Theory of

Consumer’s Behaviour
P R ES E N T E D BY :
ANAND PANT
FACULTY OF ECONOMICS
K A T H FO R D IN T E R N A T I O N A L
C O L L EG E O F E N GI N E ER I N G
A N D M A N A GE M E N T ,
BA L K U M A R I
 Introduction to Utility

Utility refers to the human wants satisfying power of

the commodity
Utility is subjective entity
It varies person to person, time to time and place to
place
 Types of Utility

Total Utility (TU):

Total utility refers to the total satisfaction derived by
the consumer from the consumption of given
quantity of goods. In other words it is the sum total
of marginal utility
TU = MU1 + MU2 + MU3 + …
TU = ∑MU
 Types of Utility

Marginal Utility (MU):

It refers to the addition of total utility from
consumption of one extra unity of a commodity
In other words MU is the ration of change in total
utility to change in unit consumed
MU = ∆TU/ ∆Q
MU = TUn – TUn-1
 Types of Utility

Average Utility (AU):

It is per unity utility gained by the consumer from
the consumption of given units of a commodity at
given period of time.
AU = TU /Q
 Cardinal Utility Approach

The concept of cardinal utility analysis was initially

developed by H.H. Gossen and popularized by A.
MarShall
According to cardinal utility analysis utility is
quantified in terms of money and measured in
cardinal numbers such as 1,2,3,…
Utility is calculated on the basis of amount of money
paid by consumer.
This approach is also known as Marshallian utility
approach
 Assumptions of cardinal Utility Approach

Consumer must be rational

Utility I measured in terms of cardinal numbers
Marginal utility of money is constant
Marginal utility of a commodity is diminishing
Utility of a commodity does not depends on
availability of another commodity
 Consumer’s Equilibrium
One Commodity Case

Consumer’s equilibrium refers to the condition from where

there is no tendency to move
In other words Consumer’s equilibrium is a situation
where consumer maximize his/her satisfaction and does
not want to change the level of consumption
According to cardinal utility analysis utility is quantified in
terms of money and measured in cardinal numbers such as
1,2,3,…
Utility is calculated on the basis of amount of money paid
by consumer.
A Consumer will be in equilibrium with marginal uitily of a
commodity equals to marginal utility of money expenditure
 Consumer’s Equilibrium Cont…

Condition for Equilibrium;

MUX = PX. MUM
MUM = MUX/PX
MUX = PX [MUM = 1]
PX.MUM = Marginal Utility of money expenditure
Px = Price of x good
MUX = Marginal Utility of X good
MUM = Marginal Utility Money
Consumer’s Equilibrium Cont…

QA = MU form X commodity
QB = MU from money
QD = MU form X commodity
D QC = MU from money

C E B
Px MUm
Px

MUx

O Q0 Q Q1
 Consumer’s Equilibrium
Two Commodity Case

Consumer’s equilibrium refers to the condition from

where there is no tendency to move
In other words Consumer’s equilibrium is a situation
where consumer maximize his/her satisfaction and
does not want to change the level of consumption
In two commodity case consumer can maximize
his/her satisfaction when the ratio of marginal utility
of a commodity and price of each commodity is
equivalent to marginal utility of money
 Consumer’s Equilibrium Cont…

Condition for Equilibrium;

MUX/ PX = MUM …i [From one commodity case]
MUY/ PY = MUM…ii [From one commodity case]
MUX/PX = MUY/PY = MUM [from i and ii]
This can be generalized for more than two
commodity
MUX/PX = MUY/PY =MUZ/PZ = … = MUM
Price/ Utility
Consumer’s Equilibrium Cont…

A
E E1 Px MUm
Px
Lost Utility

Gained Utility
B

MUY
MUx
O
X0 X Y Y1 Units of commodities
 Criticism

Cardinal measurement of utility is not practical

Marginal utility of money does not remains constant
Diminishing marginal utility is not valid for all types
of goods
Utility are dependent
Failed in classification of goods
No analysis of price effect
 Ordinal Utility Approach
Indifference Curve
Indifference curve is the locus of various
combinations of two goods which yields same level of
satisfaction
Indifferent schedule is a list of combinations
arranged in such a way that consumer is indifferent
regarding preferring any of them.
The curve representing indifferent schedule is
indifferent curve (IC)
If two or more than two indifferent curves are
presented in a same figure, it is known as
indifference map or preference scheldule
Y Goods Indifference Curve and Map

IC1
IC
IC0
O
X Goods
 Law of Diminishing Marginal Rate of
Substitution (MRS)

Marginal rate of substitution is the rate of exchange

between two goods in order to maintain same level of
satisfaction
In other words MRS is the rate of sacrificing units of
a good in order to increase one extra unit of another
good.
MRSXY represent the amount of Y that a consumer
has to give up for gain of one extra unit of X good so
that level of satisfaction remains same
 MRSXY Cont…

Mathematically,
Let us suppose that a consumer consumes only two goods X and Y
and they are substitutable
The utility function of the consumer is given as
U = f(X,Y) … … … (i)
Now, let use suppose that consumer substitutes X for Y such that
his total utility remains the same
When he sacrifice some units of Y goods, total utility will change as
-∆Y. MUY … … … (ii)
Similarly, when he increases some units of X goods, total utility
will change as
+∆X. MUX … … … (iii)
MRSXY Cont…
 Properties of Indifference Curve

Indifference Curve Always Slopes Downwards from

Left to Right
Indifference Curve is convex to the origin
Higher Indifference Curve Yields Higher Level of
Satisfaction than lower one
Indifference Curve Do Not Intersect Each Other
Indifference Curve neither touches any axis
 Budget Line

Budget line is the locus of various combinations of

two goods that can be purchased by spending fixed
income at given price
Budget line is also price ratio of two goods
Budget line indicates purchasing power of the
consumer
Equation of budget line is
B = PX. QX + PY. QY
Slope of budget line = - PX/PY
 Budget Line

Increase in money income or purchasing power

causes rightward shift in budget line
Decrease in money income or purchasing power
causes leftward shift in budget line
If two or more than two budget line are represented
in a figure, it is known as family of budget line.
Consumer’s Equilibrium Under Ordinal Utility Approach

Ordinal utility approach is also known as indifference

curve analysis.
An English Economist F. Y Edgeworth invented the
technique of indifference curve.
Indifference curve were popularized by J. R. Hicks
and R.G.D. Allen
Consumer’s equilibrium is the point where he/she
maximize his/her utility subject to resource constant
At equilibrium consumer is supposed to have spent
entire income on two goods, optimum allocation of
expenditure and maximize satisfaction
 Assumptions

Consumer must be rational

Consumer must have budget line and indifference
map
Price of two goods is given and unchanged
Objective of the consumer is to maximize utility by
spending all money income
Condition for Equilibrium
Necessary (First order) Condition: Budget line
must be tangent with IC
Sufficient (Second order) Condition: IC must
be convex to the origin
Consumer’s equilibrium can be explained by the help of following
figure

A
C
Y Goods

E
X

IC3
D IC2
IC1
O B
Y X Goods
 Income Effect and Derivation of
ICC and Engel Curve

Income effect shows total effect on demand of a

commodity due to change in income of the consumer
Income effect may be classified as positive income
effect and negative income effect
Income Consumption Curve (ICC) is a locus of
equilibrium points at various level of consumer’s
income.
Engel curve introduced by Ernest Engel
Engel curve is the graphical presentation the
relationship between equilibrium quantity purchased
of a commodity and consumer’s equilibrium
Positive Income Effect, ICC and Engel
Curve

A
ICC
Y Goods

Y1 E1
E
Y
E0
Y0
IC3
IC2
IC1
O B G X Goods
X0 X X1 D
 Positive Income Effect, ICC and Engel Curve

F
A
ICC
C
Y Goods

Y1 E1
Y E
Y0 E0
IC3
IC2
IC1
O B G X Goods
X0 X X1 D
Engel Curve

Y1
Income

b
Y a
Y0 c

X Goods
X0 X X1
 Negative Income Effect, ICC and Engel Curve

F
Y Goods (Normal Goods)

Y0 E0 E
Y E1
Y1 ICC
IC1 IC3
IC2

O B G
X0 X D X1

X Goods (Inferior Goods)

 Price Effect and PCC

Price effect shows total effect on consumer’s demand

for a commodity due to change in price of same
commodity.
Fall in price, budget line swings outwards or rightwards
Rise in price, budget line swings inwards or leftwards
Price consumption curve (PCC) is the locus of
equilibrium points of the consumer’s determined by
change in price of the commodity.
Price effect can be seen for substitute goods and
complementary goods
 Price effect for Substitute Goods

E1
Y1
E2
Y0
IC1
IC2
PCC

0 X
X1 B X2 B'
 Price Effect and Demand Curve
Y
A

E1
Y Goods

Y1
E2
Y0
IC1
IC2

0 B X2 B' X
Y X1 X Goods
D
P1 a
Price

P b

D
0 X1 X2 X X Goods
Price effect for Complementary Goods

A PCC

E2
Y0

E1 IC2
Y1

IC1

0 X
X1 B B'
X2
Decomposition of Price Effect into Substitution
and Income Effect Hicksian Approach

E1
E2
E3
IC2
IC1 X
0 Q1 Q3 B D Q2 B'
PE
SE IE
Decomposition of Price Effect into Substitution and Income Effect
Slutsky Approach

E1

IC1
E3 E2
IC3 IC2
0 Q1 B Q3 D Q2 B’ X

PE
SE IE
Decomposition of Price Effect into Substitution and Income Effect
For Inferior Goods

C E1

E2

IC2

E3

IC1
0 X
Q1 Q2 Q3 B D B'
PE IE
SE
Decomposition of Price Effect into Substitution and Income Effect
for Giffen Goods

E2

C IC2

E1

E3

IC1 X
0 Q2 Q1 Q3 B D B'
PE SE
IE
Criticism Of Ordinal Utility Approach

 Unrealistic Assumption
 Old wine in New Bottle
 Law of Transitivity is wrong
 Does not explain about more than two goods
 Based on hypothetical experimentation of IC
 All the Goods are not divisible
 Unable to explain the preferences of consumers
during uncertainty
 Superiority of IC Approach
 More Realistic and Scientific Measurement of Utility
 No Need to Assume Constant Marginal Utility of
Money
 Clear Explanation of Price Effect
 Free From The Assumption of Independent Utility
 Clear Explanation about Giffen Goods
 Similarities

Assumption of Rational Consumer

Proportionality Rule
Diminishing MU and MRS
Same Conclusion
 Direct Taxes Vs Indirect Taxes

Indifferent curve is useful for identification for

welfare of different types of taxes.
Indirect taxes causes more negative effect on
individuals welfare.
It means government must identify new tax base on
direct taxes rather than indirect tax
 Direct Taxes Vs Indirect Taxes

F IC1
C

G E1
E3
Money

IC3
E2
IC2

0 X
Q B' D B
X Goods
 Application of IC on Subsidy

On the other hand in case of cash subsidy the

government provides a lump sum cash income to
the consumer. 
The analysis results that cash subsidy is better than
price subsidy.
 Application of IC on Subsidy

Subsidy is provided by government for promotion

of welfare.
We will explain and compare the effects of two
types of subsidies, price subsidy and lump sum cash
grant, on consumer’s wel­fare.
It is worth noting that price subsidy on a
commodity is also generally called excise subsidy.
Under price or excise subsidy the Government pays
a part of the price of a good and allows the
consumer to buy as many units of the good he
desires at the subsidised price
 Cash Subsidy Vs Price subsidy

A
E3
Income

D E2
G
IC2

I
H
X
O X1 X2B M B’
X goods
 Income Leisure Choice

A
Income

M E1

IC

X
O L B
Leisure
 o u
k Y
a n
Th