not know precisely the amount
of satisfaction. It is not necessary to assume
that utility is cardinally measurable. Only
ordinal measurement is required.
 3. Consistency: this condition requires that if a
consumer prefers bundle A to bundle B, he does
not, at the same time prefers bundle B to
bundle A.
Assumptions (Contd.)

 4. Transitivity: If the consumer prefers bundle A to B

and B to C, he prefers bundle A to bundle C.
 5. Non- satiety: A bigger bundle is preferred to a
smaller bundle.
 6. Diminishing Marginal Rate of Substitution:
Preferences are ranked in terms of indifference curves,
which are assumed to be convex to the origin. This
implies that the slope of the indifference curves
increases. The slope of the indifference curve is called
marginal rate of substitution of the commodities. This
theory is based on the axiom of the diminishing
marginal rate of substitution.
What is an Indifference Curve

A curve that shows different combinations

of two goods yielding the same level of
utility (satisfaction) to the consumer is
known as an Indifference Curve (or, Equal –
utility Curve).
Since all points on the curve yield equal
satisfaction, the consumer likes equally all
the combinations, and is thus indifferent
between these combinations.
An Indifference Map
● A set of indifference curves is called an indifference
map.
● The further the curve from the origin, the higher the
level of satisfaction it represents.
● Moving along the arrow, is moving to ever-higher
utility levels.
Properties of Indifference
Curve
1. Indifference curve is downward
sloping: By defn, different points on an
indifference curve represents the same
level of utility. If we decrease the
consumption of one good, obviously we
need to increase the consumption of the
other good to attain the same level of
satisfaction a before the change. This gives
rise to a downward sloping indifference
curve.
 Properties of Indifference
Curve (contd.)
2. Indifference curve is convex to the origin: Convexity of
indifference curve implies that the two goods can substitute
on another, but not perfectly. As the consumer gets additional
units of good X at the cost of good Y, marginal utility of good
X(MUx) decrease.
On the other hand, due to reduced availability of good Y the
marginal utility of Y(MUy) increases. So, the consumer would
be ready to sacrifice lesser and lesser amount of Y for each
additional unit of X.This gives rise to diminishing MRS.
In case the phenomenon of diminishing MRS holds good, the
indifference curve would be convex to the origin
 Properties of Indifference
Curve (contd.)
 Indifference curve is convex to the origin (contd.):
 The assumption of convexity implies imperfect substitution
among the two goods. However, there are cases where the
shape and slope of indifference curve will not be convex to
the origin.
 a) Perfect substitutes: Two goods are perfect substitutes
if each is substituted for the other at a constant rate, e.g.
ball pen and fountain pen. In other words, marginal rate of
substitution of these goods is constant.
 This results in a straight line downward- sloping IC or IC
becomes a straight line with negative slope.
 Here the equilibrium of the consumer will be at corner
solution, a situation in which the consumer spends all his
income on one commodity.
Properties of Indifference
Curve (contd.)
 Indifference curve is convex to the origin
(contd.):
 b) Perfect Complements: Two goods are perfect
complements if they are always consumed
together in a fixed proportions, e.g., an electric
bulb and a bulb – holder.
 Here the ICs breaks down, since there is no
possibility of substitution between the
commodities.
 Here the ICs are L-shaped, with its kink towards
the origin.
Properties of Indifference
Curve (contd.)
3. ICs can do not intersect each other: If they did,
the point of their intersection would imply two
different levels of satisfaction, which is
impossible.
4. The further away from the origin an IC lies, the
higher the level of satisfaction it denotes; bundles
of goods on a higher indifference curve are
preferred by the rational consumer.
 Marginal rate of substitution
Marginal rate of substitution can be defined as
the rate at which a customer is willing to
substitute one product for the other,
maintaining the same level of utility. It is
assumed that consumer has to make choice
Click to edit Master text styles
between two products food and clothing, with
the limited income.
Second level
● Third level
In the given illustration it can be observed that
at ‘stage A’ a consumer is ready to swap 3 units
● Fourth level
of clothing to get one additional unit of food. ●
Fifth level
At stage B, consumer is ready to forego only
one unit of clothing for an additional unit of
food. The rate of substitution declines further
at stage C, where the consumer is ready to
forego only ½ unit of clothing to get an
additional unit of food.

The slopes of A and B, B and C, C and D are

respectively 3, 1 and ½. Joining these points
would give the indifference curve. The figures
3, 1 and ½ are the substitution rates or can also
be called as marginal rate of substitution. 
Marginal Rate of Substitution

 The marginal rate of substitution of X for

Y (MRSx,y ) is defined as the number of
units of good Y that must be given up in
exchange for an extra unit of goodX so
that the consumer maintains the same
level of satisfaction.
 In other words, it shows the rate at which
one good is substituted for another good,
while remaining on the same indifference
curve. Thus,
(slope of indifference curve) = -dY / dX =
MRS x,y
Marginal Rate of Substitution
(contd.)
There is a relationship between marginal utility
and marginal rate of substitution.
This is because the slope of an indifference curve
is caused by the law of diminishing marginal utility.
As we move down the indifference curve, Y is
reduced resulting in utility loss(-) ΔY.MUy units.
Which is exactly compensated by additional X,
giving utility (+) ΔX. MUx . So,
(-) ΔY.MUy = (+) ΔX. MUx
or, MUx / MUy = (-) ΔY / ΔX = MRS x,y
The Budget Line or
Iso – Expenditure Line
A good is demanded by the consumer if he has
(i) A preference for that good, and (ii)
purchasing power to buy the good.
His preference pattern is represented by a set
of ICs,
His purchasing power depends upon his money
income and market prices of the goods.
The Budget Line or
Iso – Expenditure Line
(contd.)
Assume that the consumer has allocated some money to
be spent on goods X and Y, whose prices are Px and Py ,
then his purchasing power can be represented in terms
of a budget equation:
Y= Px Qx + Py Qy
Where Y = Income or expenditure on goods X and Y
Qx and Qy = Quantity of good X and Y respectively
Px and Py = Prices of good X and Y respectively.
The budget equation gives us a budget line.
The Budget Line or
Iso – Expenditure Line
(contd.)
Suppose the consumer has Y = Rs. 2,000, Px =
Rs. 50 and Py = Rs. 40.
The maximum amount of X which he can buy
can be found from his budget equations:
2000 = 50(Qx) + 40 (0) or, Qx = 40
Similarly, the maximum amount of Qy = 50
Graph
The Budget Line or
Iso – Expenditure Line
(contd.)
So, the combinations (40,0) and (0,50)are
possible consumption bundles within the
budgeted amount of money.
By joining these two points we get the budget
line AB
Consumer equilibrium

 A consumer attains
equilibrium when he
maximizes his satisfaction
with the available money
income. In the given figure
different indifferent curves Click to edit Master text styles
are given. But the consumer Second level
maximizes his satisfaction, ● Third level

when the indifference curve ● Fourth level

is U3. The consumer reaches ● Fifth level

the highest indifference

curve attainable with fixed
income at point B, which is
tangential to the budget line.
At this point, substitution
ratio equals the price ratio of
both the commodities.
 Income and substitution effect
 Indifference curve analysis takes into account the substitution and income effect due
to change in price. This helps in understanding the reason for decline in demand with
rise in prices.
 Substitution Effect:
 The concept of substitution effect says that when the price of any product rises,
consumers substitute the product with a low priced product.
 Example: Assume a customer with limited income, wants to buy both trousers and polo
shirt. The price of the trousers is Rs 900 and the price of the polo shirt is Rs 150. Thus,
the relative price of a trouser is 900/150 = 6 polo shirts. If the price of the trouser
decreases from Rs 900 to Rs 600, the relative price falls from six to four polo shirts. Law
of demand says that decrease in the price results in increase in demand. Hence, the
consumer will substitute more of the trousers whose price has fallen for the relatively
more expensive product i.e. Polo shirts. Therefore, in order to keep the utility constant
and satisfy the utility-maximizing condition, the customer must now purchase higher
quantities of trousers and purchase fewer Polo shirts.
 It can be seen in the figure that once the price of the trouser falls, consumer increases
the consumption by Q1.
 Income effect:
 Income effect says that change in price of a product has an effect on the purchasing
power of the customer. The decrease in the price enables to buy more of the same
commodity or some other. Hence, the quantity demanded increases from Q1 to Q2 .