STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr.

Pradipta Bhattacharya

UNIT III: A NOTE ON CONSUMER BEHAVIOR

Consumer consumes (demands) a commodity because by consuming the commodity, his/her need
is fulfilled and the consumer derives satisfaction. Focus of this Unit will be to analyze (i) How the
consumer chooses from available goods & services the optimal bundle of commodities to obtain
highest level of satisfaction; (ii) How the optimal choice changes with changes in income of
consumer, changes in the prices of commodities. And finally, (iii) derivation of demand function of
the consumer.

Approaches:

 Introspective approach
1. Cardinal utility approach
2. Ordinal utility approach
 Behaviourstic approach
1. Revealed preference approach

However, for the present course we would focus rudimentarily on Introspective approach and
that too only on Ordinal Utility approach steering clear of technical specifications.

Let us denote X as a vector of commodities consisting of say n commodities, X = {x1, x2, ……..xn}
which is called a consumption combination or a commodity bundle or a consumption basket.

Unit of consumer is household, household chooses to buy a particular commodity in exchange of

some amount money (or, in exchange of another commodity in a barter exchange system) only
because it somehow generates some satisfaction to them; in fact any rational individual always
aims at maximization of satisfaction derived from the entire consumption basket, given the money
income and prices of the commodities. This is known as Axiom of Utility Maximization (Utility
means satisfaction).

Definitions

a) Utility Function (U) – Utility derived by a consumer is a function of the units of various
commodities consumed, i.e., U = U (x1, x2,…,xn) is called Utility Function of the consumer
consuming xi( i = 1 to n) units of the i-th commodity. This also denotes the Total Utility (TU)
derived from entire consumption bundle by a particular consumer.
b) Average Utility (AU) – Utility derived per unit of consumption of any commodity, i.e., for
an Utility Function U = U (x), AU (x) = U(x) / x ; where x is the number of units consumed of
any good X.
c) Marginal Utility (MU) – MU for a particular unit of any good consumed is the change in
Total Utility due to additional consumption of that very unit. Thus, Marginal Utility of the
n-th unit of any good consumed is expressed as MUn = TUn – TUn-1, Or, in calculus notation,
we may write, MUi = ∂U(x1, x2,…xi, …,xn)/∂xi

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

d) Law of Diminishing Marginal Utility (Law of DMU) – Marginal utility derived from each
additional units of any good consumed goes on diminishing, as consumption increases
successively unit after unit. This can be expressed as ∂2U/∂xi2< 0, where ∂2U/∂xi2 is the
change in marginal utility derived from an extra unit consumption of the concerned
commodity.

(Technical Note: This requires that the Utility function U = U (x1, x2,…, xn) should be a continuous
function of xi and it is at least twice derivable to get Marginal utility U’= ∂U/∂xi > 0 and change in
marginal Utility U” = ∂2U/∂xi2< 0 )

Basic Assumptions:

1. Consumer is Rational, i.e., always aims at maximization of satisfaction (s)he derives from
the consumption of goods, given his/her limited money income and prices of the goods
2. Consumer is supposed to have Full Knowledge, i.e., perfect information regarding all issues
related with consumption without any uncertainty.

Cardinal Utility approach and Ordinal Utility approach of consumer behavior primarily differ in the
ways they attempt to measure Utility derived from some units of any commodity consumed.
Cardinal approach attempted to measure utility derived from units consumed of goods with the
help of objective units. Thus Cardinal Ranking of various goods available to a consumer was
explicitly based on quantities/amounts indicated by specific cardinal numbers of measurement. On
contrary, the Ordinal approach uses only ordinal numbers free from any objective unit for the same
task. In Ordinal ranking therefore, quantities indicated by the numbers used are not important
(thus, it is unimportant to know which number is how much less or more than the other), only
important is their relative positions in number system. More explicitly, e.g., in ascending order of
arrangement the vectors each consisting three ordinal numbers {20980, 2098, 100}, {10500, 234,
12} or {5, 2, 1} indicate same Ordinal Ranking, where the first number is the largest among three
(Rank 1, say), the third one is lowest (Rank 3) and the second one lies in between (Rank 2) the
largest and the lowest numbers.

Ordinal Utility based Indifference curve Analysis: An Axiomatic Approach

Let the Utility Function for a consumer is U = U (x, y) where x and y are respectively the units of
good X and Y consumed, and utility 'U', is neither observable nor measurable cardinally. In this
approach we need not require to measure objectively the utility derived from consumption of a
commodity bundle. Rather, it is only required that, a rational consumer is able to compare and thus
rank different commodity bundles available, in some order of preference.
We will make several assumptions (technically speaking, these are actually to be read as Axioms,
and that is why the approach is called Axiomatic approach) about these preferences:

1. Individuals are rational in the choices they make

2. Individuals are able to make choices and rank their preferences for different commodity
bundles available
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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

3. More is preferred to less (more is better) – the bundle containing more of at least one good
is preferred over the other bundle
4. Additional units consumed provide less additional satisfaction relative to previous units
consumed (the more you have of a particular good, the less satisfaction you receive with
additional consumption of that same good).
The first assumption states that given several commodity bundles 'a', 'b', and 'c', a consumer can
define his preferences for these commodity bundles and put these preferences in some type of
order. For example 'b' may be at least as good as (preferred to) 'a', and 'a' may be at least as good
as (preferred) to 'c'. We summarize this assumption by saying that preferences are complete.
The second assumption states that if 'b' is at least as good as (preferred to) 'a' and 'a' is at least as
good as (preferred to) 'c' then it must be true that 'b' is at least as good as 'c'. This is known as the
transitivity condition.
The third assumption is straight-forward in that greater quantities provide greater levels of
satisfaction to the individual. This is known as non-satiation.
The last assumption states that consumers prefer bundles (or combinations) of goods and services
that contain some variety of those goods rather than extreme bundles that contain large amounts
of just one particular good. This is the law of diminishing marginal utility.
If we consider two goods: books and movies, as shown in the diagram of figure 1 below. Both goods
are desired by a given consumer (known as economic Goods rather than economic Bad). Points a,
b, c, d, e each represents distinct commodity bundles with different combinations of these two
goods.
From assumptions 1 and 2 we find that the consumer will decide on one of the following:
 b > c, a preference for the bundle with more movies (‘>’ denotes ‘preferred over’), thus bundle
b is preferred over bundle c
 c > b, a preference for the bundle with more books
 b = c, indifference between a bundle that contains more movies and fewer books and the
bundle with more books and fewer movies.
In the case where preferences for the two bundles are defined, (e.g., bundle b is preferred over
bundle a, written as b > a) it must be the case that one bundle will provide more satisfaction (utility)
relative to the other bundle. When indifference is the case, it must be true that the two bundles
provide equal levels of satisfaction, and hence the consumer is said to be indifferent among choice
between the two bundles (written with ‘=’ sign between the two bundles).

From our third assumption we can state that: d > b > a and d > c > a

Finally the fourth assumption allows for comparison between the bundle a and any other bundle
where utility loss from less of one commodity may exactly be compensated by utility gain in the
amount of other commodity. If such bundles are found (say, bundle f and g) we may conclude that
bundles a, f and g lies on the same Indifference curve (like IC0 in Figure 2), on which all bundles give
same level of satisfaction as a, to any particular consumer, i.e., on IC0 , a = f = g in terms of utility
they provide.

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Figure 1 Figure 2

Using these notions with respect to preferences, we can define a mapping that includes additional
bundles of books and movies. This mapping is shown with the addition of the curves in the diagram
on the right of figure 1. These curves, known as indifference curves represent combinations of the
two goods that provide equal levels of satisfaction to a particular consumer. All points on IC1
represent bundles of books and movies that provide the same level of satisfaction as bundle b (8
movies, 1 book) or bundle c (2 movies, 3 books). All bundles on IC2 provide more satisfaction than
bundles included on IC1 which provide more satisfaction than bundles on IC0.

Properties of Indifference Curves

An indifference curve shows combination of commodity bundles for which a person is indifferent
about choice between the bundles. The main attributes or properties or characteristics of
indifference curves are as follows:

(1) Indifference Curves are Negatively Sloped:

The indifference curves must slope down from left to right. This means that an indifference
curve is negatively sloped. It slopes downward because as the consumer increases the
consumption of X commodity, he has to give up certain units of Y commodity in order to
maintain the same level of satisfaction.
On a particular Indifference Curve (like IC0) we may find
∆X. MUX = – ∆Y. MUY
i.e., – ∆Y / ∆X = MUX / MUY = MRSX for Y
MRSX for Y is Marginal Rate of Substitution of Good X for Y, which gives the rate of
substitution between two goods in such a way that total utility is unchanged and in effect,
it gives the value of slope of the indifference curve at a particular point on it.

(2) Higher Indifference Curve Represents Higher Level:

A higher indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction and combination on a lower indifference curve
yields a lower satisfaction.
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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

(3) Indifference Curve are Convex to the Origin:

This is an important property of indifference curves. They are convex to the origin (bowed
inward). This is equivalent to saying that as the consumer substitutes commodity X for
commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference
curve.
(4) Indifference Curve cannot Intersect Each Other:
Given the definition of indifference curve and the assumptions behind it, the indifference
curves cannot intersect each other. It is because at the point of intersection, a particular
commodity bundle is supposed to yield two different levels of utility to a particular
consumer. This is absurd and impossible.

Budget Line

Now let us introduce the concept of budget line. It is the locus of all possible combinations of
commodities (i.e., commodity bundles) that can be purchased by spending the entire amount of
the consumer’s money income given prices of commodities. Let us for sake of simplicity consider
two commodities X and Y, their prices be PX and Py and income of individual be M0. Thus the
equation of budget line is M0 = PX. X + Py. Y. Diagrammatically it can be shown as below:-

Units of Good Y

0 B Units of Good X

AB is the budget line where point A denotes an extreme combination OA of Y ( i.e. M0/ Py) with no
X and point B implies another extreme combination OB of X (i.e. M0 / PX ) of X with no Y. Other
points on the line AB imply all other combinations of X & Y that can be purchased spending the
entire amount of the given income at given prices. The slope of this budget line is – (PX / Py ), i.e.,
negative of the price ratio.

Effects of Change in Money Income on Budget Line: If there is a ceteris paribus change in Money
Income there will be no change in the slope of budget line, only the intercept terms will change
implying budget line will shift parallel, in either direction depending upon increase or decrease in
income. Budget Line will shift parallel rightwards (for rise in money income) or leftwards (for fall in
money income), slope being unchanged since prices have not changed.

Effects of Change in Prices on Budget Line: Due to a fall in price of X (Px), the segment OB will be
larger, i.e., Budget line will be flatter than before. For any rise in PX, it will be steeper clearly.

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Consumer’s Equilibrium

Given the budget, the consumer now attempts to maximize his/her satisfaction by selecting a
particular commodity bundle from the available choices of commodity bundles. This implies
individual will choose a bundle (containing some units of X & some units of Y) on the budget line
that ensures attainment of highest possible indifference curve. This would occur at a point, say, E 0
where the budget line becomes tangent to convex indifference curve, as shown in the diagram
below –

Y0 E0

IC0

0 X0 B X
In the diagram above we have shown, how individual chooses the optimal commodity bundle. AB
is the budget line and this line has become tangent to IC0 indifference curve at point E0 implying
individual’s optimal choice consists of OX0 of X and OY0 of Y. The property of this point is slope of
indifference curve is equal to price ratio, MRSX.Y = PX / PY (ignoring the negative sign).

Income Consumption Curve (ICC) is the locus of all optimal point or optimal combination of
commodities with changing level of income when prices of commodities remain unchanged. With
unchanged prices, changing income can be shown by family of budget lines parallel to each other.
Now tangencies of different indifference curves with different budget lines forms a locus, known
as Income Consumption Curve (ICC). This is shown below.

Income Consumption Curve (ICC)

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

This ICC may be upward rising in the north-east when both the commodities are normal
(Normal/Superior commodity implies an increase in income leading to increase in its consumption).
ICC may be backward bending towards the Y axis if X is an inferior commodity beyond a certain
level of money income (remember, for inferior good consumption falls with rise in money income
of the consumer) and it may be bending towards the X axis if Y is an inferior commodity. It is to be
noted that in a two-commodity world both the commodities cannot be simultaneously inferior in
consumption since that will violate the condition of budget equation.

Engel Curve illustrates various amounts of a commodity that a consumer will be willing to purchase
at various levels of money income, other things remaining unchanged (ceteris paribus).

Units of Good X Engel Curve for Good X

Demanded (x)
x1

x2

0 M1 M2 Money Income (M)

The Engel Curve drawn above clearly shows that Good X is a Normal good (Superior Good).
Obviously for an Inferior good Engel curve would be negatively sloped, indicating inverse relation
between its quantity demanded and consumer’s money income. It is worth noting that, no good is
inferior at all levels of income. A good can be a luxury good at low income levels, a necessity at
middle income levels and an inferior good at very high levels of income (e.g., compact cars).

Price Consumption Curve (PCC) of a particular good is the locus of all optimal combination of
commodities when price of that particular commodity changes but consumer’s money income and
price of the other commodity are held unchanged. Let price of X alone changes and price of Y and
income of individual remain unchanged. Given this we would trace the optimal choice of individual
along the “Price Consumption Curve” of Good X. In diagram below we are depicting the PCC of X
for changes in price of good X (fall in price – Budget line rotates anti-clockwise from AB1 to AB3):-

A
Units of Good Y

PCC of X

0 B1 B2 B3 Units of Good X

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Price Effect, Substitution Effect & Income Effect

Basically PCC is the graphical exposition of the price effect.

Price Effect of a change in price on demand for a commodity is the change in quantity demanded
due to change in the price of the commodity, when prices of other commodities consumed
together and consumer’s money income remain unchanged.

1
2

0 x1 B1 x2 B2 X

Let the consumer’s Initial equilibrium is indicated by point 1, with given prices of X and Y and
consumer’s money income. Now as price of X falls and price of Y & consumer’s money income are
unchanged, budget line AB1 rotates out to AB2 to enable the consumer to reach a higher level of
satisfaction as indicated by equilibrium point 2 on a higher indifference curve. Price Effect is
therefore indicated by the movement from equilibrium point 1 to point 2 and corresponding
change (rise) in quantity demanded of X, i.e., x1x2 in opposite direction of the change (fall) in price.
Thus the Price Effect, mathematically combines two changes, change in price and resulting change
in quantity demanded of a good. Price Effect for a normal good is obviously negative, because for
normal good price and demand are inversely related, the case of a normal good is depicted in the
figure above.

If money income of the consumer and price of the other good Y that is consumed together with X
are held unchanged, with fall (a change for example; reverse will be the case for rise in price) in
price of X, the consumer feels better off. The consumer feels better off in two ways –

1. Good X has become relatively cheaper compared to Y, because relative price of X has fallen.
Thus the consumer can substitute good Y with more of good X to maintain the same level
of satisfaction, i.e., to stay on the same indifference curve. This is called Substitution Effect,
which is a component of Price Effect. Substitution Effect is always negative, because
relatively costlier good is substituted by the cheaper good when the consumer maintains
same level of utility.
2. With fall in price of X, the real purchasing power on the consumer in terms of X has gone
up, even with unchanged money income. Thus the consumer can switch on to higher level
of satisfaction, i.e., can move to higher indifference curve, consuming higher amount of X
(if X is normal/superior good) or lower amount of X (if X is an inferior good). This is known

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

as Income Effect of a price change and it is the other component of Price Effect. Income
effect can be +ve or –ve, depending upon the nature of the good.

In the figure below, we have shown the Substitution Effect and Income Effect as the components
of Price Effect resulting from a change (fall) in price of good X, and good X is taken as a normal good
obeying Marshallian Law of Demand. The method we illustrate here is known as Hicksian (income
compensation) Method after the name of its proposer J R Hicks.

A
IC1

C IC2

3 2

0 x1 x3 B1 x2 D B2 X

In the above figure, AB1 represents the initial budget line and point 1 represents initial equilibrium
of the consumer on the indifference curve IC1. As price of X falls ceteris paribus, AB1 rotates out to
AB2 and the consumer moves to a higher indifference curve IC2. Thus x1x2 represents the total Price
Effect of the given change in price of X. Now if the consumer is faced with the new lower (relative)
price of X with unchanged real income (note that, consumer’s real income in terms of X has
increased with fall in price of X), the consumer must be restricted to stay on the initial level of
utility, i.e., on the same indifference curve IC1. Hence, with lower (relative) price of X and
unchanged real income, the consumer will seek to choose a new optimum consumption
combination indicated by point 3. So, x1x3 is the Substitution Effect. Now, the remainder of the
total effect, i.e., x3x2 is exclusively due to rise in consumer’s real income (purchasing power)
resulting from a fall in (relative) price of X and thus this is the Income Effect. It should be noted
that, the position of point 2 in the figure is to the right of point 3 indicating a rise in consumption
of X (from x3 to x2) as consumer’s real income rises. This is because we have taken good X as a
normal (Superior) good. For an inferior good, point 2 may lie to the left of point 3 indicating a fall
in consumption of the good with rise in income of the consumer. For a Giffen good, point 2 may lie
even further left, to the left of point 1, indicating a fall in quantity demanded (i.e., consumption)
with fall in price.

Hicksian method of decomposition of Price Effect in Substitution Effect and Income Effect is
theoretically quite an attractive exercise, but practically non-operational in the sense that point 3
cannot be observed in practice.
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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Derivation of Demand Curve

Y
IC1 IC2

1
2

0 x1 B1 x2 B2 X
Px
P1

P2 Demand Curve of Good X

0 x1 x2 X

The tangency of AB1 and IC1 i.e., Point 1 is the initial equilibrium point of the consumer when price
of X (Px) is say, p1 and demand for X is x1. Now price of X falls to p2 and obeying Marshallian law of
demand (X is a normal good), consumption of X rises to x2 at the new equilibrium point indicated
by point 2. We plot these information of price and corresponding quantity demanded of X in the
lower panel to derive the Demand Curve of X. It is usual –vely sloped, indicating inverse relation of
price and quantity demanded.

Taxes & Subsidies

In this course we don’t have much scope to analyze the cases of taxes and subsidy in any details,
we would just touch upon a few rudimentary issues for both. First and foremost point about tax is,
it is a kind of mandatory payment to govt., without the right of demanding anything in return.
Sounds funny, isn’t it ?

Incidence of Tax & Tax Burden

Incidence of tax means on whom (target group) a particular tax in levied. And, burden of tax means
who actually bears the tax. By these two simple ideas, we must now understand that, incidence &
burden of tax may or may not be on the same group of people. For a particular tax, it may be the
case that incidence of tax is on a set of people but actually the tax is paid by (i.e., the tax-burden is
borne by) another set of people. Based on this property taxes are classified in two groups – (a)

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Direct Tax, for which incidence and burden is on same person(s), e.g., Income tax; and (b) Indirect
Tax, for which the tax burden can be shifted on to different person(s), e.g., excise duty, sales tax
etc.

Imposition of Direct Tax would mean a sum is snatched away from the consumer’s money income
and that can be shown by a downward parallel shift of the budget line (Fig 1). If for an Indirect Tax,
the tax is tied on a particular commodity, price of that commodity would almost certainly go up
because the seller has the opportunity to shift the tax burden (entire, or a part) on to the buyers
of the commodity (Fig 2). The Budget line will rotate inward indicating rise in price (in Fig 2, we
have shown tax is tied on good X). Consumer’s equilibrium decisions would be affected accordingly.
It would be interesting to note that, consumers are often better off and hence prefer imposition of
an income tax over a selective (on specific commodity) indirect tax.

Y Y
A Fig 1 A Fig 2

0 D B X 0 D B

Case of Subsidies

Subsidies can either be in cash or in kind. Providing Cash subsidy is just the reverse case of
imposition of income tax, and in this case the budget line shifts rightward, shift is parallel since by
cash subsidy the price ratio (slope of budget line) is not affected (Fig 3). But in the case of provision
of subsidy in kind tied to any of the goods (say X), the shift in budget line in shown in Fig 4.

Y Fig 3 Y Fig 4
C

A A C

0 B D X 0 B D X
In Fig 3, CD is the Budget line with cash subsidy and in Fig 4, ACD is the budget line with in-kind
subsidy of AC amount of X. From the standpoint of economic wellbeing, consumer may prefer cash
subsidy over in-kind subsidy tied to a particular good, because with a cash subsidy the consumer
may have the scope of moving to even higher level of utility than with an in-kind subsidy.

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