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Classical approach to analyse consumer behaviour

MEANING OF UTILITY: The word utility, means they want satisfying power of a commodity. Utility is the psychological feeling of satisfaction, pleasure, happiness or well being which a consumer derives from the consumption, possession or the use of a commodity. TOTAL UTILITY: It is the sum derived by a consumer from various units of goods and services he consumes. Suppose a consumer consumes four units of a commodity, X, at a time and derives utility as U1, U2, U3, and U4. His total utility (TUx) from commodity X can be measured as follows. Tux = U1 + U2 + U3 + U4 If n number of commodities he consumes then his total utility will beTUn = Ux + Uy + Uz Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure and happiness. Measurability of utility has, however, been a contentious issue. Early economists-classical economists, viz. Jeremy Bentham, Leon walrus, Carl Menger, etc. and neo-classical economist, notably Alfred Marshall- believed that utility is cardinally or quantitatively measurable like height, weight, length, and temperature and air pressure. This belief resulted in Cardinal concept. The modern economists, most notable J.R Hicks and R.G.D Allen, however, hold the view that the view that utility is not quantitatively measurably-it is not measurable in absolute terms. This approach is called ordinal approach. CARDINAL UTILITY: Cardinal utility is that utility which can be expressed in quantitative terms i.e., utility can be measured in quantitative terms. Analysis of cardinal utility is based on the law of diminishing marginal utility. ORDINAL UTILITY: Ordinal utility is that utility which cannot be expressed in quantitative terms i.e., it can be expressed in terms of preference scales. Analysis of ordinal utility is based on the law of diminishing marginal rate of substitution. TWO APPROACHES TO CONSUMER BEHAVIOUR Based on the cardinal and ordinal utility, there are two approaches to the analysis of consumer behaviour. 1). Cardinal Utility Approach 2). Ordinal utility Approach Analysis of consumer behaviour: Cardinal Utility Approach The classical and neo-classical economists assumed it to be objective or, in other words, they thought that the utility is imbibed in the commodity. This resulted in what we call the CARDINAL Managerial Economics University of Technologies, Mauritius Page 1 of 12

Classical approach to analyse consumer behaviour


UTILITY APPROACH, where utility is considered to be measurable in specific units in numerical terms. The law of diminishing utility is based on this approach.

The cardinal utility approach to consumer analysis makes the following assumptions:RATIONALITY - it is assumed that the consumer is a rational being in the sense that he satisfies his wants in the order of their preferences, that is, he or she buys the commodity first which yields the higher utility and that least which gives the least utility. LIMITED MONEY INCOME - The consumer has a limited money income to spend on the goods and services he or she chooses to consume. Limitedness of income, along with utility maximisation objective makes the choice between goods inevitable. MAXIMIZATION OF SATISFACTION -Every rational consumer intends to maximise his/her satisfaction from his/her given money income. UTILITY IS CARDINALLY MEASURABLE - The cardinalists have assumed that the commodities that the utility is cardinally measurable and that utility of one unit of a commodity equals the money which a consumer is prepared to pay for it or 1util = 1 unit of money. DIMINISHING IN MARGINAL UTILITY - Following the law of diminishing marginal utility, it is assumed that the utility gained from the successive units of a commodity consumed decreases as a consumer consumes larger quantity of the commodity. This is an axiom of the theory of consumer behaviour. CONSTANT MARGINAL UTILITY OF MONEY -The cardinal utility approach assumes that the marginal utility of money remains constant whatever the level of a consumer's income. This assumption is necessary to keep the scale of measuring rod of utility fixed. it is important to recall in this regard that cardinalists used 'money' as the measure of utility. UTILITY IS ADDITIVE - Cardinalists assumed not only that utility is cardinally measurable bit also that utility derived from various goods and services consumed by a consumer can be added together to obtain the total utility. in other words, the consumer has a utility function which may be expressed as: U= f(X1, X2, X3 ...Xn) Where X1, X2 ...X3 denote total quantities of the various goods consumed. Given the utility function, total utility obtained from n items can be expressed as: Un = U1(X1) +U2(X2) + U3(X3) + ......+ Un(Xn) It is the utility function which the consumer aims to maximise. HYPOTHESIS OF INDEPENDENT UTILITIES: It is assumed that the utility which a consumer obtains from a good does not depend upon the quantity consumed of other goods; it depends upon the quantity purchased of that good alone. INTROSPECTIVE METHOD: Introspection is the ability of observer to reconstruct events which go in the minds of another person with the help of self observation. That is by looking into ourselves we see inside the heads of other individuals.

To attain the maximum level of satisfaction, given his resources and other conditions, a consumer should have to reach his equilibrium position. This can be explained easily with the help of Law of Diminishing Marginal Utility and Law of Equi-Marginal Utility.

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Classical approach to analyse consumer behaviour


MARGINAL UTILITY: It is defined as the utility derived from the marginal unit consumed. It may also br defined as the addition to the utility resulting from the consumption (or accumulation) of one additional unit. Marginal utility (MU) thus refers to the change in the total utility obtained from the consumption of additional unit of a commodity. It may be expressed asMU = TU Q THE LAW OF DIMINISHING MARGINAL UTILITY The additional benefit, which a person derives from a given increase of a stock of a thing diminishing, other things being equal, with every increase in the stock that he already has. -Prof. Marshall The law of diminishing marginal utility is universal in character. It is based upon the important fact that human want are unlimited but a single want can be satisfied at a particular time. As a consumer consumes more and more units of a particular commodity, intensity of his want for a commodity goes on falling. With a fall in the intensity of want, marginal utility derived from every successive unit goes on declining and after a certain point it becomes zero. At this point, he will get maximum total utility and stops consumption. If he still continues his consumption, marginal utility will be negative and total utility will starts to fall. This behaviour of marginal utility is called the law of diminishing marginal utility. CONSUMERS EQUILIBRIUM Conceptually, a consumer is said to have reached his equilibrium position when he has maximised the level of his satisfaction, given his resources and other conditions. Technically, a utilitymaximising consumer reaches his equilibrium position when allocation of his expenditure is such that the last penny spent on each commodity yields the same utility. Consumer has limited income and that the utility which he derives from the various commodities may not be same. Some commodities yield higher marginal utility and some lower for the same units consumed. In some cases, MU decreases more rapidly than in other consuming the same number of units. A rational and utility maximising consumer consumes commodities in order of their utilities. He first picks up the commodity which yields the highest utility followed by the commodity yielding the second highest utility and so on. He switches his expenditure from one commodity to the other in accordance with their marginal utilities till he reaches a stage where MU of each commodity is same per unit of expenditure. This is the state of consumers equilibrium. LAW OF EQUI MARGINAL UTILITY The utility will be maximised, when the marginal unit of expenditure in each direction brings in the same increments of utility. -Prof. J.R. Hicks

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Classical approach to analyse consumer behaviour


Thus, the law of equi-marginal utility explains that wants of every consumer are unlimited, but the resources available with him to satisfy these wants are limited, that too having alternative uses. Therefore, he spends these resources in a manner that he may get maximum satisfaction. DERIVATION OF INDIVIDUAL DEMAND CURVE The isolated effect of price on individual demand is usually shown with the help of the individual demand curve. The individual demand curve is a curve drawn with the price of the commodity on one axis and the quantity demanded on the other axis. The curve is usually drawn as a downward sloping one, i.e., it slopes downward from left to right, in Fig. We have shown an individuals Price of tea per Kg

K
P1

L P2 M
P3

D O

Demand (Kgs.)

Q1 Q2 Q3 demand curve for tea. When the price of tea per kilograms is OP, the consumers demand for tea is OQ kilograms. When the price falls to OP2, demand rises to OQ2 and so on. Thus, when the price is OP1, the price quantity combination is shown by the point K. Similarly, when the price is OP2, it is shown by the point L. The curve that we get by joining the points like K, L, M, etc. is called individual demand curve. It is a curve that shows how an individuals demand changes when the price changes. DD is our individual demand curve for tea.

THE LAW OF DEMAND The law of demand states that price and quantity demanded of a commodity move in opposite directions. When the price of a commodity rises, the demand for it falls. When the price falls demand rises. As the law states, there is an inverse relationship between the price and the quantity demanded. This law holds under the condition that other things remain constant. Other things include determinants of demand, like, consumers income, price of the substitutes and complements, tastes and preferences of the consumer, etc. These factors remain constant only in short run. In the long run they tend to change. The law of demand is based on the law of diminishing marginal utility. It can be explained through a demand schedule and demand curve. DEMAND SCHEDULE Managerial Economics University of Technologies, Mauritius Page 4 of 12

Classical approach to analyse consumer behaviour


Demand schedule expresses different quantities of a commodity that can be sold in a market at its different prices. A demand schedule is an aggregate of individual demand schedules of all individual consumers of a commodity in a market. Following is the imaginary market demand schedule of a commodity:

DEMAND SCHEDULE FOR TEA No. of cups of tea Price per cup of demanded by a tea(Rs.) consumer per day 4 3 2 1 1 2 3 4 Points representing price-quantity combination A B C D

DEMAND CURVE The law of demand can also be presented through a demand curve. A demand curve is the locus of points showing various alternative price-quantity combinations. Demand shows the quantities of a commodity which a consumer would buy at different prices per unit of time, under the assumptions of the law of demand.

DEMAND CURVE

PRICES

X QUANTITY

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Classical approach to analyse consumer behaviour


EXCEPTIONS TO THE LAW OF DEMAND Sometimes, however, the law of demand may not work, i.e., price and demand may not move in opposite directions. We can know indicate some of such exceptions to the law of demand: (a). Conspicuous consumption : Some commodities are very costly, particularly for the common people. The person who consumes such goods wants to show it off to other people. This is called conspicuous consumption. In that case he price and demand may move in same direction. Diamond ornaments and expensive furniture are examples of such goods. (b). Bandwagon effect: The consumer may let his demand for a good be affected by the tastes and preferences of the social class to which he belongs. If playing golf is fashionable among successful businessmen, then as the price of a golf ball rises, a businessman may increase his demand for golf balls in order to show that he is a successful businessman. (c). Snob effect: The opposite also may happen. A consumer may try to show that he no longer belongs to a particular social class. This shows the Snobbish nature of a consumer. (d). Occupying insignificant portion of the consumers budget: If a commodity occupies an insignificant position in the total budget of the consumer, variations in its price may leave the demand of the commodity unaffected. In that case the demand curve will be vertical. For example, salt. (e). Speculation: Goods which are objects of speculation may defy the law of demand. When the price of such a good rises, people may increase the purchases of the good in the expectation that price would rise even further in the future. This happens in the share market. (f). Giffen effect: Sir Robert Giffen had observed that a typical poor class commodity may display an odd behaviour. When the prices of such a good rises the poor people may cut down on their purchases of other items and increases their purchase of this commodity. In this case, we get a positive correlation between price and quantity demanded. (g). Veblen effect: Sometimes, the consumers judge the quality of a product by the price. In that case, demand for the product may increase with an increase in its price. This is known as Veblen effect. In all such cases, the demand curve will be upward sloping showing a positive relationship between price and quantity demanded. By considering The Cardinal Approach, following problem arises:

1. If, suppose, the utility of x commodity is 15 units and of y is 10 units, then as per measurable approach, we should get a utility of 25 units when both commodities are taken together. However, if we see the reality, then total utility can be less than or greater than the summation of their individual utilities and this will depend upon the nature and properties of the two commodities. If the commodities are substitutes, like tea and coffee the total utility of their joint use will be less Managerial Economics University of Technologies, Mauritius Page 6 of 12

Classical approach to analyse consumer behaviour


than the summation of their individual utilities. If they have opposite attributes, then the total utilities can be zero or negative also. For example, if the utility of a cup of tea is 5 and of a cold drink are 10. Then the total utility of their joint use will be zero or even negative. If the two commodities are complementary, then the total utility from their joint use will be far greater than the summation of their individual utilities. 2. If the utility is considered to be objective, then, every person using a commodity should get the same utility. But in reality it is not so. Some people get a higher level of utility from a commodity but for other the utility may be quite low. 3. If the utility is objective and measurable, then it should not change according to time and place. However, in reality it is not so. Some goods provide a higher level of utility at a place, but by change of place or time the utility may increase or decrease. 4. Suppose, utility is considers as cardinal and numerically measurable, then the question arises that what will be the unit of measurement. The classical and neo-classical economists had assumed it to be some imaginary unit i.e. util, but this is also an imaginary unit and it has no realistic existence. Now, if money is considered to be a unit, the problem is that the marginal utility of money itself is not constant. Hence, it cannot be the right unit of measuring utility. Even otherwise, money is a unit of measuring price and not utility. CRITICAL EVALUATION OF MARSHALLS CARDINAL UTILITY ANALYSIS Utility analysis of demand has been criticised on various grounds. The following are the shortcomings and drawbacks of marginal utility analysis have been pointed out by other economists: (a). Cardinal measurability of utility is unrealistic: - It is assumed in this analysis that utility is cardinally measurable. But in actual practise utility cannot be measured in such quantitative terms. In real life consumer can state only whether a good or a combination of goods gives him more, or less, or equal satisfaction as compared to another. Thus, economists like J.R.Hicks are of the opinion that the assumption of cardinal measurement of utility is unrealistic and therefore should be given up. (b). Hypothesis of independent utilities is wrong: - It is assumed that the utility which a consumer obtains from a good does not depend upon the quantity consumed of other goods; it depends upon the quantity purchased of that good alone. But in actual life the utility or the satisfaction derived from a good depends upon the availability of some other goods which may be either substitute for or complementary with each other. For ex., the utility derive from a pen depends upon whether ink is available or not. (c). Assumption of constant marginal utility: - It assumed that marginal utility of money remains constant whatever the level of consumers income. But in actual practice this is not correct as consumer spends his money income on the goods; money income left with him declines. With the decline in the money income of the consumer as a result of increase in his expenditure on goods, the marginal utility of money to him rises.

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Classical approach to analyse consumer behaviour


(d). Marshallian demand theorem cannot genuinely be derived except in a one commodity case: Marshallian demand theorem and constant marginal utility of money are incompatible except in a one commodity case. As a result this theorem cannot be derived in the case when a consumer spends his money on more than one good. Consider a consumer who has a given amount of money income to spend on some goods with given prices. According to utility analysis, consumer will be in a equilibrium when he is spending in such a way that ratios of marginal utilities of various goods to their prices are equal. (e). Cardinal utility analysis does not split up the price effect into substitution and income effect: Another drawback of this analysis is that it does not distinguish between the income and substitution effect of the price change. We know a fall in the price of a good brings about an increase in the real income of the consumer. Besides when the price of a good falls, it becomes cheaper than other goods and as a result the consumer is induced to substitute that good for others. This is the substitution effect. Thus with the fall in the prices of a good, the quantity demanded of it rises because of income and substitution effect. But the marginal utility analysis does not make clear the distinction between the income and substitution effect of the price change by assuming the (f). Marshall could not explain Giffen Paradox :- By not visualising the price effect as a combination of substitution and income effects and ignoring the income effect of the price change, Marshall could not explain Giffen Paradox. According to the indifference curve analysis, in case of Giffen good negative income effect of the price change is more powerful than the substitution effect so that when he price of a Giffen good falls the negative income effect outweigh the substitution effect with the result that quantity demanded of it falls. (g). Cardinal utility analysis assumes too much and explains too little: - Cardinal utility analysis assumes, among others, that utility is cardinally measurable and also that marginal utility of money remains constant. Indifference curve analysis does not take these assumptions and even then it is not only able to deduce the entire theorem which cardinal utility analysis can but also deduces a more general theorem of demand. Because of the above reasons the cardinal utility approach of utility measurement was considered improper and defective and a new concept was, therefore, warranted. The new concept was called The Ordinal Utility Approach and J.R Hicks and R.C.D. Allen are credited for developing this approach. Analysis of Consumer Behaviour: ORDINAL UTILITY APPROACH Unlike Marshall, the modern economists- Hicks in particular- have used the ordinal utility concept to analyse consumer behaviour. This is called ordinal utility approach. Hicks have used a different tool of analysis called Indifference curve to analyse consumer behaviour. It has been evolved to supersede the marginal utility analysis of demand. The indifference curve analysis has however, retained some of the assumptions of old marginal utility analysis which are as follows: (a). Rationality : the consumer is assumed to be a rational being. Rationality means that a consumer aims at maximising his total satisfaction given his income and prices of the goods and services that he consumes and his decisions are consistent with this objective. Managerial Economics University of Technologies, Mauritius Page 8 of 12

Classical approach to analyse consumer behaviour


(b). Ordinal utility: It assumes that utility is only ordinally expressible. That is, the consumer is only able to tell the order of his preference for different basket of goods. (c). Transitivity and consistency of choice: Consumers choices are assumed to be transitive. Transitivity of choice means that if a consumer prefers A to B and B to C, he must prefer A to C. Or , if he treats A=B and B=C, he must treat A=C. Consistency of choice means that if he prefers A to B in one period, he will not prefer B to A in another period or even treat them as equal. (d). Nonsatiety: It is also assumed that the consumer is never over-supplied with goods in question. That is, he has not reached the point of saturation in case of any commodity. (e). Diminishing marginal rate of substitution: The marginal rate of substitution is the rate at which consumer is willing to substitute one commodity (X) for another (Y) s that his total satisfaction remains the same. This rate is given as DY/DX. The ordinal utility approach assumes that DY/DX goes on decreasing when a consumer continues to substitute X for Y. (f). Uniformity and divisibility of commodities: It is assumed that all the units of commodity are uniform and divisible.

MEANING OF AN INDIFFERENCE CURVE It is the focus of all such points representing pairs of quantities between which individual is indifferent, so it is termed as indifference curve. -Prof. J. K. Smith Concept of indifference curve is based upon the assumption that every consumer has a scale of preferences between two or more commodities. There are some combinations of these commodities which provide him equal satisfaction. He can choose any of these combinations. If he chooses one combination, he is indifferent to all other combinations. Such combinations can be presented on a curve also. Such a curve is called the indifference curve. The consumer is indifferent to these combinations of commodities. Thus, an indifference curve is a curve which represents various combinations of commodities which provides equal satisfaction to a consumer. Let us take an example:COMBINATION A B C D QUANTITY OF X 1 2 3 4 QUANTITY OF Y 20 15 11 8

In the above table we show five combination of two commodities X & Y. At combination A we have 1 unit of X and 20 units of Y commodity. At combination B, we have 2 units of X and 15 units of Y and Managerial Economics University of Technologies, Mauritius Page 9 of 12

Classical approach to analyse consumer behaviour


so on. All these combinations have been drawn in such manner that satisfaction derived from all these combinations is equal and the consumer is indifferent between them. We find that quantity of X is increasing while that of Y is decreasing. In other words, X is substituting Y but not at constant rate. In this way we can say that, as the quantity of X is increasing its MARGINAL RATE OF SUBSTITUTION (MRS) for Y is diminishing. MRSxy = X = Slope of Indifference Curve Y X = Change in quantity of X Y = Change in quantity of Y

INDIFFERENCE CURVE
Y

Commodity- Y

A B C D

E
O X Commodity-X

PROPERTIES OF INDIFFERENCE CURVES Properties of indifference curve reveal the consumers behaviour, his choices and preferences. They are as follows: (a). They are Convex to the Origin : Indifference curves are always convex to the origin. Left hand position of the indifference curve is normally steep and right hand position is normally flat. This is due to the diminishing marginal rate of substitution. (b). They Slopes downward to the Right: Indifference curves slopes downwards from left to right because every consumer wants to keep total satisfaction constant. He will have to give up one commodity and get it compensated for by the other. They cannot be horizontal straight lines, nor can they be upward rising lines.

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Classical approach to analyse consumer behaviour


(c). They do not intersect: Indifference curves can never meet or intersect each other. It is based on the assumption that a particular indifference curve represents a particular level of satisfaction to the consumer. (d). They are not necessary to be parallel to Each Other: Indifference curves may not be parallel to each other. If the rate of substitution between two commodities is equal, the curves will be parallel. If the rate of substitution is not equal, the curves will not be parallel. (e). Higher Indifference Curves Give Greater Satisfaction : In an Indifference curve map, Indifference curve on right hand gives greater satisfaction than the Indifference curves on left hand. INDIFFERENCE CURVE MAP There can be infinite indifference curves for a consumer corresponding to the possible levels of his satisfaction. All the curves can be presented on an indifference map.

Indifference map
Y

Commodity-Y

5 4 3 2 1 O Commodity-X X IC

Budget line or Price line It is the line which shows various combination of two goods which are available to the Consumer at a given income and price. The Price line or Budget line indicates that the consumer shall be somewhere on the given Price line. Price line or budget line indicates the equilibrium of consumer that he will choose which yield him maximum satisfaction. For example if the persons income is Rs. 20 and the price of X & Y are Rs. 4 & 5 respectively. In this situation he can purchase maximum 5 units of X and 4 units of Y or any combination between them. Y=Px.Qx +Py.Qy Or, 20= 4.Qx + 5.Qy Managerial Economics University of Technologies, Mauritius Page 11 of 12

Classical approach to analyse consumer behaviour


Through Indifference curve, we shall find these specific quantities of X & Y commodities. We draw price line on the basis of two points, which show maximum quantities of X & Y.

Price Line
Y

Commodity-Y

Commodity-X

CONSUMER EQUILIBRIUM A consumer is said to have reached his equilibrium position when he has maximized the level of his satisfaction, given his recourses and other condition. Three things are necessary for determining consumers equilibrium in ordinal approach. Consumers Income. Price of two commodities. Indifference map of consumer. CHARACTERSTIC OF CONSUMERS EQUILIBRIUM It is on the highest attainable IC. The price line is always tangent to the IC and it never intersects the IC. The slope of IC and the slope of price line is always equal. MRSxy is equal to the Price Ratio CONCLUSION It is important to know that in spite of tremendous development in consumption theory based on ordinal utility, the classical demand theory on cardinal has retained its appeal and applicability to the analysis of market behavior. Besides, the study of classical demand theory serves as a foundation for understanding the advanced theories of consumer behavior. The study of classical theory of demand is of particular importance and contributes a great deal in managerial decisions. Managerial Economics University of Technologies, Mauritius Page 12 of 12