CONSUMER THEORY

The explanation of how consumers allocate their resources (income) to the purchase of different goods
and services to maximize their well being (utility).

In consumer theory, our focus is on consumer preferences. Economists believe that individuals’
decisions, such as what goods and services to buy, can be analyzed as choices made within certain
budget constraints. Generally, consumers are trying to get the most for their limited budget. In
economic terms they are trying to maximize total utility, or satisfaction, given their budget constraint.

CARDINAL APPROACH (UTILITY APPROACH, CARDINAL UTILITY APPROACH)

Assumptions:

 Consumer is rational
 Utility is cardinal (utility can be measured)
 Consumer has limited budget income
 Constant utility of money
 Utility is additive (U= U1X1+U2X2+U3X3….. UnXn)

Law of Diminishing Marginal Utility:

According to the assumption the marginal utility derives from the successive use of a product goes on
diminishing (the utility gains from successive units of a product consumed decreased as a consumer
consumes more and more units of it). This is called the “Law of Diminishing Marginal Utility”.

Explanation: The law of diminishing marginal utility is based on observations from daily life. The more a
person consumes a commodity, the less is the commodity important for him because the desire to
consume the commodity may gradually be fulfilled. In simple words, “the marginal utility of a
commodity diminishes as a consumer consumes greater amounts of that commodity”. To understand
this, suppose that a person is considering purchasing small pack of Pepsi. The first pack gives him 10 utils
of utility. His desire to the extent of one pack of Pepsi has been fulfilled. Now he may like to drink the
second pack, but, naturally, the desire will be less than before. The second pack may give him only 8
utils. When two packs of Pepsi are consumed, the total satisfaction derived is 10+8=18. In other words,
when the person consumed the second (additional) unit of Pepsi, there was a change of 8 utils in total
utility (18-10=8). This is called marginal utility. Similarly, the satisfaction will continue to decrease and
when a point of saturation will come, then an additional unit (sixth)of Pepsi will not add to the level of
satisfaction (where there is no more desire) and there will be no change in total utility, i.e marginal
utility will be zero. If some friend of the person makes him drink the seventh pack of Pepsi by force, the
pleasure of consumer may decrease. Total utility may actually decrease; i.e marginal utility may be
negative.

Total Utility: Total utility is the total amount of satisfaction a person derives from consuming some
specific quantity.
 Marginal Utility: Marginal Utility is the extra satisfaction a consumer realizes from an additional unit of
that product.

Units of Pepsi Total Utility (TU) Utils
1 10
2 18
3 24
4 28
5 30
6 30
7 28
Marginal Utility (MU) Utils Level of Desire
10 Positive
8 Positive
6 Positive
4 Positive
2 Positive
0 No Desire (Saturated Point)
-2 Negative

Marginal Utility
Total Utility

TU

Quantity of Pepsi
Quantity of Pepsi MU

Law of Equi Marginal Utility:

A consumer is in equilibrium when he spends his money income on different goods in such a way that
the marginal utility of last unit of money spend on each group is equal.

Assumptions:

 Consumer is rational
 Limited income
 Both goods are substitutes (he wants to buy two products x and y)
 Marginal utility of each group is known to the consumer
 Utility can be measured

Explanation: A consumer faces a problem of choice. A rational consumer must allocate his resources
(income) between different commodities in such a way that the total satisfaction is maximized. So we
must assume that all the consumer will act to maximize their total utility. According to the law, “a
consumer maximizes total utility, given the budget constraint and prices, where utility per unit of money
spent on the last unit purchased of all commodities is equal. In simple words, “a consumer will be in
equilibrium (will maximize total utility) at a point of selection where the marginal utilities per unit of
price of all the commodities is equal”. Mathematically we can state that the consumer will be in
equilibrium where
Equilibrium condition: MUx/Px = MUy/Py

i.e. the ratio of marginal utilities to prices are equal for all the commodities. We need a example to clear
this concept.

Let us first take a simple two-commodity case (say ‘x’ and ‘y’) with the same price (let it be one rupee)
so that we can compare the marginal utilities. Given that the money he indents to spend on these
commodities is Rs.5 (budget constraint) and he doesn’t change his mind. The satisfaction achieved by
consuming different units (marginal utilities) for both ‘x’ and ‘y’ are given in this table.

Units MUx @rs.1 MUy @rs1

1 12 10
2 10 8
3 8 6
4 6 4
5 4 2
Total 40 30

A consumer can spend his money income in three ways:

1. He spends all of his money on product x and gets 40 utils

2. He spends all of his money on product y and gets 30 utils
3. He spends some money on good x and some money on good y

He spends Rs. 3 on product x and his MU is 8 and total MU is 30. And he spends Rs.2 on good y, his MU
is 8 and his total MU is 18. So, with Rs. 5 his total MU is 48 which is maximum. He cannot get equal to
this by spending his money income by any other way. The highest utility yielding combination, according
to the law of equi-marginal utility, will be the one for which the utilities of last unit (MUs) of both the
commodities are equal. The combination of three units of x and two units of y is the equilibrium
combinations.

MUx
MUy
ORDINAL APPROACH (Indifference Curve Approach):

The utility theory was criticized by many philosophers and economists because satisfaction was assumed
to be cardinal. Satisfaction was indicated by numerical values called ‘utils’. A better innovation in the
consumer theory was based on the concept of ordinal utility. This theory required that the satisfaction
attached to different commodities or combinations of commodities can only be ranked and not assigned
numerical values. J.R. Hicks used ‘indifference analysis’ to explain this concept.

“An indifference curve is a locus of points which yield the same level of satisfaction to the consumer and
consumer is indifferent to any particular point or combination”

In other words all points situated on indifference curve represent the same level of satisfactions

A
10
Y B
6 Y
C
3 Y IC

X
1 2 3

MAJOR ASSUMPTIONS:

 Consumer is rational
 Preferences are transitive (if A>B>C then A>C)
 Diminishing marginal rate of substitution (to attain one unit of product x we have to sacrifice
one unit of Y)
 Ordinal utility (consumer can rank their preferences)

Marginal Rate of Substitution:

Remaining on the same level of satisfaction, the amount of one good that an individual is willing to give
up to obtain one more unit of another good is called marginal rate of substitution (MRS). If commodity y
is given up to increase the consumption of x, then we call it marginal rate of substitution x for y (MRS xy)
and vice versa. It can also be defined as the slope of indifference curve.

Why does MRS diminish?

We assume that the MRS diminishes as the consumer increases the consumption of x on an IC. The
reason is simple. Start from combination A. the consumer has 1 of ‘x’ and 10 of ‘y’. She sacrifices 4 units
of ‘y’ to get a unit of ‘x’, which shows the value she gives to commodity ‘x’. Next time she will not
sacrifice 4 units to increase the consumption of x by one unit because now ‘x’ is not as important to her
as before (Now she has more ‘x’). The change in the relative importance of a commodity causes
marginal rate of substitution to diminish.

CONSUMER EQUILIBRIUM:

A consumer is said to be in equilibrium if he is getting maximum satisfaction from his limited resources,
he will get maximum satisfaction when his budget line touches the highest indifference curve.

E0
IC3
IC2
IC1

At point E0 the consumer is getting maximum satisfaction because IC2 is representing the highest level
of satisfaction.