UNIT

02 Theory of Consumer Choice

Names of Sub-Units

Concept of Utility – Total Utility and Marginal Utility, Law of Diminishing Marginal Utility, Cardinal
approach, Ordinal Approach, Revealed Preferential approach, Indifference Curve – Meaning and
Properties, Budget Line, Consumer Equilibrium, Income and Substitution effect of price change, MRS

Overview
This unit discusses the cardinal and ordinal approaches to the measurement of utility. It discusses
important tools and concepts such as the law of diminishing marginal utility, indifference curve
analysis, consumer’s equilibrium and decomposition of price effect.

Learning Objectives
In this unit, you will learn to:
 Understand the cardinal approach to the measurement of utility
 Discuss the ordinal approach to the measurement of utility
 Explain important laws such as the law of diminishing marginal utility and consumer’s equilibrium
 Analyse indifference curves and decompose the effect of a price change into income effect and
substitution effect.
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Learning Outcomes

At the end of this unit, you would:

 Assess the cardinal approach to measuring utility
 Analyse the ordinal approach to measuring utility
 Apply the law of diminishing marginal utility and its related concepts to the real world
 Evaluate the importance of ordinal approach and study indifference curves and their application
to the study of consumer behaviour.

2.1 INTRODUCTION
In this unit we learn about the measurement of utility. The utility is the want the satisfying quality of a
commodity. Why is utility important? Remember we learnt in the first unit that economics is a science of
scarcity where every consumer or producer is trying to maximize either satisfaction or profits with the
given resources. To maximize satisfaction, we need to understand the utility of different goods to us as
a consumer. Only when utility is maximized, can we say that the scarce resources have been optimally
used, which is the ultimate goal of economics. While the cardinal approach propounded by the classical
economists contends that utility can be measured, the ordinal approach contests the argument and
says that a consumer can only rank his preferences but cannot measure it in units. We analyze both
these approaches in this unit.

2.2 CONCEPT OF UTILITY – TOTAL UTILITY AND MARGINAL UTILITY

The utility is defined as the want the satisfying quality of a commodity. We learnt in the earlier unit
that human beings have unlimited wants. It is for their want satisfying quality that commodities are
demanded. They command a price for this power. Total utility refers to the total satisfaction derived
from consuming a given commodity in a reference time period. The total utility increases at the initial
stages of consumption becomes constant after the consumption of certain units and decreases with
additional consumption beyond a certain point.
Marginal utility refers to the addition made to total utility by consuming one more unit of the commodity.
Marginal utility starts diminishing as the consumer starts consuming more and more units of a product.
When marginal utility reaches zero, the total utility reaches its maximum. The total utility starts
diminishing when marginal utility is negative. The concept of utility is useful in explaining consumer
choice and behavior. However, the concept of utility is purely subjective. It differs from person to person,
place to place and from time to time. Utility cannot be measured but can only be compared on a relative
basis. This helps sellers in understanding how consumers make choices.

2.3 LAW OF DIMINISHING MARGINAL UTILITY

The Law of Diminishing Marginal Utility (LDMU) states that other things remaining constant, as a
consumer increases the consumption, of a commodity, the additional utility derived from consuming
an additional unit of the good continuously diminishes. Let us understand the law with the help of an
example.
Sandeep is crazy about laddus, a sphere-shaped Indian sweet mainly made from gram flour, fat and
sugar. On his birthday, his mother offered a plateful of laddus for him to enjoy. He had a field day,
swallowing one laddu after the other. He imagined that every successive laddu gave him more and more

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utility. However, he observed that after eating the 4th laddu, when he achieved maximum satisfaction,
say 10 utils, eating the 5th laddu gave him only 9 utils. Consuming, 6th laddu gave him only 7 utils and so
on. In this case, the utility after consuming the 4th laddu was 10 utils, whereas, after consuming the 5th
laddu, utility was 9 utils. Hence, the marginal utility is minus 1 utils. Similarly, after consuming the 6th
laddu, utility was 7 utils. Hence, the marginal utility is 2 utils. His love for laddu can be explained with
the help of the following diagram. Total utility reaches its maximum at the point T, and after that as
Sandeep increases the consumption of laddus, the total utility curve starts sloping downwards, showing
a negative impact on consumption. The Marginal Utility curve continually declines downward denoting
that consuming more and more units of the good results in lower and lower satisfaction.

Table 1: Law of Diminishing Marginal Utility

Total and Marginal Utility

Quantity of a Product Consumed Total Utility Marginal Utility
0 0 –
1 5 5
2 8 3
3 10 2
4 10 0
5 9 –1
6 7 –2

Total Utility Marginal Utility

12
10
8
6
TU & MU

4
2
0
0 1 2 3 4 6
–2 5

–4
Quantity Consume

Figure 1: Law of Diminishing Marginal Utility

The LDMU, as stated by Alfred Marshall, is: “The additional benefit which a person derives from a
given increase of his stock diminishes with every increase in the stock that he already has.” The law of
diminishing marginal utility states that as more of the product is consumed, the satisfaction derived
from each additional unit is less than earlier unit, which means the marginal utility decreases with the
consumption of each additional unit of the product.
Assumptions of LDMU
 Cardinal measurement: Utility can be measured and a consumer can express his satisfaction in
quantitative numbers.

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 Monetary measurement: Utility is measurable in monetary terms.

 Consumption of reasonable quantity: Only reasonable quantities of the commodity of uniform size
and quantity is consumed. For example, if initially, we gave Sandeep big laddus and later small
laddus, his satisfaction will not diminish and we cannot demonstrate the operation of the law.
 Continuous consumption: There is no time gap in the consumption of the good, or the law will not
operate.
 No change in Quality: Quality of the commodity consumed is assumed to be uniform. For instance,
Sandeep has to be given the same type of laddus throughout. If he is given some other variety of
laddu the law cannot operate.
 Rational consumer: The consumer is assumed to be rational and aims at maximising total
satisfaction.
 Independent marginal utilities: MU of one commodity has no relation with MU of another
commodity. Further, it is also assumed that one person’s utility is not affected by the utility of any
other person.
 MU of money remains constant: As MU of a commodity has to be measured in monetary terms, it is
assumed that MU of money remains constant.
 Fixed Income and prices: It is assumed that income of the consumer and prices of the goods
consumed remain constant.

Importance of LDMU
 Explains the factors which determine the value of a product.
 Provides the basis for the law of demand and explains the downward slope of the demand curve.
 Explains consumer surplus and how it is derived.
 The law is also useful in framing taxation policies and other fiscal measures.
 LDMU also helps in explaining the value of a good to the consumer

2.3.1 Cardinal Approach

The Utility can be measured through two approaches. They are the cardinal approach and the ordinal
approach. The cardinal approach was proposed by Alfred Marshall. In this approach, it is assumed
that utility can be measured in terms of units called ‘utils’, which are measurable and quantifiable. The
approach also assumes that the utility is derived from a particular product is not dependent on the
utility derived from other products. The approach conveys the price a consumer is willing to pay for a
given unit of product. The laws of diminishing marginal utility and equimarginal utility were derived
based on this approach.

2.3.2 Ordinal Approach

The ordinal approach to utility was proposed by J.R. Hicks. The approach assumes that utility cannot be
measured but can only be ranked in order of preferences. The approach states that since utility can be
ranked in order of preference, a consumer can compare different degrees of satisfaction. This approach
assumes that the consumer is consistent in ranking, and that the preferences of the consumer are based
on the choice of products available. This led to the indifference curve analysis.

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2.3.3 Revealed Preferential Approach

Revealed preference theory tries to explain an individual’s consumption patterns by observing their
purchasing behavior. It assumes rational consumers. That is, having duly considered a set of alternatives
and evaluating all available alternatives, consumers make a purchasing decision that is best suited for
them. Thus, the theory hypothesizes that if a consumer chooses one option out of the set, this option
must be the preferred option. However, the preferred option could change depending upon price and
budgetary constraints. By examining the preferred preference at each point of constraint, a schedule
can be created under a varied schedule of pricing and budget constraints. The theory states that given
a consumer’s budget, the consumer will select the same bundle of goods (the “preferred” bundle) as long
as that bundle remains affordable. If the preferential bundle becomes unaffordable that they will switch
to a less expensive or less desirable bundle of goods.

2.4 INDIFFERENCE CURVE – MEANING AND PROPERTIES

An indifference curve is a curve that denotes various combinations of two goods between which the
customer is indifferent at a given level of income. Since the consumer is indifferent towards the various
combinations of the products on an indifferent curve, all the combinations on the IC give the same level
of utility.
Properties
 Higher indifference curves represent higher levels of satisfaction.

 Indifference curves are negatively sloped.

 Indifference curves are convex to the origin.
 Indifference curves can never intersect each other.
Good Y

Y
X

IC 3
IC 2
IC 1
Good X

Figure 2: Indifference Curves

2.5 BUDGET LINE

The budget line shows the various combinations of two commodities which a consumer can purchase
with his given budget and the commodity prices. For instance, the following table shows the various
combinations of Good X and Good Y which can be purchased when the consumer has Rs. 50 budget and

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both cost Rs 5 per unit. The consumer can spend the entire Rs. 50 for purchasing 10 units of X or Y or
combinations thereof.

Table 2: Budget Line

Good X Good Y
0 10
1 9
2 8
3 7
4 6
5 5
4 6
3 7
2 8
1 9
0 10

5
A
4
Good Y

0
1 2 3 4 5 60
B
Good X

Figure 3: Budget Line

2.6 CONSUMER EQUILIBRIUM

A consumer is said to be in equilibrium at the point of tangency between the budget line and indifference
curve. At that point, the slope of the budget line is equal to the slope of the indifference curve. That is, the
available budget can be spent on a desirable combination of goods. Thus, a consumer can attain a state
of equilibrium when he maximizes his satisfaction with the given budget. Consumer satisfaction can be
measured by the ranking provided for the consumption of goods and services.

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In the diagram below, point E on IC1 is within the consumer’s budget. However, since a rational
consumer will try to maximize utility, he will not stop his consumption there. Point G on IC3 is beyond
the consumer’s budget, even though it’s on a higher IC curve and so the consumer cannot attain it. The
optimal bundle of goods that he can consume is at point F on IC2 where he can maximize consumption
and utility with the given budget. At point F, the IC curve is tangential to the budget line and so denotes
an equilibrium point.
The MRTS (Marginal Rate of Technical Substitution) shows how much of Good Y has to be given up in
order to increase the consumption of Good X. In the diagram it is denoted as ∆Y/∆X. This shows for every
one percentage change in Good Y, how much percentage of consumption in Good X is being gained.
Thus, indifference analysis helps in maximising utility with given scarce resources.
Good Y

F IC 3

IC 2
E
IC 1

0 Good X

Figure 4: Consumer’s Equilibrium

2.7 INCOME AND SUBSTITUTION EFFECT OF PRICE CHANGE

When the price of a commodity falls the consumer experiences an increase in real income and so is able
to move to a new equilibrium position at a higher indifference curve by buying more bundle of goods.
The price effect is decomposed into substitution effect and income effect in the following diagram.
When the price of good X falls, the budget line shifts outward to PL2, since the real income of the
consumer rises, i.e., he can buy more of both the goods with the same money income. The new budget
line PL2 he is in equilibrium at point R on a higher indifference curve IC2 capturing the impact of lower
prices resulting in higher real incomes. If there is however a reduction in income, budget line shifts to AB

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which has been drawn parallel to PL2 so that it is tangential to the original indifference curve IC1. Since
the price line AB has the same slope as PL2, it represents the changed in relative prices with X becoming
relatively cheaper than before.
Therefore, the consumer substitutes more X for Y. Thus, when the consumer’s money income is reduced,
the consumer moves along the same indifference curve IC, and substitutes X for Y with price line AB, he
is in equilibrium at S, on indifference curve IC1, and is buying MK more of X in place of Y.
This movement from Q to S on the same indifference curve IC, represents the substitution effect since it
occurs due to the change in relative prices alone, since real income remains constant. If the amount of
money income is restored, he would move from S, on indifference curve IC1, to R on a higher indifference
curve IC2.The movement form Q to R is due to price effect which can be decomposed as two parts: one
from Q to S as a result of substitution effect and two from S to R as a result of income effect.
Price effect = MN
Substitution effect = MK
Income effect = KN
MN = MK + KN
Good Y

A
ICC
Q R PCC

S IC2
Income
effect IC1

O M K N L1 B L2 Good X
Substitution
effect

Figure 5: Price Effect, Income Effect and Substitution Effect

2.8 MRS
Neeta Menon is a native of Kerala, a land which is famous for both bananas and coconuts. Neeta likes
both these items very much and consumes both intermittently.
Following is the indifference curve schedule for Neeta, were to achieve the same level of satisfaction,
if she decreases the consumption of one item, she has to increase the consumption of the other. The
marginal rate of substitution is the rate at which a consumer is willing to substitute one product for

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another while maintaining the same level of satisfaction. The ratio of the marginal utilities of the two
products and the rate at which a consumer is willing to trade one product for another can be derived by
measuring the marginal rate of substitution between keeping the total utility constant. We calculate the
Marginal Rate of Substitution (MRS) in Neeta’s case.

Table 3: Marginal Rate of Technical Substitution

Utility Quantity of Coconuts Consumed Quantity of Bananas Consumed MRS (∆Y/ ∆X)
30 50 10 -
30 40 15 10/5=2
30 35 20 5/5=1
30 28 30 7/10=0.7
30 19 45 9/15= 0.6

Conclusion 2.9 CONCLUSION

 Total utility refers to the total satisfaction derived from consuming a given commodity in a reference
time period. Marginal utility refers to the addition made to total utility by consuming one more unit
of the commodity. The marginal utility starts diminishing as the consumer starts consuming more
and more units of a product.
 The Law of Diminishing Marginal Utility (LDMU) states that other things remaining constant, as a
consumer increases the consumption of a commodity, the additional utility derived from consuming
an additional unit of the good continuously diminishes
 The utility can be measured through two approaches. They are the cardinal approach and the
ordinal approach. The cardinal approach was proposed by Alfred Marshall. In this approach, it is
assumed that utility can be measured in terms of units called ‘utils’, which are measurable and
quantifiable.
 The ordinal approach to utility was proposed by J.R. Hicks. The approach assumes that utility cannot
be measured but can only be ranked in order of preferences. The approach states that since utility
can be ranked in order of preference, a consumer can compare different degrees of satisfaction.
 Revealed preference theory tries to explain an individual’s consumption patterns, by observing
their purchasing behavior. It assumes rational consumers. That is, having duly considered a set of
alternatives and evaluating all available alternatives, consumers make a purchasing decision that
is best suited for them. Thus, the theory hypothesizes that if a consumer chooses one option out of
the set, this option must be the preferred option.
 An indifference curve is a curve that denotes various combinations of two goods between which
the customer is indifferent at a given level of income. Since the consumer is indifferent towards the
various combinations of the products on an indifferent curve, all the combinations on the IC give
the same level of utility.
 A consumer is said to be in equilibrium at the point of tangency between the budget line and
indifference curve. At that point, the slope of the budget line is equal to the slope of the indifference
curve. That is the available budget can be spent on a desirable combination of goods. Thus, a
consumer can attain a state of equilibrium when he maximizes his satisfaction with the given

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budget. Consumer satisfaction can be measured by the ranking provided for the consumption of
goods and services.
 When the price of a commodity falls, the consumer experiences an increase in real income and so is
able to move to a new equilibrium position at a higher indifference curve by buying more bundles of
goods. The price effect is decomposed into substitution effect and income effect.
 The marginal rate of substitution is the rate at which a consumer is willing to substitute one product
for another while maintaining the same level of satisfaction.

2.10 GLOSSARY

 Consumer: Economic agent who makes decisions on which bundle of goods to consume based on
preferences and budget. Consumption is defined as destruction of utility.
 Producer: Economic agent who makes decisions on which bundle of goods to produce based on
profits and costs. Production is defined as the creation of utility.
 Maximization Criterion: All human beings, are considered to be rational. As rational beings they
want to maximize their benefits. In case of consumers, they want to maximise satisfaction, whereas
in case of producers, they want to maximize profits.

2.11 CASE STUDY: RELATIONSHIP BETWEEN UTILITY AND DEMAND BEHAVIOUR

Case Objective
This caselet introduces the concept of consumer choice and utility.
Vani likes to collect sarees and watch plays in theatre. In economic terms, she derives ‘utility’ from
collecting sarees and watching plays. Utility is described as the satisfaction or happiness that an
individual gets from consuming a good or service.
Suppose Vani measures her own utility with a unit called utils. The following table shows how many utils
she gets by consuming sarees and plays:

Table: Total Utility

Sarees Total Utility Plays Total Utility

1 22 1 16
2 43 2 31
3 63 3 45
4 81 4 58
5 97 5 70
6 111 6 81
7 123 7 91
8 133 8 100

The first column in the above table shows the quantity of sarees bought, while the second column shows
the total satisfaction she derives from that quantity of sarees. This total amount of satisfaction is called

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total utility. As you can see, consuming additional units of sarees increases her total utility, but at a
decreasing rate. The other columns indicate the utility that she would get from watching different units
of plays.
Now, Vani has only $56 to spend. The price of sarees is $14 while that of plays is $7. She has to decide how
to spend her income on these two goods so that she gets maximum satisfaction. What will be this best
combination, which gives her the highest utility possible? This will depend on her income, price of goods
and preferences.

Questions
1. If Vani watches 2 plays, her TU is 31 utils. Calculate the utility if she watches one more play.
(Hint: 45 utils)
2. What is total utility?
(Hint: Total amount of satisfaction)

2.12 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. Illustrate the law of diminishing marginal utility with suitable examples. Why does marginal utility
decrease with the consumption of additional units of good? Explain its assumptions and importance.
2. Define indifference curves? What are their properties?
3. What is consumer’s equilibrium? How is it attained? Explain with the help of a diagram.

2.13 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. The Law of Diminishing Marginal Utility (LDMU) states that other things remaining constant, as a
consumer increases the consumption, of a commodity, the additional utility derived from consuming
an additional unit of the good continuously diminishes. Refer to Section the Law of Diminishing
Marginal Utility
2. An indifference curve is a curve that denotes various combinations of two goods between which
the customer is indifferent at a given level of income. Since the consumer is indifferent towards the
various combinations of the products on an indifferent curve, all the combinations on the IC give the
same level of utility. Refer to Section Indifference Curve - Meaning and Properties
3. A consumer is said to be in equilibrium at the point of tangency between the budget line and
indifference curve. At that point, the slope of the budget line is equal to the slope of the indifference
curve. That is, the available budget can be spent on a desirable combination of goods. Thus, a
consumer can attain a state of equilibrium when he maximises his satisfaction with the given
budget. Refer to Section Consumer Equilibrium

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@ 2.14 POST-UNIT READING MATERIAL

 https://corporatefinanceinstitute.com/resources/knowledge/economics/law-of-diminishing-
marginal-utility/
 https://www.masterclass.com/articles/economics-101-what-is-diminishing-marginal-utility
 https://www.economicsonline.co.uk/Competitive_markets/Introduction-to-indifference-curves.
html#:~:text=Indifference%20curve%20analysis%20suggests%20that,consumer%27s%20
preferences%20between%20two%20goods.
 https://www.economics.utoronto.ca/jfloyd/modules/idfc.html

2.15 TOPICS FOR DISCUSSION FORUMS

 Organize a group discussion and compare the merits and demerits of the cardinal and ordinal
approaches to measurement of utility.

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