THEORY OF CONSUMER BEHAVIOUR

CONCEPTS

Demand arise due to utility Measurement of Utility:  Cardinal Utility: Utility is objectively measurable  Ordinal Utility: Consumers can rank their preferences

TOTAL UTILITY(TU)

Sum total of all the utilities derived from the total number of all units consumed Sum of Marginal Utility (MU) of different units of the commodity TUn = MU1 + MU2 + ……..+ MUn =∑ MU

MARGINAL UTILITY (MU)
Change in TU resulting from a one unit change in consumption of good MUn = TUn – TUn-1

RELATION B/W TU & MU
No of units 1 2 3 4 5 6 7 8 TU 10 18 24 28 30 30 28 24 MU 10 8 6 4 2 0 -2 -4

RELATION B/W TU & MU

TU MU TU o MU No of units consumed

CARDINAL APPROACH TO CONSUMER EQUILIBRIUMMARGINAL UTILITY ANALYSIS

ASSUMPTIONS OF MU ANALYSIS

• • • • •

Cardinal measurement of Utility Hypothesis of Independent utility Constancy of marginal Utility of Money Rationality Limited Money Income

LAW OF DIMINISHING MU

Utility derived by consumer from the consumption of each additional unit of a commodity keeps on decreasing with every increase in the stock of the commodity which he/she already has. NOTE: TU continues to increase though at a decreasing rate

EXAMPLE
Cups of tea consumed per day 1 2 3 4 5 6 7 8 TU 12 22 30 36 40 41 39 34 MU 12 10 8 6 4 1 -2 -5

APLICATION OF CONCEPT OF DIMINISHING MARGINAL UTILITY

Diamond Water Paradox: Water which is so essential & useful to life has such a low price while diamonds which are quite unnecessary have such a high price….???? Water….available in abundance…relatively low MU

LAW OF EQUI MARGINAL UTILITY

Consumer will redistribute his money income b/w goods in such a way that utility derived from last rupee spent on each good is equal Consumer is in equilibrium when MU of money expenditure on each good is the same NOTE: does not mean spending of equal amount of money on each commodity

LAW OF EQUI MARGINAL UTILITY

Consumer will spend his money income between goods in such a way that MU of each good is proportional to its price If there are 2 goods ‘x’ and ‘y’ then MUx/Px = MUy/Py

LAW OF EQUI MARGINAL UTILITY
If MUx/Px > MUy/Py then consumer will substitute good ‘x’ for good ‘y’ Reasoning: • As a result of increase in the quantity of good ‘x’ MUx will fall and because of a decrease in the quantity of ‘y’ MUy will increase • Consumer will continue substitution till MUx/Px becomes equal to MUy/Py

EXAMPLE ON CONSUMER EQUILIBRIUM Given: Px = Re ; PY = Rs 2; Money Income= Rs 19
Units 1 2 3 4 5 6 MUx 20 18 16 14 12 10 MUy 24 21 18 15 9 3 MUx/Px 10 9 8 7 6 5 MUy/Py 8 7 6 5 3 1

CRITICAL EVALUATION OF MU ANALYSIS
• • • • • Unrealistic assumption of Cardinal measurability of utility Wrong hypothesis of independent utility Invalid assumption of Constant Marginal utility of money Failed to explain the giffen paradox Failed to explain the splitting of price effect into income effect and substitution effect

ORDINAL UTILITY APPROACH TO CONSUMER EQUILIBRIUMINDIFFERENCE CURVE ANALYSIS

ASSUMPTIONS
• • • • • • •

Perfect Knowledge Rationality Ordinal Utility Transitivity Consistency Non satiety (MIB) Diminishing Marginal Rate of Substitution

MORE IS BETTER

Bundles that have at least as much of every good & more of some good are preferred to other bundles Bundle B is preferred to A- B contains at least as much of good Y & strictly more of good X. Bundle B is preferred to C- B contains at least as much of good X & strictly more of good Y. More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.

Good Y III. II. I.
100 A B

33.33

C

1

3

Good X

INDIFFERENCE CURVE (IC)
• •

Locus of points among which consumer is indifferent Each point on an IC yields the same TU as any other point on the same IC Consumer is indifferent among all points on IC It does not indicate exactly how much satisfaction is derived from these combinations

• •

INDIFFERENCE SCHEDULE
COMBIN ATION UNITS UNITS OF GOOD OF GOOD X Y 3 4 5 6 7 21 15 11 8 6

Good Y
IC

A B C D E

Good X

INDIFFERENCE MAP

Set of ICs corresponding to different levels of satisfaction Higher IC represent greater satisfaction

Good Y
III. II. I.

Good X

MARGINAL RATE OF SUBSTITUTION (MRS)
MRS of X for Y (MRSXY) measures the number of units of Y that must be sacrificed per unit of X gained so as to maintain a constant level of satisfaction. MRSXY = (-1) ΔY/ ΔX 0
X1 X2
Units of X Units of Y

Y1

Y2

EXAMPLE
COMBINATION A B C D E GOOD X 1 2 3 4 5 GOOD Y 12 8 5 3 2 4 3 2 1 MRSxy

DIMINISHING MARGINAL RATE OF SUBSTITUTION
The Convexity of an IC implies that MRS diminishes as X is substituted for Y along an IC. Units of Y

Y1 Y2 Y3 0 X1

P Q R

MRS at Q = Y1Y2 / X1X2 MRS at R = Y2Y3 / X2X3

X 2 X3

Units of X

NOTE

The rate at which a consumer is willing to trade good Y for good X is equal to the ratio of MU X to MU Y

MRSXY = -ΔY/ ΔX = MU X / MU Y

CHARACTERSTICS OF IC
• • • •

negative slope (Slope downwards from left to right) convex to the origin (diminishing MRS) higher IC represents a higher level of satisfaction can not intersect each other

IMPOSSIBLE INDIFFERENCE CURVES
Horizontal

Units of Y

Units of X

IMPOSSIBLE INDIFFERENCE CURVES
Vertical

Units of Y

Units of X

IMPOSSIBLE INDIFFERENCE CURVES
Units of Y Upward Sloping
b

a I

Units of X

IMPOSSIBLE INDIFFERENCE CURVES Intersection 
Units of Y

e a

b

IC 1 IC 2

Units of X

EXCEPTIONAL SHAPES OF IC
PERFECT SUBSTITUTES . MRS between two goods is constant and therefore the IC is linear. PERFECT COMPLEMENTS: no possibility of substitution so MRS will be 0. Satisfaction can not be increased by increasing the units of one commodity at the expense of the other so MRS will be infinity.

BUDGET LINE/ PRICE LINE/ CONSUMPTION POSSIBILITY LINE
Set of commodity bundles that can be purchased if the entire money income is spent, given the prices of the two commodities

I = xpx + ypy y = 1/py . I – px/ py .x

Good Y 25 = M / PB
20 a b

BUDGET CONSTRAINT

L1 (Pz 10 Opportunity set

= Re 1, PB = Rs 2, M= Rs 50)
c

d 0 10 30

50 = M / Pz

Good X

SHIFTS IN THE BUDGET LINE
INCREASE IN MONEY INCOME : Budget line shift outwards to the right

Units of Y

0

Units of X

SHIFTS IN THE BUDGET LINE
DECREASE IN THE MONEY INCOME : Budget line shift inwards to left

INCREASE IN THE PRICE OF GOOD X
Budget line pivots from AB to AC i.e. it will shift only at its end touching the X axis.

Units of Y

A

0

C
Units of X

B

INCREASE IN THE PRICE OF GOOD Y

Budget line pivots from AB to B AC i.e. it will shift only at its Units of end touching the Y axis. Y
C

0

A
Units of X

SLOPE OF THE BUDGET LINE
Slope of the Budget Line is equal to the ratio of prices of two goods. Slope of Budget line = OA/OB = (I/Py) / (I/Px) = Px/Py

Units of Y

A

Units of X

0

B

CONSUMER EQUILIBRIUM
Consumer is said to be in equilibrium where he maximizes his satisfaction subject to his Units of Y budget constraint.
A E

B

0

Units of X

CONDITIONS FOR CONSUMER EQUILIBRIUM
FIRST ORDER CONDITION (NECESSARY) Slope of budget line should be equal to the slope of IC MRSXY = PX/ PY SECOND ORDER CONDITION (SUFFICIENT) At the point of equilibrium, IC must be convex to the origin.
0

Units of Y P Q

Units of X

DECOMPOSITION OF PRICE EFFECT INTO INCOME AND SUBSTITUTION EFFECT
PRICE EFFECT: total change in quantity demanded caused by a change in the price SUBSTITUTION EFFECT: change in quantity demanded resulting from a change in price when the change is restricted to a movement along the original IC, thus holding real income constant INCOME EFFECT: change in quantity demanded resulting exclusively from a change in real income, all other prices and money income held constant

INCOME EFFECT
Positive I.E. With an increase in the income the consumer consumes more units of the good. Negative I.E. With an increase in income the consumption of the good falls (inferior goods)

INCOME CONSUMPTION CURVE & INCOME EFFECT (1)

ICC UNITS OF GOOD Y

+VE I.E. for Good X & Good Y

UNITS OF GOOD X

INCOME CONSUMPTION CURVE & INCOME EFFECT (2)
ICC UNITS OF GOOD Y -VE I.E. for Good X (inferior good)

UNITS OF GOOD X

INCOME CONSUMPTION CURVE & INCOME EFFECT (3)

UNITS OF GOOD Y

-VE I.E. for Good Y (inferior good) ICC

UNITS OF GOOD X

INCOME CONSUMPTION CURVE & INCOME EFFECT (4)

Good X inferior UNITS OF GOOD Y Good Y inferior

UNITS OF GOOD X

SUBSTITUTION EFFECT

UNITS OF GOOD Y
IC

UNITS OF GOOD X

HICKSIAN APPROACH: NORMAL GOODS
Units of Y

For a decline in price of good x PE = SE(x1 x2) + IE (x2 x3)

P R Q Units of X

x1

x2

x3

HICKSIAN APPROACH: INFERIOR GOODS
Units of Y

PE = SE(x1 x2) + IE (-x2 x3)

R P

SE >Negative IE

Q Units of X

x1

x3

x2

HICKSIAN APPROACH: GIFFEN GOODS
Units of Y

R

PE = SE(x1 x2) + IE (-x2 x3)
P

Negative IE > SE
Q Units of X

x3

x1

x2

POSSIBLE COMBINATIONS OF INCOME EFFECT AND SUBSTITUTION EFFECT OF A DECLINE IN THE PRICE OF GOOD X Case A B Substitution Income Effect Effect -ve +ve -ve -ve but smaller than SE -ve but larger than SE Total Effect ↑ ↑ Nature of the commodity Normal Inferior

C

-ve

Giffen

SIMILARITY B/W MARSHALLIAN APPROACH & INDIFFERENCE CURVE APPROACH
 

Assume that consumers are rational Assumption of diminishing MU in some sense or the other

SUPERIORITY OF IC ANALYSIS
• • • • •

Ordinal measurement of utility Analysis of demand without assuming constant MU of money Hypothesis of interdependent utility Greater insight into price effect Less restrictive & fewer assumptions

CRITIQUE OF IC ANALYSIS
• • •

Includes most ridiculous combinations Suitable for two good case only Limited empirical nature.

EXERCISE: Textbook Page # 106

Consider a world in which there are only 2 goods. An individual has an income of Rs 30,000. Price of deodorant is Rs 30 per can & price of mouthwash is Rs 40 per bottle. Expressing deo as dependent variable, write eq for budget constraint. What is the slope of budget constraint? If P of mouthwash increases to Rs 50., write new eq for budget constraint.

• •

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