MODULE II: CONSUMER BEHAVIOUR

Consumption: Consumption is best described as the final purchase of goods and

services by individuals. By consumption we mean, the satisfaction of our wants by
the use of commodities and services.

Composition
Consumption may be divided according to the durability of the purchased objects.
In this way, a broad classification includes:
• durable goods: Durable goods are the tangible goods purchased by consumers
that tend to last for more than a year. Common examples are cars, furniture,
and appliances.
• non-durable goods: Nondurable goods are the tangible goods purchased by
consumers that tend to last for less than a year. Common examples are food,
clothing, and gasoline.
• Services: Services are activities that provide direct satisfaction of wants and
needs without the production of tangible goods. Common examples are
information, entertainment, and education.

The Concept of Utility: Utility of a commodity is its want-satisfying capacity.

Utility, in economics, refers to the usefulness or enjoyment a consumer can get from
a service or good. Utility is subjective. Different individuals can get different levels
of utility from the same commodity. Utility that one individual gets from the
commodity can change with change in place and time. Various schools of thought
differ as to how to model economic utility and measure the usefulness of a good or
service.

Cardinal Utility and Ordinal Utility: Cardinal utility analysis assumes that level
of utility can be expressed in numbers. Cardinal utility analysis suffers from a major
drawback in the form of quantification of utility in numbers i.e., the idea that
individuals could order or rank the usefulness of various discrete units of economic
goods.

Measures of Utility:

Total Utility: Total utility of a fixed quantity of a commodity (TU) is the total
satisfaction derived from consuming the given amount of some commodity x. More
of commodity x provides more satisfaction to the consumer. TU depends on the
quantity of the commodity consumed
Marginal Utility: Marginal utility (MU) is the change in total utility due to
consumption of one additional unit of a commodity.

The Law of Diminishing Marginal utility:

Law of Diminishing Marginal Utility states that marginal utility from consuming
each additional unit of a commodity declines as its consumption increases, while
keeping consumption of other commodities constant.

MU becomes zero at a level when TU remains constant. Thereafter, TU starts falling

and MU becomes negative.

Consumer's Surplus:
Consumer surplus is an economic
measurement of consumer
benefits. Consumer surplus, also
known as buyer’s surplus, is the
economic measure of a customer’s
excess benefit. It's a measure of the
additional benefit that consumers
receive because they're paying less
for something than what they were
willing to pay. It is calculated by
analyzing the difference between
the consumer’s willingness to pay
for a product and the actual price
they pay.
Demand and Supply and their Determinants:
The quantity of a commodity that a consumer is willing to buy and is able to afford,
given prices of goods and consumer’s tastes and preferences is called demand for
the commodity. Demand is desire backed by ability to afford and willingness to pay.

Determinants:
(1) Tastes and Preferences of the Consumers
(2) Incomes of the People
(3) Changes in the Prices of the Related Goods
(4) The Number of Consumers in the Market
(5) Consumers’ Expectations with regard to Future Prices

Law of demand: Law of Demand states that other things being equal, there is a
negative relation between demand for a commodity and its price. In other words,
when price of the commodity increases, demand for it falls and when price of the
commodity decreases, demand for it rises, other factors remaining the same.

Changes in demand: A change in demand refers to a shift in the entire demand

curve, which is caused by a variety of factors (preferences, income, prices of
substitutes and complements, expectations, population, etc.). In this case, the entire
demand curve moves left or right. A change in quantity demanded refers to a
movement along the demand curve, which is caused only by a chance in price. In
this case, the demand curve doesn’t move; rather, we move along the existing
demand curve.
Elasticity of Demand: Elasticity of demand refers to the degree in the change in
demand when there is a change in another economic factor, such as price or income.
If demand for a good or service remains unchanged even when the price changes,
demand is said to be inelastic.
Examples of elastic goods include luxury items and certain food and beverages.
Inelastic goods, meanwhile, consist of items such as tobacco and prescription drugs.

Price elasticity of Demand: Price elasticity of demand is a measurement of the

change in consumption of a product in relation to a change in its price.
Price Elasticity of Demand
= % Change in Quantity Demanded /
% Change in Price
eD = percentage change in demand for the good
percentage change in the price of the good

NOTE:Degrees of Elasticity (given in class notes)

Income elasticity of Demand: Income elasticity of demand is an economic measure

of how responsive the quantity demand for a good or service is to a change in
income.
The formula for calculating income elasticity of demand is the percent change in
quantity demanded divided by the percent change in income.

Cross elasticity of Demand: The cross elasticity of demand is an economic concept

that measures the responsiveness in the quantity demanded of one good when the
price for another good changes. The cross elasticity of demand for substitute goods
is always positive because the demand for one good increase when the price for the
substitute good increases. Alternatively, the cross elasticity of demand for
complementary goods is negative.
Exy=Percentage Change in Price of Y/Percentage Change in Quantity of X

Law of supply:
Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price
paid by buyers for a good rise, then suppliers increase the supply of that good in the
market.

Elasticity of Supply:
The law of supply indicates the direction of change—if price goes up, supply will
increase. But how much supply will rise in response to an increase in price cannot
be known from the law of supply. To quantify such change, we require the concept
of elasticity of supply that measures the extent of quantities supplied in response to
a change in price.
Elasticity of supply measures the degree of responsiveness of quantity supplied to a
change in own price of the commodity. It is also defined as the percentage change
in quantity supplied divided by percentage change in price
It can be calculated by using the following formula:
ES = % change in quantity supplied/% change in price
Symbolically,
ES = ∆QS/QS ÷ ∆P/P
= ∆QS/∆P × P/QS
Since price and quantity supplied, in usual cases, move in the same direction, the
coefficient of ES is positive.

Types of Elasticity of Supply

(a) Elastic Supply (ES>1):
Supply is said to be elastic when a given percentage change in price leads to a larger
change in quantity supplied. Under this situation, the numerical value of E s will be
greater than one but less than infinity. SS1 curve of Figure exhibits elastic supply.
Here quantity supplied changes by a larger magnitude than does price.

(b) Inelastic Supply (ES< 1):

Supply is said to be inelastic when a given
percentage change in price causes a smaller
change in quantity supplied. Here the numerical
value of elasticity of supply is greater than zero
but less than one. Fig. depicts inelastic supply
curve where quantity supplied changes by a
smaller percentage than does price.
(c) Unit Elasticity of Supply (ES = 1):
If price and quantity supplied change by the same magnitude, then we have unit
elasticity of supply. Any straight-line supply Curve passing through the origin,
such as the one shown in Fig, has an elasticity of supply equal to 1. This can be
verified in this way.

For any straight line positively-sloped supply curve drawn through the origin, the
ratio of P/Q at any point on the supply curve is equal to the ratio ∆ P/∆ Q. Note
that ∆ P/∆ Q is the slope of the supply curve while elasticity is (1/∆P/∆Q =
∆Q/∆P). Thus, in the formula (∆Q/∆P. P/Q), the two ratios cancel out each other.
(d) Perfectly Elastic Supply (ES = ∞):
The numerical value of elasticity of
supply, in exceptional cases, may reach up
to infinity. The supply curve PS1 drawn in
Fig. has an elasticity of supply equal to
infinity. Here the supply curve has been
drawn parallel to the horizontal axis. The
economic interpretation of this supply
curve is that an unlimited quantity will be
offered for sale at the price OS. If price
slightly drops down below OS, nothing
will be supplied.

(e) Perfectly Inelastic Supply (ES = 0):

Another extreme is the completely or perfectly inelastic supply or zero elasticity.
SS1 curve drawn in Fig. illustrates the case of zero elasticity. This curve describes
that whatever the price of the commodity, it may even be zero, quantity supplied
remains unchanged at OQ. This sort of supply curve is conceived when we consider
the supply curve of land from the viewpoint of a country, or the world as a whole.
Indifference Curves:
The indifference curve analysis measures utility ordinally. It explains consumer
behaviour in terms of his preferences or rankings for different combinations of two
goods, say X and Y. An indifferent curve is drawn from the indifference schedule of
the consumer. The latter shows the various combinations of the two commodities
such that the consumer is indifferent to those combinations.
It is the locus of points representing pairs of quantities between which the
individual is indifferent, so it is termed an indifference curve.” It is, in fact, an
iso-utility curve showing equal satisfaction at all its points. A single indifference
curve concerns only one level of satisfaction.
The indifference curve approach is based upon the following assumptions:
(1) Rationality
(2) Ordinal utility
(3) Non-Satiety
(4) Transitivity and consistency of choice
(5) Diminishing Marginal Substitutability

Properties of Indifference Curve:

Property I: Indifference curves slope downward to the right:
This property implies that an indifference curve has a negative slope.
This property follows from assumption (1). Indifference curve being downward
sloping means that when the amount of one good in the combination is increased,
the amount of the other good is reduced. This must be so if the level of satisfaction
is to remain the same on an indifference curve. If, for instance, the amount of good
X is increased in the combination, while the amount of good Y remains unchanged,
the new combination will be preferable to the original one and the two combinations
will not therefore lie on the same indifference curve provided more of a commodity
gives more satisfaction.
Property II: Indifference curves are convex to the origin:
Another important property of indifference curves is that they are usually convex to
the origin. In other words, the indifference curve is relatively flatter in its right-hand
portion and relatively steeper in its left-hand portion. This property of indifference
curves follows from assumption 3, which is that the marginal rate of substitution of
X for Y (MRSxy) diminishes as more and more of X is substituted for Y.
Only a convex indifference curve can mean a diminishing marginal rate of
substitution of X for K If indifference curve was concave to the origin it would imply
that the marginal rate of substitution of X for y increased as more and more of X was
substituted, for Y.
When the indifference curve is convex to the origin, MRS diminishes as more of X
is substituted for K. We therefore conclude that indifference curves are generally
convex to the origin. Our assumption regarding diminishing MRS xy and the
convexity of indifference curves is based upon the observation of actual behaviour
of the normal consumer. If indifference curves were concave or straight lines, the
consumer would succumb to monomania, that is, he would buy and consume only
one good. We know that consumers in actual world do not generally buy and
consume one good. It is for this reason that we reject indifference curves of concave
or straight-line shapes and assume that indifference curves are normally convex to
the origin.
The degree of convexity of an indifference curve depends on the rate of fall in the
marginal rate of substitution of X for Y. As stated above, when two goods are perfect
substitutes of each other, the indifference curve is a straight line on which marginal
rate of substitution remains constant. The better substitutes the two goods are for
each other, the closer the indifference curve approaches to the straight line so that
when the two goods are perfect substitutes the indifference curve is a straight line.
Property III: Indifference curves cannot intersect each other:
Third important property of indifference curves is that they cannot intersect each
other In other words only one indifference curve will pass through a point in the
indifference map 1 his property can be easily proved by first making the two
indifference curves cut each other and then showing the absurdity or self-
contradictory result it leads to.
In Fig., two indifference curves are shown cutting each other at point C. Now take
point on indifference curve IC2 and point B on indifference curve IC1 vertically
below A. Since an indifference curve represents those combinations of two
commodities which give equal satisfaction to the consumer the combinations
represented by points A and C will give equal satisfaction to the consumer because
both lie on the same indifference curve IC2.
Likewise, the combinations B and C will
give equal satisfaction to the consumer;
both being on the same indifference curve
IC1. If combination A is equal to
combination C in terms of satisfaction, and
combination B is equal to combination C, it
follows that the combination A will be
equivalent to B in terms of satisfaction. But
a glance at Fig. will show that this is absurd
conclusion since combination A contains
more of good Y than combination B, while
the amount of good X is the same in both
the combinations.
Thus, the consumer will definitely prefer A to B, that is, A will give more satisfaction
to the consumer than B. But the two indifference curves cutting each other lead us
to an absurd conclusion of A being equal to Bin terms of satisfaction. We therefore
conclude that indifference curves cannot cut each other.
Another point which is worth mentioning in this regard is that indifference curves
cannot even meet or touch each other or be tangent to each other at a point. The
meeting of two indifference curves at a point will also lead us to an absurd
conclusion. The same argument holds good in this case as developed above in the
case of intersection of indifference curves.
Property IV: A higher indifference curve represents a higher level of satisfaction
than a lower indifference curve:
The last property of indifference curve is that a higher indifference curve will
represent a higher level of satisfaction than a lower indifference curve. In other
words, the combinations which lie on a higher indifference curve will be preferred
to the combinations which lie on a lower indifference curve. Consider indifference
curves IC1 and IC2 in Fig., IC2 is a higher indifference curve than IC1. Combination
Q has been taken on a higher indifference curve IC2 and combination S on a lower
indifference curve IC1.
Combination Q on the higher indifference
curve IC2 will give a consumer more
satisfaction than combination S on the lower
indifference curves IC1 because the
combination Q contains more of both goods X
and Y than the combination S. Hence the
consumer must prefer Q to S. And by
transitivity assumption, he will prefer any
other combination such as combination R on
IC2 (all of which are indifferent with Q) to any
combination on IC1 (all of which are
indifferent with S) We, therefore, conclude
that a higher indifference curve represents a higher level of satisfaction and
combinations on it will be preferred to the combinations on a lower indifference
curve.
REVEALED PREFERENCE THEORY
One of the most significant contributions to consumer behaviour was made by Paul
A Samuelson in his ‘Revealed Preference Theory’. Samuelson showed, in his
Revealed Preference Theory, that the consumer’s demand curve may be derived
straightway from the consumer’s budgetary constraint and his preferences revealed
in the market, without involving the problem of cardinal and ordinal measurement
of utility.