Utility Analysis

Unit 3 – Utility Analysis
• Theory of Consumer Behavior

• Consumer Preferences
• Consumer Preferences: Some Basic Assumptions about Preferences
• Budget Constraint
• Consumer Choice
• Concepts of Utility
• How to Measure Utility?
• Cardinal Utility Approach and Ordinal Utility Approach
• Utility and Money
• Total Utility Vs. Marginal Utility
1
• The Law of Diminishing Marginal Utility
• Law of Equi-marginal Utility
• Indifference Curve Analysis
• Marginal Rate of Substitution (MRS)
• Properties of Indifference Curve
• Indifference Map
• The Budget Line: What is Attainable?
• Shifts in the Budget Line
2
• Consumer Equilibrium
• Income Effect
• Price Effect
• Income Effect and Substitution Effect Together
• Consumer Surplus
• Producer Surplus
• Total Surplus
• Marginal Utility and Marginal Rate of Substitution
• Price Consumption Curve
• Income Consumption Curve or Engel Curve
3
Introduction
• Consumer behavior refers to the study of how individuals, households, or groups
of people make decisions related to the selection, purchase, use, and disposal of
goods, services, ideas, or experiences. It is a multidisciplinary field that draws
insights from economics, psychology, sociology, and marketing.
• Utility, in economics, refers to the measure of satisfaction or happiness that
individuals derive from consuming goods, services, experiences, or any other
commodities. It is a crucial concept that helps economists understand and analyze
consumer choices and behavior. One of the fundamental assumptions in
economics is that consumers seek to maximize their utility when making
consumption choices. Given their budget constraints and the prices of goods,
consumers aim to allocate their resources to maximize their overall satisfaction.
• Economists use utility theory to explain why individuals make specific
consumption decisions and how they respond to changes in prices, income, and
other economic variables. It provides a foundation for studying the allocation of
resources and market behavior in economics.
4
Introduction
• Cardinal utility assumes that utility can be measured numerically and assigned specific
values. In this framework, economists try to quantify the level of satisfaction or happiness
that individuals derive from consuming goods and services. The concept of "utils" is often
used to represent these numerical values of utility. The principle of diminishing marginal
utility states that as a consumer consumes more of a good, the additional satisfaction
derived from each additional unit tends to decrease.
• Ordinal utility, on the other hand, does not assign numerical values to utility. Instead, it
focuses on the ordinal ranking of preferences. In this framework, consumers are only able
to indicate their preferences by ranking choices in order of preference.
• In modern economics, ordinal utility is more widely accepted and used because it doesn't
require the assumption of measurable utility and aligns better with the idea that utility is a
subjective and ordinal concept. This approach allows economists to analyze consumer
choices and behavior without the need for precise utility measurements.
5
Objectives of Unit - 3
• At the end of the unit you would be able to -
• Recall the Theory of Consumer Behavior
• Explain Consumer Preferences
• Categorize Some Basic Assumptions about Consumer Preferences
• What if Budget Constraint
• Measure the Consumer Choice
• Concepts of Utility
• How to Measure Utility?
• Show the difference between Cardinal Utility Approach and Ordinal Utility
Approach
6
• Discuss Utility and Money
• Distinguish between Total Utility and Marginal Utility
• Critically Explain The Law of Diminishing Marginal Utility
• Illustrate the Law of Equi-marginal Utility
• Define Indifference Curve
• What do you mean by Marginal Rate of Substitution (MRS)
• Briefly Explain the Properties of Indifference Curve
• What is an Indifference Map
• Define The Budget Line
• Why the Budget Line Shift?
7
• Critically Explain the Consumer Equilibrium
• Measure Income Effect and Price Effect
• Correlate the Income Effect and Substitution Effect
• Analyze the Consumer Surplus and Producer Surplus
• Show the Total Surplus
• Correlate Marginal Utility and Marginal Rate of Substitution
• Explain the Price Consumption Curve
• Describe the Income Consumption Curve or Engel Curve
8
Theory of Consumer Behavior
• Theory of consumer behavior is a fundamental concept in economics
that seeks to explains how consumers allocate their income among
different goods and services to maximize their well-being.
• Consumer behavior is best understood in three distinct steps:
• Consumer preferences
• Budget constraints
• Consumer choices
9
Consumer Preferences
10
Consumer Preferences
• Market Basket or Bundle
• List with specific quantities of one or more goods.
Table: Alternative Market Baskets
Market Basket Units of Food Units of Clothing
To explain the theory of
A 20 30
consumer behavior, we
B 10 50
will ask whether C 40 20
consumers prefer one D 30 40
market basket to another. E 10 20
F 10 40
11
Consumer Preferences : Some Basic
Assumptions about Preferences
• 1. Completeness: Preferences are
assumed to be complete. In other
words, consumers can compare and
rank all possible baskets. Thus, for
any two market baskets A and B, a
consumer will prefer A to B, will
prefer B to A, or will be indifferent
between the two.
• Note that these preferences ignore
costs. A consumer might prefer
steak to hamburger but buy
hamburger because it is cheaper.
12
13
• 2. Transitivity: Preferences are
transitive. Transitivity means that if a
consumer prefers basket A to basket B
and basket B to basket C, then the
consumer also prefers A to C.
Transitivity is normally regarded as
necessary for consumer consistency.
14
• 3. More is better than less (Non-
satiety): Goods are assumed to be
desirable—i.e., to be good.
Consequently, consumers always
prefer more of any good to less. In
addition, consumers are never satisfied
or satiated; more is always better, even
if just a little better.
• The more is better than less preference
is a cognitive bias where individual
perceive larger quantities or options as
more desirable than smaller ones. This
preference is the rooted in the belief
that abundance provides grater
opportunities, satisfaction and security.
15
Budget Constraint
•A budget line shows all possible
combination of two commodities that could
be pursued with a given amount of income.
•straight line that slope downwards
•The budget line, also known as the budget
constrain
16
Budget Constraint
• The equation of the budget line equation can be represented as
follows:
• M = Px × Qx + Py × Qy
Where,
Px = cost of product X.
Qx = the quantity of product X.
Py = cost of product Y.
Qy = quantity of product Y.
M = consumer’s income.
• Px × Qx + Py × Qy≤ M is the consumer’s budget constraint
17
Consumer Choice
• Consumer choice is the choice of a consumer to buy a product or not.
Usually, consumption or the behavior to buy products increase with
increasing income. Moreover, it also depends on the happiness the
consumer derives out of the product he/she buys.
• In other words, a consumer will choose to buy a product if his budget
exceeds the price of the product. Typically, when incomes increase, the
budgets for consumption increase automatically. However, utility or
the satisfaction derived from buying a product does not necessarily
increase with increasing incomes. In fact, the utility may be related to
a lot of factors, such as geography, climate, cultural factors, and
personal choices of consumers.
18
Consumer Choice
• Consumer choice examines why people make the economic choices
they do when facing trade-offs, restrictions, and changes in their
environment that affect their ability to consume.
• “Among all the bundles the consumer could possibly choose,
which one returns the highest level of utility?”
• For example, when you decided to keep the ice cream bar and
return the cookies, you, consciously or not, applied the marginal
decision rule to the problem of maximizing your utility: You
bought the ice cream because you expect that eating it will give you
greater satisfaction than would consuming the box of cookies.
19
Concepts of Utility
• The value a consumer places on a unit of a good or service depends on
the pleasure or satisfaction he or she expects to derive form having or
consuming it at the point of making a consumption (consumer) choice.
• In economics the satisfaction or pleasure consumers derive from the
consumption of consumer goods is called “utility”. It is the “want
satisfying power” of the commodity.
• Consumers, however, cannot have every thing they wish to have.
Consumers’ choices are constrained by their incomes.
• Within the limits of their incomes, consumers make their consumption
choices by evaluating and comparing the available consumer goods
with regard to their “utilities.”
20
How to Measure Utility ?
• Measuring utility in “utils” (Cardinal):
• Jack derives 10 utils from having one slice of pizza
• but only 5 utils from having a burger.
• Measuring utility by comparison (Ordinal):
• Joy prefers a burger to a slice of pizza and a slice of pizza to a hotdog.
• Often consumers are able to be more precise in expressing their
preferences.
• For example, we could say:
• Joy is willing to trade a burger for four hotdogs but he will give up only
two hotdogs for a slice of pizza.
• We can infer that to Joy, a burger has twice as much utility as a slice of
pizza, and a slice of pizza has twice as much utility as a hotdog.
21
Cardinal Utility Approach and Ordinal Utility Approach
Cardinal Utility Approach Ordinal Utility Approach

• Propounded by Marshall • Propounded by Hicks and
Allen
• Known as Marshallian
Approach • Known as Indifference
Curve Analysis
• Cardinal Utility is a utility that • On the other hand, Ordinal
determines the satisfaction of a Utility defines that satisfaction of
commodity used by an user goods can be ranked in
individual and can be supported order of preference but cannot be
with a numeric value. evaluated numerically.
22
Cardinal Utility Approach and Ordinal Utility Approach
23
Utility and Money
• Because we use money (rather than hotdogs!) in just about all of our
trade transactions, we might as well use it as our comparative measure
of utility.
• (Note: This way of measuring utility is not much different from
measuring utility in utils)
• Joy could say: I am willing to pay $4 for a burger, $2 for a slice of
pizza and $1 for a hotdog.
• Note: Even though Joy obviously values a burger more (four times as
much) than a hot dog, he may still choose to buy a hotdog, even if he
has enough money to buy a burger, or a slice of pizza, for that matter.
24
Total Utility Vs. Marginal Utility
• Total Utility is the total satisfaction obtained from all units of a particular commodity
consumed over a given period of time.
• Marginal Utility. It is the utility of the last unit consumed or marginal utility is the
change in total utility that results from in one unit change in consumption of the
commodity within given period of time.
• When you buy more and more units of commodity the marginal utility begins to diminish
but the total utility goes on increasing at a diminishing rate. When marginal utility comes
to zero (O) or we say the point of saturation (Satisfaction) is reached, total utility at this
point is maximum.
• If consumption is increased further from this point, the marginal utility becomes negative
and total utility begin to diminish.
• The relationship between total utility and marginal utility can be explained in the table.
• Schedule showing Marginal Utility and Total Utility
25
26
• Up to first 4 units, the marginal
utility decreases but remain
positive. Total utility
increases. So as long as the
marginal utility does not touch
horizontal axis total utility
increase. Marginal utility
becomes 0 on 5th unit and total
utility become the highest i.e. 14
unit and marginal utility is zero
and after becomes negative and
total utility fall.
27
The Law of Diminishing Marginal Utility
• Marshall who was the famous exponent of the marginal utility analysis has
stated the law of diminishing marginal utility as follows:
• “The additional benefit which a person derives from a given increase of his stock
of a thing diminishes with every increase in the stock that he already has.”
• According to the Law of Diminishing Marginal Utility, marginal utility of a good
diminishes as an individual consumes more units of a good. In other words, as a
consumer takes more units of a good, the extra utility or satisfaction that he
derives from an extra unit of the good goes on falling.
28
Assumptions of the Law of Diminishing
Marginal Utility
• The law of diminishing marginal utility makes several assumptions:
• The goods being consumed are identical.
• The units are consumed quickly with few breaks in between.
• Units are not too big or too small.
• The consumer's taste is constant.
• There is no change in the price of the goods or of their substitutes.
• The unit can be measured.
• The consumer is making rational decisions about consumption.
29
• Schedule for the Law of Marginal Utility
Cups of Tea Total Utility Marginal utility

Consumed per day (units) (units)
1 12 ---
2 22 10
3 30 8
4 36 6
5 40 4
6 42 2
7 42 0
8 40 –2
30
• Consider the above table in which we have presented the total and marginal
utilities derived by a person from cups of tea consumed per day. When one cup of
tea is taken per day, the total utility derived by the person is 12 units. And because
this is the first cup its marginal utility is also 12.
• With the consumption of 2nd cup per day, the total utility rises to 22 but marginal
utility falls to 10. It will be seen from the table that as the consumption of tea
increases to six cups per day, marginal utility from the additional cups goes on
diminishing (i.e., the total utility goes on increasing at a diminishing rate).
• However, when the cups of tea consumed per day increase to seven, then instead
of giving positive marginal utility, the seventh cup gives negative marginal utility
equal to -2. This is because too many cups of tea consumed per day (say more than
six for a particular individual) may cause him acidity and gas trouble. Thus, the
extra cups of tea beyond six to the individual in question give him disutility rather
than positive satisfaction.
31
32
• We have graphically represented the data of the above table in the Figure. We have
constructed rectangles representing the total utility obtained from various numbers
of cups of tea consumed per day. As will be seen in the Figure, the length of the
rectangle goes on increasing up to the sixth cup of tea and beyond that length of
the rectangle declines, indicating thereby that up to the sixth cup of tea total utility
obtained from the increasing cups of tea goes on increasing whereas beyond the
6th cup, total utility declines. In other words, marginal utility of the additional
cups up to the 6th cup is positive, whereas beyond the sixth cup marginal utility is
negative.
• The marginal utility obtained by the consumer from additional cups of tea as he
increases the consumption of tea has been shaded. A glance at the Figure will
show that this shaded area goes on declining which shows that marginal utility
from the additional cups of tea is diminishing. We have joined the various
rectangles by a smooth curve which is the curve of total utility which rises Up to a
point and then declines due to negative marginal utility.
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• Moreover, the shaded areas of the rectangles representing marginal utility of the
various cups of tea have also been shown separately in the figure given below. We
have joined the shaded rectangles by a smooth curve which is the curve of
marginal utility. As will be seen, this marginal utility curve goes on declining
throughout and even falls below the x-axis. Portion below the x-axis indicates the
negative marginal utility.
• This downward-sloping marginal utility curve has an important implication for
consumer’s behavior regarding demand for goods. We shall explain how the
demand curve is derived from marginal utility curve. The main reason why the
demand curves for good slope downward is the fact of diminishing marginal
utility.
34
Limitations of the Law of Diminishing
Marginal Utility
• Some of the important limitations of the law are discussed as
follows:
• i. Unrealistic assumptions:
• Include homogeneity, continuity, and constancy conditions. All these
assumptions are impossible to find at once.
• ii. Inapplicability to certain goods:
• Implies that the law of diminishing marginal utility cannot be applied
to goods, such as television and refrigerator. This is because the
consumption of these goods is not continuous in nature.
35
Limitations of the Law of Diminishing
Marginal Utility
• iii. Constant marginal utility of money:
• Assumes that MU of money remains constant, which is unrealistic. There is also a
gradual decline in the MU of money.
• iv. Change in other people’s stock:
• Implies that the utility of consumers is also dependent on what other people have
in their stock. Thus, the utility depends on social needs.
• v. Other possessions:
• Assumes that utility of consumers also depends on possessions already owned by
them. For example, a consumer is suffering from diabetes, thus, he is not allowed
to consume sugar that he/she already possesses. In such a case, the utility of coffee
derived by him/her would be less.
36
Law of Equi-marginal Utility
• Propounded by Hermann Heinrich Gossen (1810-1858), Also Known as Law of
Substitution or Law of Maximum Satisfaction, Also Known as Gossen’s Second
Law.
• Alfred Marshall made significant refinements of this law in his 'Principles of
Economics’.
• According to Marshall, 'If a person has a thing which can be put to several uses,
he will distribute it among these uses in such a way that it has the same marginal
utility in all’.
• A consumer, generally is confronted with the problem of buying from among
several goods and services, given his limited income.
• This law explains the behavior of a consumer in distributing his limited income
among various goods and services as to obtain maximum satisfaction.
37
• Each commodity purchased provides marginal utility that diminishes as
consumption increases and each can be purchased at a particular price
𝑀𝑈𝑥 𝑀𝑈𝑦
• 𝑃𝑥
= 𝑃𝑦
=………………………………….= 𝑀𝑈𝑚
• At this point the consumer can no longer increase total utility by buying more or
less, the marginal utility per last dollar spent is equal for all commodities.
• Where ,
MUx = Marginal Utility of Good x
MUy = Marginal Utility of Good y
Px = Price of Good x
Py = Price of Good y
MUm = Marginal Utility of Money
38
• Assumptions
• The consumer should behave rationally.
• He has full knowledge about the commodities i.e., their
attributes, price, etc. in the market.
• Utility is measurable cardinally in terms of utils.
• Commodities that are chosen are divisible and substitutable.
• The income of the consumer is given.
• The law is based on the law of diminishing marginal utility.
39
• For Example:
• A man purchases two goods X and Y whose prices are PX and PY, respectively. Let Px= 4 and Let
Py= 5
• By purchasing these combinations of X and Y (= Tk.. 4 x 5 + Tk. 5 x 3) gets maximum
satisfaction [10 + 9 + 8 + 7 + 6] + [11 + 10 + 6] = 67 units.
• Purchase of any other combination other than this involves lower volume of satisfaction.
Unit Consumed MUx MUy Unit MUX MUY

Consumed PX PY
1 40 55
1 10 11
2 36 50
2 9 10
3 32 30
3 8 6
4 28 20 4 7 4
5 24 15 5 6 3
6 20 5 6 5 1
40
• The consumer maximizes his

total utility by spending OD
amount on good X and O’D
amount on good Y.
• The consumer equalizes
marginal utilities per Taka spent
on X and Y at point E (i.e.,
MUX/PX = MUY/PY = ED).
• No other combination will give
greater satisfaction.
41
• If our consumer spends OC on good X and O’C on good Y then MUX/P X will
exceed MUY/ PY by the distance AB. This will induce the consumer to buy more
of X and less of Y. As a result, MUX/P X will fall, while MUY/PY will rise until
equality is restored at point E. Similarly, if the consumer spends OH on X and
O’H on Y then MUX/P X< MUY/P Y. Now, the consumer will buy more of Y and
less of X.
• This substitution between X and Y will continue until MUX/P X= MUY/PY.
Therefore, the consumer can derive maximum satisfaction only when marginal
utility per rupee spent on good X is the same as the marginal utility per Taka spent
on another good Y. When this condition is met, the consumer does not find any
interest in changing his expenditure pattern.
42
• The equilibrium condition can now be rewritten as:
• MUX/PX= MUY/PY
• This equation can, however, be rearranged in the following form:
• MUX/MUY = PX/PY
• This equation states that a consumer reaches equilibrium when he equalizes the
ratio of marginal utilities of both goods with the price ratio.
• However, this equilibrium condition can be extended to ‘n’ number of
commodities.
• For ‘n’ number of commodities, the equilibrium condition is:
• MUA/PA= MUB/PB= MUC/PC = ……… = MUn/Pn
43
Law of Equi-marginal Utility-Limitations
• 1. Indivisibility of Goods
• The theory is weakened by the fact that many commodities like a car, a
house etc. are indivisible. In the case of indivisible goods, the law is not
applicable.
• 2. The Marginal Utility of Money is Not Constant
• The theory is based on the assumption that the marginal utility of money is
constant. But that is not really so.
• 3. The Measurement of Utility is not Possible
• Marshall states that the price a consumer is willing to pay for a commodity
is equal to its marginal utility. But modern economists argue that, if two
persons are paying an equal price for given commodity, it does not mean
that both are getting the same level of utility. Thus utility is a subjective
concept, which cannot be measured, in quantitative terms.
44
Law of Equi-marginal Utility-Limitations
• 4. Utilities are Interdependent
• This law assumes that commodities are independent and therefore
their marginal utilities are also independent. But in real life
commodities are either substitutes or complements. Their utilities are
therefore interdependent.
• 5. Indefinite Budget Period
• According to Prof. K.E. Boulding, indefinite budget period is another
difficulty in the law. Normally the budget period is assumed to be a
year. But there are certain commodities which are available in several
succeeding accounting periods. It is difficult to calculate marginal
utility for such commodities.
45
Indifference Curve Analysis
• Indifference Curve Analysis combines two concepts; indifference curves
and budget lines (constraints)
• Indifference Curve: Indifference curve is a curve which represents the
combinations of two goods or services which give the same level of utility
to the consumer at every point.
• It can also be defined as a line that shows all the possible combinations of
two goods between which a person is indifferent.
• Since each combination of two goods yields the same level of utility, the
consumer is indifferent between any two combinations of goods.
• Indifference curve is also called Iso-Utility Curve and Equal Utility Curve.
46
Indifference Curve
• Example: Suppose a consumer consumes only two commodities X and Y, and he
makes 5 combinations he calls a, b, c, d, and e.
• All these combinations yield the same level of utility or they are all equally
preferred.
• His combinations are presented in Table 1.
• Assumptions
• Rational Consumer Ordinal Utility Non-Satiety (More is Preferred to Less)
Diminishing Marginal Rate of Substitution.
• Consistency: If a consumer prefer A to B in one period then he will not prefer B to
A in another period.
• Transitivity: If a consumer prefer A to B and B to C, then he must prefer A to C.
47
Indifference Curve
• Table: Indifference Schedule of Commodities X and Y.
Combination Good X Good Y Utility MRS
A 1 7 u ----
B 2 4 u 1:3
C 3 2 u 1:2
D 4 1 u 1:1
48
Indifference Curve
Indifference Curve
49
Indifference Curve
• All combinations (A, B, C, D) which fall along the indifference curve, yield
the same level of satisfaction.
• Points G and F fall outside the indifference curve (IC), therefore they yield
different level of satisfaction.
• Each indifference curve represents the consumers choices of two goods-
choices at which he is equally happy or indifferent, hence the term
indifference curves.
• Higher indifference curves give the consumer more of satisfaction.
• Lower indifference curve gives the consumer less satisfaction.
• The slope of Indifference curve is known as Marginal Rate of Substitution
and is convex to the origin.
50
Marginal Rate of Substitution (MRS)
• Is a rate at which a consumer is willing to substitute one good for the other.
• One of the basic assumption of indifference curve analysis is that MRS
diminishes.
• When a consumer substitutes one commodity (say X) for another (say Y), The
Marginal Rate of Substitution (MRS) decreases as the stock of X increases and
that of Y decreases.
• Measuring MRS
• To explain symbolically, suppose that the utility function of a consumer is given
as:
• U = f (x, y)
• Suppose that the consumer substitute x for y.
• When consumer foregoes some units of y, his stock of y decreases by –ΔY.
51
• His loss of utility may be expressed as:
–ΔY.MUy
• On the other hand, as a result of this substitution, his stock of X increases by ΔX.
• His utility from ΔX = +ΔX.MUx
• For the total utility U to remain the same; –ΔY.MUy +ΔX.MUx =0
• (along an indifference curve U = 0)
• Rearranging the terms we get:
∆𝑌 𝑀𝑈
• -∆𝑋=𝑀𝑈𝑋 =𝑀𝑅𝑆𝑋𝑌 = Slope of indifference curve
𝑌
When x is substituted for y.
52
• Similarly,
∆𝑋 𝑀𝑈𝑌
•- = =𝑀𝑅𝑆𝑌𝑋 = Slope of indifference curve
∆𝑌 𝑀𝑈𝑋
• When y is substituted for x.
• Note That
•- = =𝑀𝑅𝑆𝑋𝑌
•- = =𝑀𝑅𝑆𝑌𝑋
53
Properties of Indifference Curve
• 1. Indifference curves have a negative slope
• An Indifference curve slopes downward from left to right. The negative
slope of the indifference curve implies that:
• Two commodities can be substituted for each other.
• If quantity of one commodity decreases, quantity of the other commodity
must increase if the consumer has to stay at the same level of
satisfaction.
• In fig. 3.4 the two combinations of commodity cooking oil and commodity
wheat is shown by the points a and b on the same indifference curve.
• The consumer is indifferent towards points a and b as they represent equal
level of satisfaction.
• At point (a) on the indifference curve, the consumer is satisfied with OE
units of cooking oil and OD units of wheat.
54
• He is equally satisfied with OF
units of cooking oil and OK units
of wheat shown by point b on the
indifference curve.
• It is only on the negatively
sloped curve that different points
representing different
combinations of goods X and Y
give the same level of
satisfaction to make the
consumer indifferent.
55
• 2. Indifference curves are convex to the origin.
• The curves are convex, which is a consequence of the assumption that as
consumers have less and less of one good, they require more of the other good to
compensate.
• They are convex to the origin (bowed inward).
• This corresponding to the law of diminishing marginal utility.
• In this figure (3.6) as the consumer moves from A to B to C to D, the willingness
to substitute good X for good Y diminishes. This means that as the amount of
good X is increased by equal amounts, that of good Y diminishes by smaller
amounts.
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• The marginal rate of substitution
of X for Y is the quantity of Y
good that the consumer is willing
to give up to gain a marginal unit
of good X. The slope of IC is
negative. It is convex to the
origin.
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• 3. Indifference curves do not
intersect
• This is due to the assumption that
consumers will always prefer to have
more of either good than to have less.
• It is because at the point of tangency,
the higher curve will give as much as
of the two commodities as is given by
the lower indifference curve. This is
impossible.
58
• In fig 3.7, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the
consumer because both lie on the same indifference curve IC2.
• Similarly the combinations shows by points B and E on indifference curve IC1
give equal satisfaction top the consumer.
• If combination F is equal to combination B in terms of satisfaction and
combination E is equal to combination B in satisfaction. It follows that
the combination F will be equivalent to E in terms of satisfaction.
• This conclusion looks quite funny because combination F on IC2
contains more of good Y (wheat) than combination which gives more
satisfaction to the consumer. We, therefore, conclude that indifference
curves cannot cut each other.
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• 4. Higher Indifference Curve Represents Higher Level of
satisfaction
• 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.
• In other words, we can say that the combination of goods which lies
on a higher indifference curve will be preferred by a consumer to the
combination which lies on a lower indifference curve.
• In this diagram (3.5) there are three indifference curves, IC1, IC2 and
IC3 which represents different levels of satisfaction. The indifference
curve IC3 shows greater amount of satisfaction and it contains more of
both goods than IC2 and IC1 (IC3 > IC2 > IC1).
60
• When the individual has a

relatively large amount of good
Y he is willing to forego 2 units
of Y in return for one more unit
of good X and still feel as well
off.
• However, lower down the
indifference curve, he will only
sacrifice less of Y (e.g. 0.5 units)
for one more unit of X as he
begins to have to relatively more
of X than Y.
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• 5. Indifference Curves do not

Touch the Horizontal or Vertical
Axis
• One of the basic assumptions of
indifference curves is that the
consumer purchases combinations
of different commodities.
• He is not supposed to purchase only
one commodity. In that case
indifference curve will touch one
axis. This violates the basic
assumption of indifference curves.
62
• In fig. 3.8, it is shown that the in difference IC touches Y
axis at point C and X axis at point E. At point C, the
consumer purchase only OC commodity of rice and no
commodity of wheat, similarly at point E, he buys OE
quantity of wheat and no amount of rice.
• Such indifference curves are against our basic assumption.
Our basic assumption is that the consumer buys two goods in
combination.
63
• 6. The indifference curves are not likely to be vertical, horizontal, or upward
sloping.
• A vertical or horizontal indifference curve holds the quantity of one of the goods
constant, implying that the consumer is indifferent to getting more of one good
without giving up any of the other good.
• An upward-sloping curve would mean that the consumer is indifferent between a
combination of goods that provides less of everything and another that provides
more of everything.
• Rational consumers usually prefer more to less.
64
65
Indifference Map
• Is a graph of indifference curves
Consumer’s indifference map
associated with different utility
levels.
• Indifference map contains a
Quantity of clothing
number of indifference curves,
ranked in the order of
per week
consumer’s preferences
Quantity of food per Week
66
The Budget Line : What is Attainable ?
• The budget line illustrates all the possible combinations of two goods
that can be purchased at given prices and for a given level of income.
• The equation of the budget line is written as: Px.X+ Py.Y=I
• It means that the amount spent on good X plus the amount spent on Y
must equal the total income available.
67
• Combinations of two products a

consumer can purchase with Unit of A Unit of B Total
their money income Price = Tk. 1.50 Price = Tk. 1.00 Expenditure (Tk.)
• Slope is the ratio of the price of 8 0 12
B to the price of A 6 3 12
• Location varies with income 4 6 12
changes 2 9 12
• Location varies with price of 1 12 12
products
68
The Budget Line : What is Attainable
12
10
𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑇𝑘. 12
8 𝑃𝑟𝑖𝑐𝑒 = 𝑇𝑘. 1.50
Quantity of A
6 Unattainable
4 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑇𝑘. 12
Attainable 𝑃𝑟𝑖𝑐𝑒 = 1.00
2
0
2 4 6 8 10 12
Quantity of B
69
• Slope of the Budget Line
• The slope of the budget line can be written as follows:
∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝐴 𝑃𝑥
• Absolute slope=(-) =
∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝐵 𝑃𝑦
• The slope of the budget line equals the relative price of good B to
good A.
• The slope of the budget line indicates how many packets of biscuits a purchaser
must give up to buy one more packet of coffee.
70
Shifts in the Budget Line
• Any change in one or more of the parameters of the budget line
(income and prices) will clearly result in a shift in its position.
• A change in income shifts the budget line parallel to the original line –
(relative prices are unchanged)
• A change in the price of one good shifts the budget line and changes
its slope – (relative prices are different)
• An equal percentage change in the price of both goods shifts the
budget line parallel to the original
71
(i) Income changes: When there is change in the income of the
consumer, the prices of goods remaining the same, the price line shifts
from the original position.
• It shifts upward or to the right hand side in a parallel position with the
rise in income.
• A fall in the level of income, product prices remaining unchanged, the
price line shifts left side from the original position.
• With a higher income, the consumer can purchase more of both goods
than before but the cost of one good in terms of the other remains the
same.
72
• In the fig. 3.10 (a), a change in
income is shown when product
prices remain unchanged. The
rise in income results in a
parallel upward shifts in the
budget line from L1 M1 to
L2M2. The consumer is able to
purchase more of both the goods
A and B.
73
• (ii) Price changes. Now let us consider that
there is a change in the price of one good. The
income of the consumer and price of other
good is held constant.
• When there is a fall in the price of one good
say commodity A, the consumer purchases
more of that good than before. A price change
causes the budget line to rotate about point L
fig. 3.10 (b).
• It becomes flatter and give the new budget line
from LM1 to LM2. A flatter budget line means
that the relative price of the good A on the
horizontal axis is lower. If the greater amount
is spent on the purchase of good A, the
consumer can buy increased OM2 amount of
good A.
74
Consumer Equilibrium
• The rational consumer wants to maximize utility subject to his preferences and
budget constraint;
• i.e. he/she will choose from the affordable bundles of goods the one which gives
them the most utility.
• Specifically, the consumer chooses the point on the budget line which is on the
highest attainable indifference curve.
• At A, utility is maximized subject to the budget constraint.
• Why?
• Because any other point on the budget line (e.g. points B and C) or within it (e.g.
point D) is on a lower indifference curve.
• Bundles beyond the budget line (e.g. point F) are unobtainable.
75
• A consumer maximizes satisfaction

by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
E
• No higher level of satisfaction (e.g.,
market basket D) can be attained.
• At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1]
is greater than the price ratio (1/2),
satisfaction is not maximized.
F
76
• Equilibrium Conditions
• At equilibrium point, two conditions must be satisfied, all income is spent - the
individual must choose a point on the budget line.
• The slope of indifference curve equals the (absolute) slope of the budget line: i.e.
𝑃
• 𝑀𝑅𝑆𝑥𝑦 = 𝑥
𝑃𝑦
• Marginal benefit : Benefit from the consumption of one additional unit of a good.
• Marginal cost : Cost of one additional unit of a good.
• In this instance, satisfaction is maximized when the marginal benefit—the benefit
associated with the consumption of one additional unit of food—is equal to the
marginal cost—the cost of the additional unit of food. The marginal benefit is
measured by the MRS.
• Limitations of Consumer Equilibrium
77
Income Effect
• The income effect is observed through changes in purchasing power.
• It reveals the change in quantity demanded brought by a change in real income.
• Graphically, as long as the prices remain constant, changing the income will create
a parallel shift of the budget constraint.
• Increasing the income will shift the budget constraint right since more of both can
be bought, and decreasing income will shift it left.
• Depending on the indifference curves, the amount of a good bought can either
increase, decrease or stay the same when income increases.
• In the diagram 13, good Y is a normal good since the amount purchased increased
as the budget constraint shifted from BC1 to the higher income BC2.
• Good X is an inferior good since the amount bought decreased as the income
increases.
78
Income Effect
79
Income Effect
• In the diagram (3.12) wheat is measured along OX and rise along OY. When the
price line or budget line is BB/ , the consumer gets maximum satisfaction or is in
equilibrium position at point K where it touches the indifference curve IC1.
• The consumer buys OS quantity of wheat and ON quantity of rice. We suppose
now that the income of the consumer has increased and the price line is now CC1.
Which shifts in a parallel fashion to the right.
• The consumer is in equilibrium at a level at point L which is its equilibrium point.
If there is further increase in income: shift of the price line now will be DD1, and
the consumer is in equilibrium at point T and will be purchasing OZ quantity of
wheat and OE quantity of rice.
• If these, equilibrium points K, L, T are joined together by a dotted line passing
through the origin, we get income consumption curve ICC.
80
Income Effect
• This shows that with the rise in income, the consumer generally buys more
quantities of the two commodities rice and wheat. The income consumer is now
better off at T on indifference curve IC3 as compared to L at a lower indifference
curve IC2 .
• The income effect is positive in case of both the goods rice and wheat as these are
normal goods. The income consumption curve ICC which is derived by joining the
successive equilibrium positions has a positive slope.
• Income Effect When Wheat is an Inferior Good:
• Sometimes it also happens that with the rise in income, the consumer buys more
of one commodity and less of another. For instance, he may buy less of wheat and
more of rice as is, illustrated in figures 3.13.
81
Income Effect
• Income Effect When Rice is an
Inferior Good:
82
Income Effect
• In diagram 3.13, the income consumption curve bends back on itself. With the rise
in income, the consumer buys more of rice and less of wheat.
• The price effect for rice is positive and for wheat is negative. The good which is
purchased less with the increase in income is called inferior good.
• In the figure 3.14, it is shown that with the rise in money income, the purchase of
wheat has increased from M1 to M4 indicating positive income effect on the
purchase of normal good wheat.
• The income effect on inferior good is negative. The income consumption curve
ICC is starts bending towards the horizontal axis which shows that wheat is a
normal good and rice is inferior good.
83
Price Effect
• Price Effect on the Consumption of a Normal Good:

• We now discuss the reaction of the consumer to the changes in the price of a good while
his money income, tastes, preferences and prices of other goods remain unchanged.
• When there is change in the price of a good shown on the two axes of an indifference
map, there takes place a change in demand in response to a change in price of a
commodity, other things remaining the same, is called price effect.
• For example in fig. 3.15, AB is the initial budget line. It is assumed that the price of wheat
has fallen and the price of rice and the income of the consumer remains unchanged. The
price line takes a new position AC and the equilibrium point shifts from P to U.
• The consumer buys now OT quantity of wheat (the amount demanded rises from OE to
OT and OZ quantity of rice. With further fall in the price of wheat, the consumer is in
equilibrium at point S, where the budget line AD is tangent to a higher indifference curve
AC3.
84
Price Effect
• He buys now OF quantity of wheat
and OR quantity of rice.
• The rise in amount purchased of
wheat (OE to OF) as a result of a
fall in its price is called price effect.
• The price effect on the consumption
of a normal good is negative. If we
join the equilibrium points PUS, we
get price consumption curve (PCC)
of the consumer for the commodity
wheat.
85
Price Effect
• Price Effect When Commodity X is a Giffen Good:
• Giffen good is a particular type of inferior good. When there is a decrease in the
quantity demanded of a good with a fall in its price, the good is called Giffen good
after the name of Robert Giffen.
• A British Economist Robert Giffen (1837-1910), observed that sometimes it so
happens that a decrease in the price of a particular good causes its quantity
demanded to fall.
• The consumer spends the money he saves (by curtailing the demand) on the
purchase of increased quantity of the other good.
• The decrease in the price of Giffen good has an effect similar to an an increase in
the income of a buyer.
• This particular type of behavior of the consumer to decrease demand for good
when its price falls is called Giffen Paradox.
86
Price Effect
• In fig. 3.16, the consumer is in
equilibrium at point E where the
budget line AB is tangent to the
indifference curve IC1. The
consumer purchases OX1
quantity of Giffen good X and
OY1 quantity of good Y.
• When there is a reduction in the
price of good X but no change in
the price of good Y, the budget
line AB/ will showing upward.
87
Price Effect
• The consumer is in equilibrium at point E/ where the budget line AB/ is a tangent
to the indifference curve IC2. In the new equilibrium position, the consumer
purchases only OX2 units of Giffen good X and OY2 units of good Y.
• We find that the decrease in the price of Giffen good X, its quantity purchased has
fallen from OX1 to OX2 and the quantity demanded of Y commodity goes up
from OY1 to OY2.
• The price effect on the consumption of Giffen good is positive. If is indicated by
the backward bending PCC in the case of X as a Giffen good.
88
Income Effect and Substitution Effect Together
• Assume the original position was

at point A and price of X has
increased.
• Due to the increase in the price
of good x, the budget line has
rotated from B1 to B2 and the
consumption point has moved.
• The decrease in the quantity
demanded can be divided into
two effects;
89
• The Substitution Effect
• The substitution effect is when the consumer switches consumption patterns due to
the price change alone but remains on the same indifference curve.
• To identify the substitution effect a new budget line needs to be constructed.
• The budget line B1 * is added, this budget line needs to be parallel with the budget
line B2 and tangential to I1.
• Therefore, the movement from Q1 to Q2 is purely due to the substitution effect.
• The income effect
• The income effect highlights how consumption will change due to the consumer
having a change in purchasing power as a result of the price change.
• The higher price means the budget line is B2, hence the optimum consumption
point is Q2. This point is on a lower indifference curve (I2).
90
• When price of one good increases, the consumer income is so increased so that he
or she can remain equally well-off as before the price changed.
• The consumer income is increased so that he/she is back to original indifference
curve.
• The logic behind increasing income is that, after the increase in price the
consumer becomes worse-off as the purchasing power will fall.
• The increased amount is known as Compensating Variation in Income (CV).
91
Consumer Surplus
• A consumer’s willingness to pay for a good is the maximum price at which he or
she would buy that good.
• Individual consumer surplus is the net gain to an individual buyer from the
purchase of a good. It is equal to the difference between the buyer’s willingness to
pay and the price paid.
• Marshall defined Consumer’s Surplus as “the excess of the Price which a
Consumer would be willing to Pay rather than go without the thing, over
that which he actually does pay.”
• Consumer’s Surplus = What a Consumer is Willing to Pay – What he Actually
Pays.
• Derived from the law of Diminishing Marginal Utility.
• The following graphs show how willingness to pay is related to consumer surplus.
92
Consumer Surplus
• A consumer’s willingness to pay for a good is the maximum price at which he or
she would buy that good.
93
Consumer Surplus
94
95
Consumer Surplus
• Willingness to Pay and Consumer Surplus
• Total consumer surplus is the sum of the individual consumer surpluses of all the
buyers of a good.
• The term consumer surplus is often used to refer to both individual and to total
consumer surplus.
The total consumer surplus
generated by purchases of a
good at a given price is equal
to the area below the demand
curve but above that price.
96
Producer Surplus
• A potential seller’s cost is the
lowest price at which he or
she is willing to sell a good.
• Individual producer surplus
is the net gain to a seller from
selling a good. It is equal to
the difference between the
price received and the seller’s
cost.
• Total producer surplus in a
market is the sum of the
individual producer surpluses
of all the sellers of a good.
97
Producer Surplus
98
Producer Surplus
The total producer surplus

from sales of a good at a
given price is the area
above the supply curve but
below that price.
99
Total Surplus
100
Marginal Utility and Marginal Rate of Substitution
• We can express the MRS for any basket as a ratio of the marginal utilities of the
goods in that basket
• Suppose the consumer changes the level of consumption of x and y. Using
differentials:
dU = MUx . dx + MUy . dy
• Along a particular indifference curve, dU = 0, so:
0 = MUx . dx + MUy . Dy
• Solving for dy/dx:
dy = _ MUx
dx MUy
• By definition, MRSx,y is the negative of the slope of the indifference curve:
MRSx,y = MUx
MUy
101
Marginal Utility and Marginal Rate of
Substitution
102
Price Consumption Curve
• Price-consumption curve shows consumption impact of price changes.
• Reflects movement along demand curve.
103
• Income Consumption Curve : Income-consumption curve shows
consumption impact of income changes. Reflects shift from one demand
curve to another.
104
The Engel Curve
• The Engel curve, named after the German

statistician Ernst Engel (1821-96), is a
relation between the demand for a good and
the income of its buyers, the former
depending on the latter.
• The income consumption curve for good x
also can be written as the quantity
consumed of good x for any income level.
This is the individual’s Engel Curve for
good x.
• When the income consumption curve is
positively sloped, the slope of the Engel
curve is positive.
105

Utility Analysis

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Utility Analysis

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Unit 3 – Utility Analysis

• Theory of Consumer Behavior

Cardinal Utility Approach Ordinal Utility Approach

Cups of Tea Total Utility Marginal utility

Unit Consumed MUx MUy Unit MUX MUY

• The consumer maximizes his

• When the individual has a

• 5. Indifference Curves do not

Quantity of food per Week

• Combinations of two products a

• Location varies with price of 1 12 12

• A consumer maximizes satisfaction

• Price Effect on the Consumption of a Normal Good:

• Assume the original position was

The total producer surplus

• The Engel curve, named after the German

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