Module-3

Analysis of Consumer Behaviour-

The Utility Theory
 Introduction
• The theory of consumer behaviour tries to
explain the decision-making behaviour of the
consumer in demanding a particular commodity.
• The law of demand states that, other things
being equal, as the price of a commodity falls,
the consumer tends to buy more of it and vice-
versa
• But why is he behaving like this?
• The reason behind such a decision making
process is sought to be explained by the theory
of demand or consumer behaviour theory
 Utility Theory
• Economists have offered their theories of
consumer behaviour on the basis of the
measurement of utility
• There are two major approaches regarding the
measurement of utility
• 1) Cardinal Utility theory of Consumer Behaviour
• 2) Ordinal Utility Theory of Consumer Behaviour.
This is popularly known as Indifference Curve
Analysis
 Origins of Utility Theory
• The utility analysis of demand behaviour
was originated in the early 1870s by three
contemporary economists, Jevons,
Menger and Walras.
• It however received perfection and
systemic presentation at the hands of
Alfred Marshall when his celebrated book
Principles of Economics was published in
1890.
 Basic Concepts of The Utility
Theory
• The Marshallian approach is based on
the following postulates
1. The concept of utility
2. Cardinal or numeric measurement of
utility
3. Total utility
4. Diminishing marginal utility
5. Equi-marginal utility
 The Concept of Utility-1
• When the consumer consumes or buys a
commodity, he derives some benefit in the form
of satisfaction of a certain want. This benefit or
satisfaction experienced by the consumer is
referred to by economists as utility.
• Utility is a subjective term. It relates to the
consumer’s mental attitude and experience
regarding a given commodity or service.
• Utility of a commodity may differ from person to
person as every individual has his own choices.
• So it derives from above that utility is a relative
term
 The Concept of Utility-2
• Utility depends on time and place.
• The same consumer may experience a
higher or lesser utility at different times
and different places.
• Utility is a function of intensity of want.
• In other words, when we have more of a
certain thing, the less and less we want it.
Cardinal Measurement of Utility
• Marshall assumes cardinal or numeric
measurement of utility
• Marshall believed that utility could be measured
in numerical terms in its own units called utils.
• According to Marshall utility is quantifiable and
so can be measured numerically
• An apple may have 10 utils of utility (satisfaction)
and a mango may have 30 utils of utility, three
times that of the apple.
 Total Utility
• Total utility means total satisfaction
experienced or attained by the consumer
regarding all the units of a commodity
taken together in consumption or acquired
at a time.
• Total utility tend to be more with a larger
stock and less with a smaller stock.
 Marginal Utility
• Marginal utility is the extra utility obtained
from an extra unit of any commodity
consumed or acquired.
 The Law of Diminishing Marginal
Utility
• The law states that, “other things being
equal, as the quantity of a commodity
consumed or acquired by the consumer
increases, the marginal utility of the
commodity tends to diminish
• This means each additional unit of
consumption adds relatively less and less
to the total utility obtained by the
consumer
 Assumptions of the Law of
Diminishing Marginal Utility
• The law is based on following assumptions:-
1. The consumer behaves rationally, seeking
maximization of total utility
2. All the units of the commodity in consideration
are homogeneous, i.e. identical in all respects
3. The units consumed or acquired are taken
successively without any interval of time
4. There is no change in income, taste, habit or
preference of the consumer
5. Utility is measurable in cardinal terms
 Equi-marginal utility
• The law of equi-marginal utility is an extension of the law
of diminishing marginal utility.
• This law is also called the law of substitution or the law of
maximum satisfaction.
• The law of diminishing marginal utility is applicable only
to a single want with a single commodity in use
• But in reality there may be a number of wants to be
satisfied at a time and they can be satisfied with several
goods
• To analyze such a situation the law of diminishing
marginal utility is extended and such extended form is
called the law of equi-marginal utility .
 Statement of the law of Equi-
Marginal Utility
• Other things being equal, a consumer gets
maximum total utility from spending his
income, when he allocates his expenditure
to the purchase of different goods, in such
a way that the marginal utilities derived
from the last unit of money spent on each
item of expenditure tends to be equal
 Assumptions of the Law of Equi-
Marginal Utility
• The consumer has limited income and it is fixed
• The consumer has more than one want to
satisfy. This he can do either by purchasing the
required number of commodities out of a given
income or putting a given commodity to various
uses to satisfy his different wants.
• The consumer is rational and seeks maximum
satisfaction
• He has no control over the prices of
commodities and prices are fixed
 Significance of the law
1. It applies to consumption: It indicates how to get
maximum satisfaction
2. Production:- in the very principle of substitution lies the
optimum allocation of resource
3. Distribution :- It has an important bearing on the
determination of value. It helps in readjustment of
resources
4. Welfare and public finance:- the principle of maximum
social advantage involves the law of substitution when
it proposes that the revenue must be distributed in
such a way that the last unit of expenditure brings
equal welfare and satisfaction to all classes of people.
 Substitution Effect
• According to Marshall when the price of a commodity
falls, the consumer is induced to substitute more of the
relatively cheaper commodity (whose price has fallen) for
the dearer one (whose price has remained unchanged)
• When the price of a commodity falls the consumer finds
it worthwhile to purchase more of the cheaper
commodity as against dearer one.
• Since substitution effect is always positive, a larger
quantity of the commodity will be purchased at a lower
price
 Income effect
• This refers to the change in the real
income of the consumer due to changes in
price.
• When the price of a commodity falls, the
real income of the consumer rises. So the
consumer can now purchase the same
amount of commodity with less money OR
more quantities with less money.
 Positive Income Effect
• When a commodity has relatively higher
marginal utility, the Income Effect will be
positive
• The extra income generated due to fall in
price will be spent on buying more
quantities of the same commodity
 Negative Income Effect
• When the quantity of the commodity
purchased is less than before with a fall in
the price of a given commodity.
• This phenomenon is described as Giffen’s
Paradox
• This generally happens in the case of
inferior goods
• In case of inferior goods, when price falls,
the demand also falls
 The Paradox of Value
• This proposition states that, the value (price) of a
good is determined by its relative scarcity, rather
than by its usefulness.
• Water is extremely useful and its Total Utility is
quite high, but because it is so abundantly
available its Price (marginal utility) is low
• Diamonds, by contrast are much less useful than
water, but their great scarcity makes their price
very high
 Consumer’s Surplus
• The extra satisfaction or utility gained by
the consumer from paying an actual price
for a good which is lower than that which
they would have been prepared to pay