THEORY OF CONSUMER BEHAVIOUR

Demand analysis studies the behaviour of individual consumers. Adam smith in his famous book
“Wealth of Nations” 1776 used the concepts of value in use and value in exchange. He pointed out that value
in exchange is actual price which a consumer pays for a commodity and value in use is the actual satisfaction a
consumer derived from its consumption. The theory of consumer further developed by the contribution of Prof.
Williom Stanley, Walrus and Carl Manger who are known as utilitarian. The full credit goes to Professor
Alfred Marshall who contributed to the theory of consumer behaviour the latest developments which were
included in his book principles of Economics in 1890. Prot. Marshall and his contemporary economists are
known as neo-classical economists.
It is concerned with the individual’s demand curve for a commodity—how it is derived and the reason for
its location and shape.
There are classical as well as modern approach to study the consumer demand theory:
• Classical Utility Approach
Cardinal Approach-Marginal utility Theory
 Modern Approach
Indifference Curve Analysis-Ordinal Approach/Empirical Approach to DD.
Difference between Cardinal and Ordinal

Cardinal Utility Analysis/Marginal Utility Theory /Neo-classical Utility Theory

 In economics, utility is a measure of the happiness or satisfaction gained from a good or
service. This concept is also used in utility functions, social welfare functions, Pareto
maximization, Edgeworth boxes and contract curves. The doctrine of utilitarianism saw the
maximisation of utility as a moral criterion for the organisation of society. According to
utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society
should aim to maximise the total utility of individuals, aiming for 'the greatest happiness for
the greatest number'.

Utility theory assumes that humankind is rational. That is, people maximize their utility
wherever possible. For instance, one would request more of a good if it is available and if one
has the ability to acquire that amount, if this is the rational thing to do in the circumstances.

Definition-Utility
The property of a commodity that satisfies a want or need of a consumer. In simple sense, it
refers to the want satisfying power of a commodity. Commodity will possess utility only if it
satisfies a want. Utility differs from person to person, place to place, and time to time.
Assumptions
• Rationality: A consumer is always rational i.e. he always prefers more of goods and services to
derive maximum utility.
• Finite money income: The consumers have limited money income which they spend on the
purchase of all the goods and services for their living. Thus they allocate this income as their
consumption expenditure on all goods and services.
• Cardinal utility: The utility derived from the consumption of each good is measureable in
terms of utils which is in turn equal to the money a consumer is willing to pay for it. i.e. 1 util=
utility of 1 unit of money.
• Constant marginal utility of money : The utility of each unit of money spent on buying the
good remains the same i.e. one (Essential feature of a standard unit of measurement is that it
be constant).
• Introspection – drawing reference about a person from one’s own experience
• Additive utility: According to this, the utility derived from the consumption of all goods and
services is additive in nature. Therefore, the utility function of a basket ‘n’, comprising of
various goods and services, is represented as follows:
U = f(x1, x2, x3, ….. , xn)
Here, x1, x2, x3, ….. , xn are the quantity of different goods and services consumed by the
consumer with his limited money income. Now based on this, the total utility function of n
items is additive and can be written as:
TU = U1(x1)+ U2(x2) + U3(x3) + ……. + Un(x4).
 Axiom of diminishing marginal utility: utility derived from the consumption of each
successive unit of the good diminishes. As we consume more of a good the utility derived
from each successive unit of it decreases. This is also known as ‘Gossen’s first law’.

Characteristics:
(i) The marginal utility diminishes which every increase in stock,
(ii) The total utility is maximum when the marginal utility is zero,
(iii) Each particular want is stable,
(iv) Goods are imperfect substitutes and consumed in appropriate portions.
Total Utility -Marginal Utility
TU= (U1+U2+U3+….Un)
MU = (TU n-TU(n-1)

Marginal Utility is the utility derived from the last unit of a commodity purchased. It can also be defined as the
addition to the total utility when one more unit of the commodity is consumed.
Total Utility is the sum of the utilities of all the units consumed.

As long as the TU curve faces up

(from O to B), the TU is increasing at
an increasing rate and the MU is
rising. At point B, the TU curve
changes direction (from facing up to
facing down). At this point, the slope
of the TU curve (the MU) is
maximum. (In mathematics, B is
called an inflection point.) Past point
B, the TU curve faces down. That is,
TU is increasing at a decreasing rate
and MU is falling. At point D, the TU
is maximum so the slope of the TU
curve, or the MU, is zero. Past point
D, the TU curve begins to fall so that
the MU is negative
Law of Equi-Marginal Utility:
It is also known as ‘law of substitution’, ‘law of maximum satisfaction’, ‘the proportionate
rule’, and ‘Gossen’s second law’.
The consumer compares the satisfaction which he obtains from the purchased commodity
and the price he pays. If the utility of commodity is greater or at least equal to the loss of utility
of money price, the consumer buys that commodity. As he buys more and more of that
commodity, the utility of successive units begins to diminish. He stops further purchases at a
point where the marginal utility of the commodity and the money he paid is just equal. Beyond
this point the marginal utility is negative. And this can be stated as the point of equilibrium,
where the consumer derives maximum satisfaction from a given commodity. If the consumer
finds that a particular expenditure in one use is yielding less utility than that of other, he will try
to transfer a part of his purchase from the previous commodity to the new one yielding higher
utility. With two commodities, the consumer is in equilibrium at a point where the marginal
utility of each commodity is in proportion to the price, and the ratio of the prices of all goods is
equal to the ratio of their marginal utilities. It can be mathematically expressed as follows:

or

Units of Marginal Marginal

Money Utility of Utility of
(Rs.) Tea Cigar
1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
Total Utility 30 39
.
Consumer Equilibrium (The Utility-Maximizing Rule)
The objective of a rational consumer is to maximize the total utility or satisfaction derived from
spending personal income. This objective is reached and the consumer is said to be in
equilibrium when able to spend personal income in such a way that the utility or satisfaction of
the last dollar spent on the various commodities is the same.
Fig 3: Derivation of demand curve from marginal utility curve
However, when we stretch the equilibrium points derived at left panel to the right then we can see
from the right panel that as the price is decreasing the quantity of the commodity consumed is
increasing, which is depicting the law of demand. Hence joining all the equilibrium points, we get
the demand curve at the right panel, which is downward sloping i.e. showing a negative
relationship between the price and the quantity of the commodity.
Critique of the cardinal Approach
There are three basic weakness in this approach:
Firstly: The assumption of cardinal utility is extremely doubtful. The satisfaction derived from
various commodities cannot be measured objectively. The attempt by Walras to use subjective
units (utils) for the measurement of utility does not provide satisfactory solution.
Secondly: the assumption of constant utility of money was also unrealistic. As income
increases the marginal utility of money changes. Thus money cannot be used as a measuring
since its own utility changes.
Finally, the axiom of diminishing marginal utility has been established from which must be
taken for grant.
Why is water, which is essential to life, so cheap while diamonds,
which are not essential to life, so expensive?
Since water is essential to life, the TU received from water exceeds the TU received from
diamonds. However, the price we are willing to pay for each unit of a commodity depends
not on the TU but on the MU. That is, since we consume so much water, the MU of the last