Theory of consumer behavior on the basis of Measurement of Utility

Cardinal Utility Theory of Consumer Behavior And Ordinal Utility Theory of Consumer Behavior
Seeks to explain the decision making behaviour of the consumer in demanding a Particular commodity. Economists have offered theories on the basis of the measurement of utility.

Marshallian Cardinal Approach or Marginal Utility Approach or Marshallian Theory of Demand 1. Concept of Utility and its Cardinal 2. Law of Diminishing Marginal Utility 3. Law of Equi Marginal Utility (Income and Substitution Effect)

UTILITY ANALYSIS OF DEMAND-MARSHALL Behaviour of a rational consumer with demand curve (Law of Demand). D curve is downward sloping towards right indicates consumer tends to buy more when P falls. -ve slope = inverse relationship between P and D.

Price

P2 P1 D

Q1

Q2

Qt. Demand

Basic Assumptions of MUA

Cardinal utility-U is measurable. Independent Utility. Additive U Constant MU of Money Diminishing Mu Rationality Introspective Analysis

Law of Diminishing Marginal Utility and The Law of Demand

Utility is the level of satisfaction from the product bought by the customer. Utility is the satisfaction of consumer from consumption which can be measurable ( i.e. be quantified ) and discernible ( i.e. comparable ). Marginal Utility (MU) is +nal U from +nal unit purchased. Law of Demand based on LMU.

Law of Diminishing Marginal Utility and The Law of Demand

From the observation of real life situation, the theory suggests that , the total utility of a consumer will increase through consumption, but for successive units of the goods consumed, the additional or extra units of utility got - the marginal utility will gradually diminish

According to the law, the consumer tries to equalize MU of a commodity with its price so that his satisfaction is maximized and he will reach equilibrium point. MUx=Px When P falls, MU > than P-----No equilibrium , no max of TU. Hence hell decrease MU till = reduced Price. Increase in stock MU decreases. Consumer buys more when P falls.

Marginal Utility of Chocolates and Ice Cream

Chocola tes per Week (Rs. 10) Ice cream per Week (Rs. 10) MU per Rs on Chocol ates MU per Rs on Ice Cream

Total Income limited to Rs. 60 per week. Chocolate and Ice cream both cost Rs. 10. To buy more chocolates, he has to give up ice cream and vice versa. MU goes of chocolates goes on diminishing as he consumes more and more units.

1 2 3 4 5

5 4 3 2 1

10 8 6 4 2

2 4 6 8 10

Assumptions
The wants of a consumer remain unchanged. He has a fixed income. The prices of all goods are given and known to a consumer. He is one of the many buyers in the sense that he is powerless to alter the market price. He can spend his income in small amounts. He acts rationally in the sense that he want maximum satisfaction Utility is measured cardinally. This means that utility, or use of a good, can be expressed in terms of units or utils. This utility is not only comparable but also quantifiable.

The Law of Equi-Marginal Utility

This law states that the consumer maximizing his total utility will allocate his income among various commodities in such a way that his marginal utility of the last rupee spent on each commodity is equal. The consumer will spend his money income on different goods in such a way that marginal utility of each good is proportional to its price. This law states that how a consumer allocates his money income between various goods so as to obtain maximum satisfaction . An extension to the law of DMU. The rationale is that as long as the marginal utility of any two or more goods are different, a consumer will try to consume the good with a higher marginal utility.

MARGINAL UTILITY THEORY

Quantity

Good A TU MU

Good B TU MU QA

POSSIBILITIES QB T U of A & B

0 1 2 3 4 5 6 7 8

0 10 19 27 34 40 45 49 52

/ 10 9 8 7 6 5 4 3

0 24 45 64 80 94 104 110 114

/ 24 21 19 16 14 010 6 4

0 2 4 6 8

7 6 5 4 3

0 + 110 = 110 19 + 104 = 123 34 + 94 = 128 45 + 80 = 125 52 + 64 = 116

Result : M U of A / Price of A = M U of B / Price of B = 7 units of utility / $ 1

Given : Income = $14 ; Price of A = $1 ; Price of B = $2.

Explanation Consumer will be at equilibrium when, MUx/Px=MUy/Py i.e when the ratio of marginal utilities and price are equalized in purchasing the various commodities. If P of X falls, then might be MUx/Px > MUy/Py. To attain equilibrium, consumer will reduce MUx and increase MUy till both ratios are equal. Will purchase more units of X and less of Y. Will substitute of X for Y till both MU and Price of X and Y are equal i.e. MUx/Px = MUy/Py. This Price change is expressed by Marshall as Substitution Effect and Income Effect.

Concept of Utility and its Cardinal

Condition of Consumer Optimum : Utility Maximization  From the example above, the consumer will consume a different quantity of good X and Y.  The MU ( obtained by the last Rs. spent ) derived from the good X & Y will equal so that a state of equilibrium could be reached.  MUx / Px = MUy / Py = MUz / Pz ..... ( A state of consumer optimum )  If the equation is re-written into another form : MUx / MUy = Px / Py ..... ( The ratio of MU of any two goods =Their relative price )

Substitution Effect

When P decreased of a commodity, consumer is induced to substitute more of the relatively cheaper commodity for the dearer one (no change in price). To increase his total satisfaction he purchased of the cheaper commodity. Most common psychological attitude of every consumer. Since SE is always +ve, will buy large Qt. at lower price.

Income Effect
Refers to changes in real income of the consumer due to changes in price. When P decreases , purchasing power of the real income increases, can purchase more with the same money. IE can be +ve, -ve or Zero. When a commodity has relatively high MU, the IE will be +ve such that the surplus amount realized due to P decrease may be spent on the same commodity. IE= 0 , if entire surplus income is spent on some other comm. IE= -ve, if Qt. purchased is less than before ( inferior good). If both SE and IE are +ve, consumer will increase purchase with fall in price. Even if IE is -ve, SE is relatively so forceful that it outweighs -ve IE, the consumer will demand more at reduced prices. Therefore when Price decreases, D increases and vice versa.

Limitations of Law of Equi-Marginal Utility

It is difficult for the consumer to know the marginal utilities from different commodities because utility cannot be measured. Consumer are ignorant and therefore are not in a position to arrive at an equilibrium. It does not apply to indivisible and inexpensive commodity. Ex: TV sets, Houses, etc.

Alfred Marshall accepts the cardinal approach. He further believes that the MU of money is constant. This is a highly controversial assertion but it makes the analysis simpler.

Limitations of Marshallian Approach

Untenable Cardinal measurement of Utility Wrong conception of +ve Utility Homogeneity Assumption is Unrealistic Separate measurement of Utility Constancy of MU of Money Inapplicability in case of Indivisible or bulky goods. Incomplete Analysis of Price Effect Inadequate Explanation of Giffen Goods Limited Scope No empirical Test