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THEORY OF CONSUMER

BEHAVIOUR
CARDINAL AND ORDINAL UTILITY
ANALYSIS

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Characteristics of utility
Utility is subjective.
Relative.
Not essentially useful.
Measurable.
Independent of morality.
Depends upon urgency or intensity
of wants.

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Total utility is the sum of the utilities obtained from all units of
a commodity consumed. The more of a commodity consumed
per unit of time, the greater will be the total utility or
satisfaction from it up to a certain point

At some point total utility will reach a maximum and this is


called the saturation point beyond which there is no
satisfaction from the consumption. After attaining the
saturation point, if there is more consumption, it will cause the
total utility to decrease. Symbolically, total utility can be
expressed as:

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Total Utility

TUn= U1+U2+U3+.+Un
Where TU n = total utility of n units
U1 = utility of the 1st unit

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Marginal Utility

Marginal utility is defined as the change in total utility


caused by the consumption of one more unit of a
commodity per unit of time. Mathematically, marginal
utility of nTh unit is the difference between total utility of n
units and total utility of n-1 units of the commodity.
Symbolically:
MU n = TU n TU n-1
MU n = marginal utility of n units
TU n = total utility of n units
TUn-1 = total utility of n-1 units

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Relationship between Marginal Utility and Total Utility

Marginal Utility Total Utility

1. Increases but at a diminishing


1. Declines
rate

2. Reaches zero; 2. Reaches maximum;

3. Becomes Negative 3. Declines from the maximum

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Cardinal Utility Approach
Developed by Alfred Marshall
The numbers 1, 2, 3, 4, 5 are cardinal numbers.
Utility is the want satisfying power of a commodity
or a service. It is a subjective concept and it resides
in the mind of the consumer.
The concept of cardinal utility assumes that the
measurement of utility of different commodities is
possible. For example, the consumption of an apple
may give 50 units of utility whereas an orange may
give only 40 units

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LAW OF DIMINISHING MARGINAL UTILITY
The Law of Diminishing Marginal Utility is a
generalization formulated from the observation of human
nature. As we get more and more of a commodity, the
satisfaction from it diminishes at some point of time.
According to Alfred Marshall the additional benefit(
marginal utility ) 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.
The tendency towards diminishing utilities from successive
doses of the same commodity is operative in all types of
commodities and services. The rate of diminishing utility may
be slow for some commodities, or rapid for others, but the
tendency to diminish is operative.

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Law of DMUAssumptions

Assumptions:
Utility can be measured in the cardinal number system.
MU of the money remains constant.
MU of every commodity is independent.
The unit of the good must be standard and as of same
quality and size.
There should be no change in taste during the process
of consumption
There must be continuity in consumption
There should be no change in the price of the substitute
goods.
No change in the income of the consumer.
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Explanation:
As more and more quantity of a
commodity is consumed, the intensity if
desire decreases and also the utility
derived from the additional unit.

Suppose a person eats Bread. and 1st


unit of bread gives him maximum
satisfaction. When he will eat 2nd bread
his total satisfaction would increase. But
the utility added by 2nd bread(MU) is less
then the 1st bread. His Total utility and
marginal utility can be put in the form of a
following schedule:

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Here, from the MU curve we can see that MU is declining as consumer consumes
more of the commodity.
When TU is maximum, MU is Zero.
After that, TU starts declining and MU becomes negative.
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Exceptions:
Curious and rare things.
Misers.
Good book or poem.
Drunkards.

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LIMITATIONS
CARDINAL MEASUREMENT
UN REALISTIC ASSUMPTIONS
HOMOGENOUS THINGS
CONTINOUS CONSUMPTION

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The law of equi-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
rupee spent on each item provides the same marginal utility.
The Equi-marginal utility theory can be stated as:
The consumer will spend his / her money income on
different goods in such a way that marginal utility of
each good will proportionate to its price. i.e.

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Utility Maximization
Consumer allocates income so that the
marginal utility per rupee spent on each good is
the same for all commodities purchased

MU X MUY

PX PY

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Assumptions:
Cardinal measurement is possible
Rational consumer
Income of the consumer remains
constant
MU of money remains constant
Prices of the commodities remains
constant

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Consumer Surplus

Consumers buy goods because it makes


them better off (or provide utility). Consumer
Surplus measures how much better off they
are.
Consumer Surplus
The amount a buyer is willing to pay for a
good minus the amount the buyer actually
pays for it.

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Consumer Surplus
P

Price

D
Qx
0

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Consumer Surplus and Demand
Consumer surplus for a given
quantity is therefore the difference
between your maximum willingness
to pay (reservation price) and what
you actually paid (actual price).

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Consumer Surplus
example
What happens when you purchase
something for a price that is less
than your maximum willingness to
pay?
E.g. you are willing to pay $20,000
for a new car and you buy it for
18,000
You receive a surplus of benefit
over cost = $2,000

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Consumer Surplus - Example
Assume a student wants to buy concert tickets.
Demand curve tells us the students willingness
to pay for each concert ticket
1st ticket worth $20 but price is $14 so
student generates $6 worth of surplus.
We can measure this for each ticket.
Total surplus is sum of surplus from each
ticket purchased.

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Consumer Surplus
Price
($ per
ticket)
20

Consumer
Surplus
14 Market Price
Demand Curve
Actual
Expenditure

0 1 2 3 4 5 6
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Consumer Surplus and Market Price

A lower market price will usually increase


consumer surplus.
A higher market price will usually reduce
consumer surplus.

Consumer surplus will be smaller when the


demand curve is more elastic and larger
when the demand curve is inelastic.

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Ordinal Approach
As utility is subjective it is not possible to measure it in real life
and though cardinal approach prompted economists to give
sight into consumer behaviour, but due to the limitation
economists develop an alternative approach called Ordinal
Approach or Ordinal Utility theory.
The theory deals with the fact that utility from different goods
can be rank able but not measurable.
The assumptions of this theory are:
Rationality :
Aim to maximize utility under condition of certainty.
Complete Ordering:
All possible goods can be offered into preferred.
Consistency:
If consumer prefers bundle B to bundle A at the same time he does not
prefer bundle A to bundle B.
Trasivity:
If Commodity basket A is preferred to B is preferred to C implies that,
A is preferred to C.
Non Satiety:
Bigger is preferred to a small bundle.
Scale of preferences
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Assumptions:

Rationality :
Aim to maximize utility under condition of
certainty.
Complete Ordering:
All possible goods can be offered into preferred.
Consistency:
If consumer prefers bundle B to bundle A at the
same time he does not prefer bundle A to bundle B.
Trasivity:
If Commodity basket A is preferred to B is
preferred to C implies that, A is preferred to C.
Non Satiety:
Bigger is preferred to a small bundle.
Scale of preferences
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The weakness of Alfred Marshalls approach was related to its
cardinal measurement of utility

The technique of indifference curves was originally developed


by F.Y.Edgeworth and later elaborated by J.R.Hicks and
Allen

Consumer can simply compare the utility of different


combinations of goods within the constraints of his income. A
consumer possesses a definite scale of preferences for goods
and services. Each scale of preference consists of a number
of alternative combinations of two or more goods, which give
the consumer same level of satisfaction. Therefore, the
consumer is indifferent towards these combinations
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Definition :

An indifference curve is the locus of points representing all the


different combinations of two goods which yield equal level of utility
to the consumer.

Indifference Schedule :

Indifference schedule is a list of various combinations of


commodities which are equally satisfactory to the consumer
concerned.

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Indifference Schedule:

Combinations Apples Mangoes

A 15 1

B 11 2

C 8 3

D 6 4

E 5 5
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Indifference curve IC shows all possible combinations of apples and
mangoes between which a person is indifferent. Point A shows
consumption bundle consisting of 15 apples and one mango. Moving
from point A to Point B, we are willing to give up 4 apples to get a
second mango (total utility is the same at points A and B).
16
A
14

12
B
10
Apples

C
8
D
6 E
IC
4
2

0
0 1 2 3 4 5 6
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Mangoes
Indifference Map :
A graph showing a whole set of indifference curves is called an
indifference map. All points on the same curve give equal level of
satisfaction, but each point on higher curve gives higher level of
satisfaction.

25

20

15
Apples

10
IC3
5
IC2
IC1
0
0 1 2 3 4 5
Mangoes
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PROPERTIES OR CHARACTERISTICS OF INDIFFERENCE
CURVES

Indifference curves have a negative slope.

Indifference curves are convex to the origin. It implies that the


consumer is prepared to sacrifice decreasing quantities of Y
for each given increment in the quantity of X.

Indifference curves never intersect. Each curve represents a


particular level of satisfaction.

Indifference curves need not be parallel to each other. This is


because the MRS between two commodities need not be the
same in all indifference curves.

IC can never touches X axis and Y axis

A higher indifference curve is always preferred to a lower one.


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MARGINAL RATE OF SUBSTITUTION - MRS

The marginal rate of substitution of X for Y (MRSxy) is defined as


the amount of Y the consumer is willing to give up to get an
additional unit of X. As the consumer gets more and more units of X,
he is willing to surrender less units of Y for each additional unit of X.
this is because, the relative importance of X in terms of Y goes on
diminishing. This feature of the consumers behaviour is known as
the principle of diminishing marginal rate of substitution

Professor BILAS says that the marginal rate of substitution of


X for Y is defined as the amount of Y the consumer is
just willing to give up to get one more unit of X and
maintains the same level of satisfaction.

MRSxy = Y X
Where X represents change in X and Y change in Y. The above
equation represents the slope of the indifference curve at a
particular point Chitkara Business School
Diagram

The slope of indifference curve measures the marginal rate of substitution. It is


negative and falling from left down to the right that shows the law of diminishing
marginal rate of substitution. The marginal rate of substitution diminishes
because (1) each particular want is satiable and (2) goods are not perfect
substitutes of one another. When wants are satiable a consumer obtains more
and more of one commodity and ultimately his demand goes on decreasing.
Consumer is ready to sacrifice less amount of other commodity to get more of
this commodity. When goods are not perfect substitutes the marginal rate of
substitution of one for the other must decrease.

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Price line/budget line
The price line shows the
combinations of goods that can be
purchased if the entire money is
spent
It shows all the different
combinations of the two
commodities that a consumer can
purchase given his money income
and price of two commodities.

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Budget constraint line or the Price line

A consumer would like to go to the highest indifference


curve to gain maximum satisfaction. However, in the real
world, the power of decision making is confined to the
given constraints of the consumer. The constraints are
referred to as the opportunity factors which consist of
three elements: (i) given money income, (ii) price of
commodity X, (iii) price of commodity Y. There may be a
number of combinations of X and Y which can be
purchased by the given budget constraint. A budget or
price line is an illustration of the various combinations of
two commodities (X and Y) which can be purchased by
the given money income

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Typical Budget Line (Figure 5.6)

Slope of price
Quantity of Y

line = Px/Py

B

Quantity of X
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Shifting Budget Lines (Figure 5.7)

R
120
A A

Quantity of Y
Quantity of Y

100 100
F
80

Z B N C B D
160 200 240 125 200 250

Quantity of X Quantity of X

Panel A Changes in money income Panel B Changes in price of X

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Consumer Equilibrium
A consumer seeks a market basket that generates the maximum
level of happiness. However, ones money income and prices of
goods imposes a limit on the level of satisfaction that one may
attain. Thus, the income at the disposal of the consumer in
conjunction with prices of the commodities will determine the
budgetary constraint or the price line.

14

12

10
Apples

8
E
6 IC
4
Price Line
2

0
0 5 10 15 20
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Mangoes
Consumer equilibrium is attained when, given his budget constraint,
the consumer reaches the highest possible point on the indifference
curve. The maximum satisfaction is yielded when the consumer
reaches equilibrium at the point of tangency between an indifference
curve and the price line. At point E, the price line is tangent to the
indifference curve.

At the equilibrium point, slope of indifference curve = slope of price


line

slope of indifference curve = MRS

slope of price line = PX / PY

Thus, at point E, MRS = PX / PY

Thus, satisfaction is maximized when the marginal rate of


substitution of X for Y is just equal to the price of X to the price of Y.
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Constrained Utility Maximization
(Figure 5.8)

50
45 A
40 B D
Quantity of pizzas


R E IV
30

III
20


C
15 II
T
10
I

0 10 20 30 40 50 60 70 80 90 100

Quantity of burgers
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