Micro Economics

Sessions 18-24
Consumer Behaviour - Cardinal utility
analysis- Law of Diminishing Marginal Utility
Consumer Behavior: Ordinal Utility Analysis-
Notion of Preferences and Indifference;
Indifference curve analysis-; consumer’s
equilibrium; Price effect- Income effect and
substitution effect (Normal Good)
Price Consumption curve and demand curve;
Income consumption curve and Engel curve;
Consumer Surplus
 LEARNING OUTCOMES
• What is consumer behaviour and what is the basis, importance and
factors influencing consumer behaviour.
• Understanding the concepts of cardinal and ordinal utility and
explaining consumer behaviour with the approach of cardinal and
ordinal utility.
• Understanding various concepts related to cardinal utility such as
law of diminishing marginal utility and law of equi- marginal
utility, Marginal rate of substitution.
• Understanding various concepts related to ordinal utility such as
indifference curve, consumer eqm with the help of Indifference
curve and budget line.
• Understanding price and income effect on various categories of
goods.
• Understanding the concepts of consumer surplus and producer
surplus
 Background
• Patanjali wants to launch a new orange flavour juice
brand. It’s Mango, grapes, jamun and bitter gourd juice
are already there in the market.
• Will consumer like it, if yes, will they pay higher prices
for this, if yes, how much, what will be their preferences?
• GOI has introduced a new App BHIM to encourage
people transfer money digitally. Some other Apps are
already there. What will be extent of acceptability of this
App.?
• Theory of consumer behaviour addresses these issues.
• Many more companies have come with new products-
Discuss
 Consumer Behaviour
• Consumer Theory focuses on the decisions made by
individuals about their purchases of goods and services.
(Consumer Preferences)
• It relies on assumptions of rationality & maximisation.
• It studies how a rational consumer will make decisions
about using her income (Budget Constraints)
• How she will respond to changing prices (e.g. higher
food prices)(Budget constraints)
• How her consumption patterns reflect her preferences
• How her consumption pattern and level will change
when her income changes
• And what goods and services she buys(Consumer
• Choices)
 Importance Of Consumer
Behaviour
• Consumer behaviour is important to understand in terms
of what influences the buying decisions of the consumers
and why does it so.
• By understanding what consumers want, it is easy for
producers to decide ‘What to produce’.
• It helps marketers to fill in the gap and identify which
product is needed and which products are obsolete in the
market.
• It also helps marketers decide how to present their
products such that they have maximum impact on
consumers.
•
•
Mini case
WILL CONSUMERS CONSUME?

• Experts argue about when it started, what the first signs were, who saw it
coming, and who was surprised when it got here. But the signs were
undeniable by the early months of 2008: The American economy was headed
for big trouble. Bear Stearns, one of the largest and oldest investment firms,
put itself up for sale. This Wall Street legend had survived the Great
Depression, but it just couldn't cope with the economic downturn the subprime
mortgage crisis ignited. Six months later, Lehman Brothers, a company so old
it was established before the Civil War, prepared to leave the marketplace.
Grave economic news continued through the end of 2008 as the government
bailed out banks and automakers. The year closed with the Dow Jones
Industrial Average below 10 000 for the first time in four years.
•      As the United States rolled into 2009, few things changed. The Dow
continued to descend, reaching below 7000 for the first time in a decade.
Unemployment rose to 8.5 percent, nearly double the rate from two years
before, and everyone realized that the United States, and in fact the world,
was in one of the deepest and most serious recessions most people had
experienced in their lifetimes—now referred to in the media as the Great
Recession.
•      Consumers were confused and caught off guard, but they reacted quickly.
They made swift changes in their consumer behaviour and spending. People
started staying home more—eating out less and cutting back on family
vacations. Data from Nielsen research identified many product categories that
were seeing a drop in sales, and at the same time categories with increases in
their sales patterns.
•      
• Wait, increases? What do people buy more of in a recession? For one thing,
baking staples as well as canning and freezing supplies began to pick up in
sales—in addition to flour and sugar there were increases in sales of jars and
freezer bags. At the other extreme, Nielsen reports that cameras experienced
the biggest sales drop among product categories. As people stayed in more
and travelled less, it's likely that photo opportunities would plummet as well.
Pricey bottled water was another loser as consumers reverted to good old
(and inexpensive) tap water.
•      In addition to cutting back in certain categories, American consumers
started to save, many for the first time in their adult lives. The U.S.
Department of Commerce tracks the personal savings rate of Americans as a
measure of the fraction of personal income that people don't immediately
spend. The rate jumped from 0.3 percent in early 2008 to 4.2 percent in
February 2009.
•      We expect a drop in consumer spending in a recession. But customers'
attitudes toward big business also declined. The Boston Consulting Group
disclosed preliminary results from a survey showing that Americans and
Europeans now have an intensified distrust of big business that might affect
their future spending—even when the economic picture gets brighter. Large
companies need to focus on rebuilding relationships with consumers to help
reduce buyers' skepticism toward big brands.
•      Will Americans return to their old free-spending ways when the economy
improves, or has their attitude toward spending versus saving changed
forever? Will they ever trust big business again? What can brands do to gain
back consumer trust?
 Factors Influencing Consumer
Behaviour
• Psychological factors
• Perceptions of consumers vary across products and
services.
• Psychological factors can be influenced by the present
situation, perception of needs and problems, the ability
to process information and their individual attitude.
• Personal factors
• Personal factors are governed by an individual’s
personal choices and preferences, interests, likes and
dislikes. The sub-factor influencing personal factors can
be age, gender and personal issues.
 Socio-Cultural factors
• Social influence is one of the major driving forces
while making a decision.
• Social class, income, living society, company an
individual keeps; workplace, etc. can have a major
effect on consumer behaviour.
• Of course, influencers and other opinion leaders
have a major role in an individual’s decision-making
process too.
• Other factors include religion, race and nationalities.
 Basic Assumptions

• Rational behaviour, No impulsive behaviour, fully

considering their budget constraints, not swayed by herd
mentality (Behavioural economics)
• Lehman brothers case, equity market behaviour
• Maximising satisfaction
• Consumer preferences are complete: Choosing one set of
goods over the others
• Consumer preferences suppose more is better than less
or consumer is never satisfied; just a little better. C. P.
can be shown by indifference curve
 Consumer’s Behaviour: Cardinal
Utility Analysis
• The basis of what to consume and what to demand is
utility.
• Utility is the want-satisfying "power" of any
commodity or the capacity of a commodity to give
satisfaction.
• Theory of consumer’s behaviour explains the demand
behaviour of the consumer for a good and the factors
determining it.
• It can be put in the following functional form:
• Dx= f(Px, I, Py, P2, T etc.)
• A consumer demands a product because he thinks that
it has the power to satisfy his satisfaction.
 The basic assumptions of
cardinal utility analysis
• Utility is measurable in quantitative terms like
1,2,3…….n
• The measuring rod of utility is money. (Marshall)
• Cardinal utility is measurable we can say that good A
gives us 20 units of utility as against 50 units by
good B.
• Utilities are independent and additive
• Total utility which a person gets from the whole
collection of goods purchased by him is simply the
total sum of the separate utilities of the goods.
 Contd…
• Marginal utility of a good diminishes with the
consumption of successive units at a given point of time.
• Marginal utility of money remains constant
• When price of a good falls and as a result the real
income of the consumer rises, marginal utility of money
to him will fall but Marshall ignored this and assumed
that marginal utility of money did not change as a result
of the change in price.
• By Introspective method we attribute to another person
what we know of our own mind. That is, by looking into
ourselves we see inside the heads of other individuals.
• This is the basis of Law of diminishing marginal utility.
 Law of Diminishing Marginal
Utility
• How will you react if you get the same food to eat,
over and over? Will you be happy? No! How will
you feel if you see the same movie again and again?
Bored!! Right?
• The marginal utility of a good diminishes as an
individual consumes more units of a good.
• In other words, as a consumer takes more units of a
good, the extra utility or satisfaction that he derives
from an extra unit of the good goes on falling.
• The law of diminishing marginal utility means that
the total utility increases at a decreasing rate.
• Marginal utility depends varies from product to
product and depends upon tastes and preferences.
Illustration of the Law of Diminishing
Marginal Utility
diagram
 Exercise
• Class no Total interestMarginal interest
• 0 0 -
• 1 30 30
• 2 55 25
• 3 75 20
• 4 89 14
• 5 99 10
• 6 95 -4
• Why does it happen? Whether it is the true example of LODMU? Relationship
btn TU and MU
• What is the rate of change of MU? And why so.What is opposite of utility?
• Why does it not happen in case of a movie?
• How does LOMU establishe LOD?
•
 Consumer Eqm- Cardinal
approach
• Definition: The Cardinal approach to
Consumer Equilibrium posits that the
consumer reaches his equilibrium when he
derives the maximum satisfaction for given
resources (money) and other conditions. A
consumer is said to be highly satisfied when
he allocates his expenditure in such a way
that the last unit of money spent on each
commodity yields the same level of utility.
Contd…
 Importance and paradox of value
• The significance of the diminishing marginal utility of a
good for the theory of demand is that it helps us to show
that the quantity demanded of a good increase as its price
falls and vice versa.
• The total utility of a commodity does not determine the
price of a commodity and it is the marginal utility which is
crucially important determinant of price.
• Water is available in abundant quantities so that its relative
marginal utility is very low or even zero. P=0.
• Diamonds are scarce and therefore their relative marginal
utility is quite high and this is the reason why their prices
are high..
• Marshallian concept of consumer’s surplus is based on the
principle of diminishing marginal utility.
 Consumer surplus. Con Eq?Is
MU=Price
No. MU Price CS

1 30 20 10

2 28 20 8

3 26 20 6

4 24 20 4

5 22 20 2

6 20 20 0

-2
7 18 20
 Principle of Equi-Marginal Utility
• Assumption
• Consumer is rational
• He wants to maximise his satisfaction
• He allocates his limited income (expenditure) across
various goods and services in such a way that he
maximises his total utility or satisfaction.
• Consumer is in equilibrium position when marginal
utility of money expenditure on each good (X,Y) is the
same. Now, the marginal utility of money expenditure
on a good is equal to the marginal utility of a good
divided by the price of the good. In symbols,
• MUx / Px= MUy / Py ------= Mum (Eqm condition)
Let the prices of goods X and Y be Rs. 2 and Rs. 3
respectively.
 Contd….
• For attaining consumer eqm, he will equate MUx / Px with
MUy / Py while spending his given money income on the
two goods.
• By looking at the Table 7.3 it will become clear that MUx /
Px is equal to 5 utils when the consumer purchases 6 units of
good X and MUy / Py is equal to 5 utils when he buys 4 units
of good Y.
• Therefore, consumer equilibrium is when he is buying 6
units of X and 4 units of Yand will be spending (Rs. 2 x 6 +
Rs. 3 x 4 ) = Rs. 24 on them that are equal to consumer’s
given income.
• MUx / Px = MUy / Py = MUm
• 10/2 = 15/3 =5
diagram
 Quiz
• Suppose the consumer buys one unit less of good X and
one unit more of good Y, what happens? Will he do
that?
• The marginal utility curve is …..
• Horizontal . Vertical. Upward Sloping
• Downward Sloping
• What shape the graph of marginal utility assumes?
• When TU is maximum, MU is-----
• If marginal utility is zero, TU is----
Suppose the price of A is $4 andf
B is $2 What is consumer eqm
Units MU A/ £4 MU B /£2

1 10 11

2 8 10

3 6 9

4 4 8

5 2 7

6 0 6
 Problems- EMP and con eqm
• Pizza price $2,MUp=10, Price of Beer $1, MUb=6
• You can increase Total utility by increasing
consumption of pizza or bear
• - Mup/Pp =10/2 and MUb/Pb=6/1 or 6>5, you should
buy more beer.
2. Cups 1 2 3 4 5
• TU 1.50 2.70 3.60 3.60 2. Is it LDMU? How
many cups of coffee, if its price is $1?
• 3. Price of Apple$7/kg and MUa=14, Price of mango
$2 and Mum=6, what should Mom do to maximise
TU. MUa/Pa=14/7=2 and Mum/Pm=6/2=3. Mom
shld increase consumption of M and reduce
consumption of A
 MCQs
1. CONSUMER IS SAID TO BE IN EQUILIBRIUM, MAXIMIZING HIS TOTAL UTILITY, WHEN
•A the marginal utilities of the two goods consumed are equal.
•B the proportions of the marginal utilities and respective prices are equal.
•C the consumer gets full satisfaction from the consumption.
•D the consumer feels satisfied with his expenditure on the various goods.

•The equi-marginal principle can also be applied in time allocation

problems such as studying for examinations. Suppose you have 3
examinations tomorrow and you only have 6 hours to study today (a usual
case for students who cram during exams!). The subjects covered are
Economics, English and Mathematics. Your objective is to maximize the
average of your grades in these 3 subjects with your limited study time. In
other words, how should you allocate your 6 hours of study time such that
the marginal grade (or additional grade) from the last hour of studying spent
in one subject is just equal to the marginal grade from the last hour of
studying spent in any of the other subjects? If you answer, “I’ll divide my lime
equally among the 3 subjects", that may not really be the most practical (or if
you prefer, strategic) thing to do. Why?
•Use in Budgeting-Allocation of resources in most Productive way
•Multiple product pricing based on MR=MC
•
Allocation of resources
Equi-marginal principle is applied in the allocation of the resource in the
way of production. Example a farmer is having different four agricultural
farms like
• 1. Paddy 2. Mangoes 3. Sugar cane 4. Corns.
• The above four agricultural farms are in the total 80 acres, each farm in
the 20 acres, all together 80 acres. The farmer is having limited 80
employees with him for employing in the four farms for production. In
general, 80 employees are divided and employed for four farms evenly as
each farm will be allotted with 20 employees. However, in reality there is
no need to allot 20 employees for each farm, because mango farm need
less number of employees, whereas paddy farm needs more number of
employees. Sugarcane and corn farms require average number of
employees. Like shown below
Farms Labour employees

Paddy 30
Mangoes 20
Sugarcane 15
Corns 15
Total 80
 Criticism of Cardinal utility
• analysis
(1) Cardinal measurability of utility is unrealistic
• Since utility is a psychic feeling and a subjective thing, it
cannot be measured in quantitative terms. In real life,
consumers are only able to compare the satisfactions
derived from various goods or various combinations of
the goods. Comparability is difficult.
• For applying this law in actual life and equate the
marginal utility of the last rupee spent on different
commodities, the consumers must be able to measure the
marginal utilities of different commodities in cardinal
terms. Habits and customs play important role.
 Contd…
• (2) Hypothesis of independent utilities is wrong
(related goods?)
• (3) Assumption of constant marginal utility of
money is not valid
• As a consumer spends his money income on the
goods, money income left with him declines.
• With this change in real income due to price
change, marginal utility of money will change.
• (4) Marshallian demand theorem cannot
genuinely be derived except in a one commodity
case
 Ordinal Utility Approach: Hicks and
Allen
• Assumptions: i. Rationality: ii. Ordinal Utility:
• Assumes that utility is expressible only in ordinal terms. This implies
that a consumer is only able to express his/her preference for goods.
• iii. Transitivity and Consistency of Choice:
• Implies that consumer choices are assumed to be transitive and
consistent. The transitivity of choice means that if a consumer prefers
A to B and B to C, he/she would prefer A to C. On the other hand, the
consistency of choice means that if a consumer prefers A to B in one
period, he or she cannot prefer B to A in another period.
• iv. Non-satiety: Implies that a consumer is assumed to be non-
satisfied. In other words, it is assumed that consumer does not reach
the level of satisfaction by consuming a good and always prefers a
large quantity of goods.
• Diminishing Marginal Rate of Substitution
 Indifference Curve
• Indifference curve is defined as the locus of various combinations
of two substitute goods, which yield the same utility or level of
satisfaction to a consumer.
• Therefore, a consumer is indifferent between various combinations
of two goods when it comes to making a choice between them. He
simply can order his preferences to a particular combination and
order various combinations is ordinal terms.Schedule, graph and
map
 Marginal Rate of Substitution
• Marginal Rate of Substitution (MRS) refers to a rate at
which one good is substituted for other, while keeping
the level of satisfaction of a consumer constant.
• It is expressed as:MRS x,y = ∆Y/∆X.It is slope of IC
• The decline in the MRS reflects a diminishing marginal
rate of substitution. When the MRS diminishes along
an indifference curve, the curve is convex.
 Properties of Indifference Curve
• i. Indifference curves slopes downward to the right
• a. Two goods can be substituted for each other
• b. As quantity of one good increases, the quantity of
another good decreases, so that the consumer stays at
the same level of satisfaction
• ii. Indifference curve is convex to the origin
• iii. Indifference curve cannot intersect each other
• iv. Higher indifference curve represent higher level
of satisfaction than lower one
 exercise
• 1. Suppose a consumer has income of 10, and buys soda pop
and movies. The price of each good is 1.
• A.Draw a budget line that represents the set of bundles this
individual can afford if they use all their income. (Put movies
on the X axis). Label the places where the budget line intercepts
each axis and the slope of the line.
• B.Suppose that in consumer equilibrium this individual
consumes 7 soda pops and 3 movies. What rules must hold in
consumer equilibrium? Label this bundle in your drawing (call
it point “A”). Draw an indifference curve associated with this
bundle, and explain how its slope at the equilibrium point
relates to the slope of the budget line.
 exercise
• C.Consider the bundle 2 Movies and 8 Sodas. Label this point.
What can you say about the slope of the indifference curve that
passes through the point? (For example, is it bigger than, equal
to, or smaller than -1?)
• D.Now suppose that income goes up to 15. Illustrate how the
budget constraint will change. If both goods are normal, explain
where the new equilibrium will be (your answer might consist
of a region of bundles, rather than just one bundle)
• Suppose that you consume two things: french fries and
bada pav. Your income is 60, the price of french fries is
20, and the price of bada pav is 10. Consider this table of
marginal utilities: Quantity MUs of the two are given in
table.
• Quantity MU FF MU from BP
• 1 200 100
• 2 150 75
• 3 100 50
• 4 50 20
• 5 25 10
• 6 20 5
 exercise
• A.What is the opportunity cost of consuming a Bada
pav?
• B.By consuming one plate FF, and one BP, the
marginal utility per dollar spent from both goods is
10. So is this the equilibrium?
• C.Suppose that you consumed 1 plate FF and 4 BPs.
Why is this not the equilibrium? What is the
equilibrium?
• No, MUff/Pff=MUbp/Pbp at 2 units each as at this
point income is exhausted and MU per rupee spent is
the same for both goods, so this is the equilibrium
Engel curve
 Engel curve

• Given the indifference map representing the

preferences of a consumer and the prices of two
goods X and Y, ICC is the income consumption
curve showing the equilibrium quantities purchased
of commodities by the consumer as his income
increases from Rs. 300 to Rs. 400 and to Rs. 500 per
day.
 Consumer and Producer Surplus
• Consumer and producer surplus. consumer surplus refers to
the difference between the price a consumer is willing to pay
and what he actually pays. It is calculated as: ½(base+ height)
• Producer surplus is the difference between price actually paid
him and the lowest price he is willing to accept.
 Economic Welfare
• Economic welfare is the total benefit available to
society from an economic transaction or situation.
• Economic welfare is also called community surplus.
Welfare is represented by the area ABE in the diagram
below, which is made up of the area for consumer
surplus, ABP plus the area for producer surplus, PBE.
Contd…