RAJAGIRI BUSINESS

SCHOOL
KAKKANAD
ERNAKULAM – 682039

MICRO - ECONOMICS

TOPIC – CONSUMER THEORY

DATE - 11TH AUGUST 2017

Submitted to, Submitted by,

Prof. Ronny Thomas Albey John
(p17165)
PGDM B
 What is Consumer Theory?

Consumer theory is the study of how people decide what to spend their money on given
their preferences and their budget constraints. Consumer theory shows how individuals
make choices given their income and the prices of goods and services and helps us to
understand how individuals’ tastes and incomes influence the demand curve.

UTILITY

Utility refers to the total satisfaction received from consuming a good or service. The
economic utility of a good or service is important to understand because it will directly
influence the demand, and therefore price, of that good or service. A consumer's utility is
hard to measure, however, but it can be determined indirectly with consumer behavior
theories, which assume that consumers will strive to maximize their utility.

Ordinal Utility

The Ordinal Utility approach is based on the fact that the utility of a commodity cannot be
measured in absolute quantity, but however, it will be possible for a consumer to tell
subjectively whether the commodity derives more or less or equal satisfaction when
compared to another.
The modern economists have discarded the concept of cardinal utility and instead applied
ordinal utility approach to study the behavior of the consumers. While the neo-classical
economists believed that the utility can be measured and expressed in cardinal numbers,
but the modern economists maintain that the utility being the psychological phenomena
cannot be measured theoretically, quantitatively and even cardinally.

The modern economist, Hicks, in particular, have applied the ordinal utility concept to study
the consumer behavior. He introduced a tool of analysis called “Indifference Curve” to
analyze the consumer behavior. An indifference curve refers to the locus of points each
showing different combinations of two substitutes which yield the same level of satisfaction
and utility to the consumer.

Assumptions

Rationality: It is assumed that the consumer is rational who aims at maximizing his level of
satisfaction for given income and prices of goods and services, which he wish to consume.
He is expected to take decisions consistent with this objective.

Ordinal Utility: The indifference curve assumes that the utility can only be expressed
ordinally. This means the consumer can only tell his order of preference for the given goods
and services.
Transitivity and Consistency of Choice: The consumer’s choice is expected to be either
transitive or consistent.
Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution refers
to the rate at which the consumer is ready to substitute one commodity (A) for another
commodity (B) in such a way that his total satisfaction remains unchanged. The MRS is
denoted as DB/DA. The ordinal approach assumes that DB/DA goes on diminishing if the
consumer continues to substitute A for B.

Cardinal Utility

Cardinal utility is the utility wherein the satisfaction derived by the consumers from the
consumption of good or service can be measured numerically. In Marshall’s theory, the
concept of utility is cardinal the price that a consumer is willing to pay for a good is an
indication of the utility of that good to the consumer.

Assumptions
Rationality: The consumer is rational. He aims at the maximization of his utility subject to
the constraint imposed by his given income.

Cardinal Utility: The utility of each commodity is measurable. Utility is a cardinal concept.
The is prepared to pay for another unit of the most convenient measure is money: the utility
is measured by the monetary units that the consumer commodity.

Constant Marginal Utility of Money: This assumption is necessary if the monetary unit is
used as the measure of utility. The essential feature of a standard unit of measurement is
that it be constant. If the marginal utility of money changes as income increases (or
decreases) the measuring-rod for utility becomes like an elastic ruler, inappropriate for
measurement.

Diminishing Marginal Utility: The utility gained from successive units of a commodity
diminishes. In other words, the marginal utility of a commodity diminishes as the consumer
acquires larger quantities of it. This is the axiom of diminishing marginal utility.

Cardinal utility approach have two laws.

These two laws are:

Law of Diminishing Marginal Utility

Law of Equi-Marginal Utility.

It is with the help of these two laws about consumer’s behaviour that the exponents of
cardinal utility analysis have derived the law of demand. We explain below these two laws in
detail and how law of demand is derived from them.

Law of Diminishing Marginal Utility

An important tenet of cardinal utility analysis relates to the behaviour of marginal utility.
This familiar behaviour of marginal utility has been stated in the Law of Diminishing
Marginal Utility according to which marginal utility of a good diminishes as an individual
consumes more units of a good. In other words, as a consumer takes more units of a good,
the extra utility or satisfaction that he derives from an extra unit of the good goes on falling.

It should be carefully noted that it is the marginal utility and not the total utility that
declines with the increase in the consumption of a good. The law of diminishing marginal
utility means that the total utility increases at a decreasing rate.

Example of this could be

As consumption of tea increases total utility increases whereas the marginal utility
diminishes which has been illustrated in the graph.

Another important relationship between total utility and marginal utility is worth noting. At
any quantity of a commodity consumed the total utility is the sum of the marginal utilities.
For example, if marginal utility of the first, second, and third units of the commodity
consumed are 15, 12, and 8 units, the total utility obtained from these three units of
consumption of the commodity must equals 35 units (15 + 12 + 8 = 35).

At the quantity Q1 marginal utility (i.e. dU/ dQ = MU1) is found out by drawing tangent at
point A and measuring its slope which is then plotted against quantity in the lower panel

At quantity Q2 marginal utility of the commodity has been obtained.

Q3 is the quantity at MU3 in the indifference curve.  

Q4 is known as satiation quantity or satiety point. Beyond Q4 marginal utility of the

commodity for the consumer becomes negative 

EQUI-MARGINAL UTILITY
The law of equi-marginal utility states that the consumer will distribute his money income
between the goods in such a way that the utility derived from the last rupee spent on each
good is equal. In other words, consumer is in equilibrium position when marginal utility of
money expenditure on each good is the same.
MUm = MUx / Px
Where MUm is marginal utility of money expenditure and MU m is the marginal utility of X
and Px is the price of X.