Unit - III

Theory of Consumer Behavior

What is Utility?
A consumer is a person who usually decides his/her need for products and commodities
according to the satisfaction he/she gets from it. The concept of utility in economics refers to
the satisfaction a customer derives from a service or a product. Customers try their best to
choose the commodities logically, to boost their utility.
Meaning of Utility- When a consumer consumes goods and services, then he feels some
satisfaction. Feeling satisfaction is called utility.
In Economics term,” Wants satisfying power of goods and services is called Utility.”
Definition: The satisfaction or happiness received from the consumption of goods and
services.
Utils
Definition: A subjective measure of the utility associated with consuming a good or
service.

Types of Utility

1. Expected utility
It is the utility that an economic agent is expected to reach in the future given several
probable outcomes. Expected utility value is a probability concept used when several future
outcomes are possible. It is calculated by multiplying each possible utility outcome by the
probability of its occurrence and then adding them up. Expected utility theory deals with
decision-making under uncertainty.
2. Subjective utility
It is utility based on an individual's perceived level of satisfaction from consuming a good
or service. Subjective utility is not based on market judgment. It is based on how attractive
an individual perceives the benefit of using a good or service.

Measures of Utility
Cardinal Utility
utility can be measured in cardinal numbers such as 1,2,3,4 etc. and these numbers either can
be added or subtracted.
Ordinal Utility
While Ordinal utility theory holds that the utility of a particular goods or service cannot be
measured using a numerical scale bearing economic meaning in and of itself. Ordinal utility
implies merely quality and ranking of the level of satisfaction experienced.

According to the Utility measurement there may be two concepts: (1) Total Utility and (2)
Marginal Utility.

Total Utility
It is the aggregation of utilities obtained from the consumption of two different units of a
commodity. In other words, total utility is the measurement of satisfaction derived from
consuming quantity of some goods. It is the function of the quantity of a commodity consumed
and is expressed as
TUx = f(Qx)
[The total value of this is read as –X (TUx), X- commodity quantity (Qx) is a function of (f).]
In the words of Left witch, “Total Utility refers to the entire amount of satisfaction
obtained from consuming various quantities of a commodity.”
Assume that you eat 8 Rasagullas at a sitting. The aggregation of the utilities obtained from
the 8 Rasagullas will be called Total Utility.
Marginal Utility
The concept of Marginal utility was put forward by the eminent economist named Jevons. The
other name for Marginal utility is additional utility. The marginal utility is the gain (or loss)
from an increase (or decrease) in the consumption of that goods or service. Assuming that by
the consumption of the 1 chapatti you get 15 units of utility while consuming the 2nd one your
total units goes up to 25.
This means that the consumption of the 2nd chapatti added only 10 units to the total utility.
Thus the marginal utility of the second chapatti is only 10 units.
According to Lipsey, “Marginal utility is the addition made to the total utility by
consuming one more unit of commodity.”

MU nth = TU n – TU n –1 Or MU = ΔTU/ ΔQ

(Here MUnth = nth marginal utility of unit; TU n = n the total value of units; TU n–1 = n – 1
the total utility of the unit ΔTU = total utility; ΔQ = change in the amount of object) Marginal
Utility can be (1) positive (2) Zero and (3) Negative.
(i) Positive Marginal Utility: Positive marginal utility is the change in total utility by the
consumption of an additional unit of commodity. Suppose to satisfy your hunger you eat
chappatis, from the first one you get 8 units and while from the second one you get 6 units.
Altogether you have got 8 + 6 = 14 units. Thus, by taking the additional units of chapattis, total
utility goes on increasing. The marginal utility which you derived from the second chapattis is
known as positive marginal utility.
(ii) Zero marginal utility: When the consumption of extra units of items has no change on the
total utility, it means that the marginal unity of the additional unit is Zero. At this level the
consumption utility will be maximum. So as far as the satisfaction of the consumer is
concerned, it will be his saturated point. Suppose 4 chapattis of bread yield total utility of 20
units and the consumption of 5th chapatti does not make any change in the total utility and the
utility remains 20, that means the marginal utility of the 5th one is Zero.
(iii) Negative marginal utility: When the consumption of every extra unit decreases the utility
derived from it, then it is known as negative marginal utility. After receiving the saturation
point, after taking 5 chapattis, if the consumer is forced to take the number 6 chapatti, he may
suffer from indigestion. Therefore, the total utility of the 6 chapattis may come down to 18
units, which signifies that the marginal utility is negative 2 i.e. (18 – 20) = –2. Hence –2 is the
negative marginal utility.

Schedule of Total Utility and Marginal Utility

Units Marginal Utility Total Utility
1 20 20
2 12 32
3 8 40
4 2 42
5 0 42
6 -3 39
Relationship Between Total Utility (TU) and Marginal Utility (MU)
When a consumer goes on to consume the units of a commodity continuously the marginal
utility derived from the successive units of the commodity goes on to fall constantly while other
factors are held constant.
From the above statement regarding the consumer behaviour the relationship between total
utility (TU) and marginal utility (MU) is deducted as under:

1. MU is the rate of change of TU.

2. When the MU decreases, TU increases at decreasing rate.
3. When MU becomes zero, TU is maximum. It is a saturation point.
4. When MU becomes negative, TU declines

Law of Diminishing Marginal Utility

The law of diminishing marginal utility describes a familiar and fundamental tendency of
human behaviour.
“The law of diminishing marginal utility states that, “as a consumer consumes more and more
units of a specific commodity, utility from the successive units goes on diminishing”.
Prof. Boulding called it, “Law of Eventually diminishing marginal utility”. It is also
known as Gossen’s First law”.
Assumptions of the Law
1. Various units of goods are homogenous.
2. There is no time gap between consumption of the different units.
3. Consumer is rational
4. Tastes, preferences, and fashion remain unchanged.
5. Consumers possess perfect knowledge of the price in the market
6. No price change
7. It assumes Law of marginal diminishing Utility
8. Utilities of different commodities are independent of each other

Law based upon three facts

The law of diminishing utility is based upon three facts.
• Firstly
The wants of a man are unlimited but single want can be satisfied. As a man gets more and
more units of a commodity, the desire of his want for that good goes on falling. A point is
reached when the consumer no longer wants any more units of that good,
• Secondly
Different goods are not perfect substitutes for each other in the satisfaction of various particular
wants.
• Thirdly
There is no change in the tastes of the consumers.
Example
Suppose a person is thirsty and the price of water is zero. He takes one glass of water which
gives him great satisfaction. We can say the first glass of water has great utility for him.
He then takes second glass of water. The utility of the second glass of water is less than that of
first glass of water. The utility declines because the edge of his thirst has been blunted to a
great extent.
If he drinks third glass of water, the utility of the third glass will be less than that of second and
so on. The utility goes on diminishing with the consumption of every successive glass of water
till it drops down to zero.
It is the position of consumer’s equilibrium or maximum satisfaction.
If the consumer is forced further to take a glass of water, it leads to disutility causing total
utility-to decline. The marginal utility will become negative. A rational consumer will stop
taking water at the point at which marginal utility becomes negative even if the good is free.
In short, when a good is free, a consumer increases consumption of a good so long its additional
units provide him positive marginal utility.

Units Marginal Utility Total Utility

1 20 20
2 12 32
3 8 40
4 2 42
5 0 42
6 -3 39

It is clear that in a given span of time: -

The first glass of water to a thirsty man gives 20 units of utility.
When he takes second glass of water, the marginal utility goes down to 12 units.
When he consumes fifth glass of water, the marginal utility drops down to zero and if the
consumption of water is forced further from this point, the utility changes into disutility (–3).
Here it may be noted that the utility of the successive units consumed diminishes not because
they are of inferior in quality than that of others. We assume that all the units of a commodity
consumed are exactly alike.

Law of Equip Marginal Utility:

The law of equip marginal utility was presented in 19th century by an Australian economists
H. H. Gossen. It is also known as law of maximum satisfaction or law of substitution or
Gossen's second law. A consumer has number of wants. He tries to spend limited income on
different things in such a way that marginal utility of all things is equal. When he buys several
things with given money income he equalizes marginal utilities of all such things. The law of
equi marginal utility is an extension of the law of diminishing marginal utility. The consumer
can get maximum utility by allocating income among commodities in such a way that last
dollar spent on each item provides the same marginal utility.
Definition:
"A person can get maximum utility with his given income when it is spent on different
commodities in such a way that the marginal utility of money spent on each item is equal".
It is clear that consumer can get maximum utility from the expenditure of his limited income.
He should purchase such amount of each commodity that the last unit of money spend on each
item provides same marginal utility.
Assumptions of the Law of Equi Marginal Utility:
1. There is no change in the prices of the goods.
2. The income of consumer is fixed.
3. The marginal utility of money is constant.
4. Consumer has perfect knowledge of utility obtained from goods.
5. Consumer is normal person so he tries to seek maximum satisfaction.
6. The utility is measurable in cardinal terms.
7. Consumer has many wants.
8. The goods have substitutes.

Explanation with Schedule and Diagram:

The law of substitution can be explained with the help of an example. Suppose consumer has
six dollars that he wants to spend on apples and bananas in order to obtain maximum total
utility. The following table shows marginal utility (MU) of spending additional dollars of
income on apples and bananas:
Units Apples (MU) Banana (MU)
1 10 8
2 8 6
3 6 4
4 4 2
5 2 0
6 0 -2
7 -2 -4
8 -4 -6

the above schedule shows that consumer can spend six dollars in different ways:
1. $1 on apples and $5 on bananas. The total utility he can get is: [(10) + (8+7+6+5+4)] = 40.
2. $2 on apples and $4 on bananas. The total utility he can get is: [(10+9) + (8+7+6+5)] = 45.
3. $3 on apples and $3 on bananas. The total utility he can get is: [(10+9+8) + (8+7+6)] = 48.
4. $4 on apples and $2 on bananas. This way the total utility is: [(10+9+8+7) + (8+7)] = 49.
5. $5 on apples and $1 on bananas. The total utility he can get is: [(10+9+8+7+6) + (8)] = 48.
Total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4 on
apples and $2 on bananas. Here the condition MU of apple = MU of banana i.e. 7 = 7 is also
satisfied. Any other allocation of the last dollar shall give less total utility to the consumer.1.
The same information can be used for graphical presentation of this law:

The diagram shows that consumer has income of six dollars. He wants to spend this money on
apples and bananas in such a way that there is maximum satisfaction to the consumer.
Limitations:
1. The law is not applicable in case of knowledge. Reading of books provides more
satisfaction and knowledge to the scholar. Different books provide variety of knowledge
and satisfaction.
2. The law is not applicable in case of indivisible goods. The consumer is unable to divide the
goods to adjust units of utility derived from consumption of goods.
3. There is no measurement of utility. It is psychological concept. It is not possible to express
it into quantitative form.
4. The law does not hold well in case fashion and customs. The people like to spend money
on birthdays, marriages and deaths.
5. The does not hold well in case of very low income. The maximization of utility is not
possible due to low income.
6. The law is not applicable in case of durable goods. The calculation of marginal utility of
durable goods is impossible.
7. The law fails when goods of choice are not available. The consumer is bound to use
commodity, which provides low utility due to non-availability of goods having high utility.
8. There are certain lazy consumers. They do not care for maximum utility. The law fails to
operate in case of laziness of consumers. They go on consuming goods with comparing
utility.
9. It does not work when there are frequent prices changes. The consumer is unable to
calculate utility of different commodities. Changing price levels create confusion in the
minds of consumers.
10. There may be unlimited resources. The does not work due to unlimited resources. There is
no need to change the direction of expenditure from one item to another when there are
gifts of nature.
Importance:
1. The law of equi marginal utility is helpful in the field of production. The producer has
limited resources. He uses limited resources to purchase production factors. He tries to
equalize marginal utility of all factors. He wishes to get maximum output and profit.
2. National income is distributed among factors of production according to this law. An
entrepreneur can pay factors of production equal to marginal product measured in money
terms. He will substitute one factor for another until marginal productivity of all factors is
equal to prices of their services.
3. The law is used in the field of exchange. The people like to exchange a commodity having
low utility with a commodity having high utility. There is maximum benefit from exchange
of commodities. The law is helpful in exchange of wealth, trade, import and export.
4. The law is applicable in consumption. A rational consumer tries to get maximum
satisfaction when he spends his limited resources on various things. He tries to equalize
weighted marginal utility of all the things.
5. The law is applicable in public finance. The government can spend its revenue to get
maximum social advantage. The marginal utility of each dollar spent in one sector must be
equal to marginal utility derived from all other sectors.
6. The law is useful for workers in allocating the time between work and rest. They can
compare the marginal utility of work and the marginal utility of rest. They can decide
working hours and rest hours.
7. The law holds well in case of saving and spending. The consumer can make choice between
present wants and future wants. He can feel that a dollar saved has greater utility than a
dollar spent, he can save more and spend less. He will substitute saving and spending till
marginal utility of a dollar spent and a dollar saved are equal.
8. The law is helpful in prices. Due to scarcity of commodity its prices go up. The law tells us
to use substitute commodity, which is less scarce. The result is that the price of commodity
comes down.