Theory of consumer behavior

By: Tamar Yohannes 11C

Definition
Consumer theory is the study of how people decide to spend their money based
on their individual preferences and budget constraints. A branch of
microeconomics, consumer theory shows how individuals make choices, subject
to how much income they have available to spend and the prices of goods and
services. Study of consumer buying behavior is most important for marketers as
they can understand the expectation of the consumers. It helps to understand
what makes a consumer to buy a product.

The concept of utility

Utility is a term in economics that 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 directly influences the demand, and therefore
price, of that good or service.

According to classical economists, utility can be measured in the same way as

weight or height is measured. for this, economists assume that utility can be
measured in cardinal (numerical) terms. by using cardinal measure of utility, it is
possible to numerically estimate utility which a person derives from consumption
of goods and services.

Economists derived an imaginary measure known as ‘utils’. Utils are imaginary

and psychological units which are used to measure satisfaction (utility) obtained
from conception of a certain quantity or commodity.

Suppose you have just eaten and ice cream has chocolate. You agree to assign
20 utils as utility derived from the ice cream. Now the question is how many utils
are assigned to the chocolate? If you like the chocolate less than you may assign
utiles less than 20. However, if you liked it more, you would give it a number
greater than 20. Suppose you assign 10 utils to the chocolate, then it can be
concluded that you like the ice cream twice as much as you like the chocolate.
Utils cannot be taken as a standard unit for measurement as it will vary from
Individual to individual. hence, many economist Including Marshall , suggested
the measure of utility in monetary terms. It means, utility can be measured in
terms of money or price, Which the consumer is willing to pay.

it must be noted that it is impossible to measure satisfaction of the person as it is

inherent to the individual and the first greatly from person to person still, the
concept of utility is very useful in explaining and understanding the behavior of
consumer.

Total Utility (TU)

Total utility refers to the total satisfaction obtained from the conception of all
possible units of locomotive. It measures the total satisfaction of team from
conception of all the units of that good. For example, if the first ice cream gives
you satisfaction of 20 utils and second one gives you 60 utils, then TU from 2
ice creams is 20 + 16=36 utils. if the third Ice Cream generates satisfaction of 10
utils, then TU from 3 ice creams will be 20+16+10=46 utils.

TU can be calculated as:

TUn = U1 + U2 + U3 +……………………. + Un

Where:

TUn = Total utility from n units of a given commodity

U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit

n = Number of units consumed

Marginal Utility (MU):

Marginal utility is the additional utility derived from the consumption of one more
unit of the given commodity. It is the utility derived from the last unit of a
commodity purchased. As per given example, when 3 rd ice-cream is consumed,
TU increases from 36 utils to 46 utils. The additional 10 utils from the 3rd
ice-cream is the MU.
In the words of Chapman, “Marginal utility is addition made to total utility by
consuming one more unit of a commodity”.

MU can be calculated as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit; TUn = Total utility from
n units;

TUn-1 = Total utility from n – 1 units; n = Number of units of

consumption

MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils One

More way to Calculate MU

MU is the change in TU when one more unit is consumed. However,

when change in units consumed is more than one, then MU can also
be calculated as:

ATU

MU = Change in Total Utility/ Change in number of units = ∆TU/∆Q

Total utility can also be calculated as the sum of marginal utilities

from all units, i.e.

TUn= MU1 + MU2 + MU3 +……………………… + MUn or simply,

TU = ∑MU

The concepts of TU and MU can be better understood from the

following schedule and diagram:
Table TU and MU

Ice-creams Marginal Utility Total Utility (TU)

Consumed (MU)

1 20 20

2 16 36

3 10 46

4 4 50

5 0 50

6 -6 44
 In Fig. 2.1, units of ice-cream, are shown
along the X-axis and TU and MU are
measured along the Y-axis. MU is positive
and TU is increasing till the 4th ice-cream.
After consuming the 5th ice-cream, MU is
zero and TU is maximum.

This point is known as the point of satiety

or the stage of maximum satisfaction. After
consuming the 6th ice-cream, MU is
negative (known as disutility) and total
utility starts diminishing. Disutility is the
opposite of utility. It refers to loss of
satisfaction due to consumption of too
much of a thing.

The cardinal utility theory

Assumptions :

1. Rationality

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

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

3. 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.

4. 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.

The law of diminishing marginal utility

The Law Of Diminishing Marginal Utility states that all else equal as consumption
increases the marginal utility derived from each additional unit declines. Marginal
utility is derived as the change in utility as an additional unit is consumed.

Equilibrium of the Consumer:

We begin with the simple model of a single commodity x. The consumer can
either buy x or retain his money income Y. Under these conditions the consumer
is in equili­brium when the marginal utility of x is equated to its market price (Px).
Symbolically we have

MUX = Px

If the marginal utility of x is greater than its price, the consumer can increase his
wel­fare by purchasing more units of x. Similarly if the marginal utility of x is less
than its price the consumer can increase his total satisfaction by cutting down the
quantity of x and keeping more of his income unspent. Therefore, he attains the
maximization of his utility when MUX = Px.

If there are more commodities, the condition for the equilibrium of the consumer
is the equality of the ratios of the marginal utilities of the individual commodities
to their prices.

The utility derived from spending an additional unit of money must be the same
for all commodities. If the consumer derives greater utility from any one
commodity, he can increase his welfare by spending more on that commodity
and less on the others, until the above equilibrium condition is fulfilled.
 The ordinal utility theory

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.

1. 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.

2. 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.

3. Transitivity and Consistency of Choice:

The consumer’s choice is expected to be either transitive or consistent. The

transitivity of choice means, if the consumer prefers commodity X to Y and Y
to Z, then he must prefer commodity X to Z. In other words, if X= Y, Y = Z,
then he must treat X=Z. The consistency of choice means that if a consumer
prefers commodity X to Y at one point of time, he will not prefer commodity Y
to X in another period or even will not consider them as equal.

4. Non Satiety:

It is assumed that the consumer has not reached the saturation point of any
commodity and hence, he prefers larger quantities of all commodities.
5. 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.

Consumers equilibrium
Definition :

The Ordinal Approach to Consumer Equilibrium asserts that the consumer is

said to have attained equilibrium when he maximizes his total utility
(satisfaction) for the given level of his income and the existing prices of goods
and services. The ordinal approach defines two conditions of consumer
equilibrium: Necessary or First Order Condition and

Indifference set

Indifference curve: The indifference curve shows the different combinations

of two substitutes (goods) that yield the same level of satisfaction (utility) to
the consumer. This means that the consumer is indifferent towards the
consumption of two goods which are closely related to each other.

Indifference map: The indifference map contains different indifference curves

showing the combinations of different quantities of two substitute goods on the
basis of the consumer preferences. The consumer can make different
combinations of goods by consuming less of one commodity or the other in
such a way that all the combinations yield the same level of satisfaction.
Marginal rate of substitution (MRS): The marginal rate of substitution
defines the rate at which one commodity is substituted for another in such a
way that the total utility (satisfaction) remains the same.

Budget line: As per the properties of the indifference curve, higher the
indifference curve on the indifference map, the higher is the utility derived from
the consumption. Thus, the consumer tries to reach the highest possible
indifference curve with two strong constraints: limited income and market price
of goods and services.Since the amount of income in hand decides how high
consumer can reach on his indifference map acts as a budgetary constraint.
Therefore, the budget line represents the different quantity combinations of
available commodities that a consumer can purchase given his level of
income and the market price of goods and services.