Theory of Consumer Behaviour

 Utility analysis is the main pillar of knowledge for the study of

demand

 What is Utility?
It is a pleasure, happiness or satisfaction derived while consuming
goods and services.

 Choices of the consumer are based on maximizing expected

utility/satisfaction
For this the consumer must be able to measure compare the utility of
various bundles of goods

 Measurement of Utility – Cardinal (money/utils) vs Ordinal (ranks)

 The Cardinalists and the theory of Demand
LAW OF DIMINISHING MARGINAL UTILITY:
As we go on consuming additional units of a commodity, the
marginal utility i.e., the pleasure derived from consumption of
the subsequent units diminishes.
CONSUMER EQUILIBRIUM:
When the marginal utility of the commodity is equal to its price.

Symbolically, MU x  Px
where, MU x is Marginal utility of commodity x
Px is price of commodity x.

If, MU x  Px - the consumer will increase quantity consumption of X till its MU is equal
to the price and vice versa.
 Assumptions of the Cardinal Utility Theory
1. Rationality:
The consumer is assumed to be rational that he aims at maximizing his utility subject to his
income constraint.

2. Cardinal measurability of utility

Utility is a cardinal concept and therefore is measurable. The most convenient measurement
of utility is money.

3. Constant marginal utility of money

If the value of money changes, it cannot be used as a measuring rod for utility.

4. Diminishing marginal utility

The marginal utility of a commodity diminishes as the consumer acquires more of it.
 Indifference Curves Analysis

Indifference curves are derived from the ordinal

concept of utility analysis.
Indifference curves are devices to represent
preferences and are used in choice theory.
Developed by F. Y. Edgeworth and V. Pareto and
others in the first part of the 20th century.
An indifference curve is a graph showing
combination of goods for which a consumer is
indifferent, i.e, he derives the same satisfaction
from each of the given combinations.

i.e., a  b  c
 Properties of Indifference Curve
1. Downward slopping
2. Convex to the origin
3. Cannot intersect or meet each other
4. A higher indifference curve represent a higher level of satisfaction
 Drawing Consumer’s Budget Line

Budget Schedule of a Consumer

with a given income (Rs. 1000) and Consumer's Budget-line
prices of goods 25
Bundle Good X Good Y
(@ Re 100) (@Re 50) 20
A 10 0
B 5 10 15

Good Y
C 4 12 10

D 3 14 5

E 2 16
0
F 0 20 0 2 4 6 8 10 12

Good X
Utility Maximization/Consumer’s Equilibrium
 Using Calculus to show
Indifference curves are downward sloping and convex to the origin

U  f ( x, y ) or U ( x, y )

Taking total derivatives

dU dU
dU  d x dy
dx dy
Since, the consumer remains on the same indifference curve, i.e. utility remains same.

So, d U  0
dU dU
Or, d x d y0
dx dy

dy dU dU
 /
dx dx dy

dy f
  1 (ratio of marginal utilities of x and y), it shows the slope of the indifference curve
dx f2
Example:
Linear Utility
 Consumer’s Equilibrium using Calculus

Maximise U = U (X, Y)
Subject to I = Px (X) + Py (Y)

Where, U is Utility, X is quantity of good x, Y is quantity of good y, I is income

or budget of the consumer,
Px is price of good x and Py is price of good y.
 
Since, it is problematic to maximize the utility function using calculus as we have an equality
constraint.

Langrangian function is a tool often used to optimization problems with an equality

constraint.

In general, the Langrangian function is the sum of the original objective function and a term
that involves functional constraint and a Langrangian multiplier ƛ.

The Lagrangian function given as:

Z = U(X, Y) + ƛ [I – Px (X) – Py (Y)] …………………………..(1)
Z = U(X, Y) + ƛ [I – Px (X) – Py (Y)] …………………………..(1)
 
To maximize Z, we find the partial derivatives of Z with respect to X, Y, and ƛ and set them
equal to zero.
 
That is,
∂Z/∂X = ∂U/∂X – ƛPx = 0
∂Z/∂Y = ∂U/∂Y – ƛPy = 0
∂Z/∂ƛ = I – Px (X) – Py (Y) = 0
 
Or, MUx - ƛPx = 0
MUy – ƛPy = 0

Solving for ƛ, MUx/Px = MUy/Py = ƛ

MUx / Px = MUy / Py …………………………(2)

That is, the consumer should buy each good (or X and Y) to the extent that the marginal utilities
of rupee spent on the last unit of each good (X & Y) are equal. This is called the principle of
equi-marginal utility.
Numeric Examples
Maximise utility function given as:
1) U = xy;
Subject to, I = x + y = 10 (where, both the prices of x and y is equal to 1)

2) U = 3x + xy + y
Subject to, I = 4x +2y = 70
Linear Indifference Curve (Perfect Substitutes)
 Right-angled indifference curves (Perfect Complements )

Perfect complements are goods that

are always consumed in fixed
proportions.

A nice example is that of a right shoe

and a left shoe. The consumer likes
shoes, but always wears right and left
shoes together. One extra right or left
shoe does not do him/her any good.