M[1] E 2


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M[1] E 2

  1. 1. MANAGERIAL ECONOMICS MODULE 2 BY Mr. Anirban Christ College Institute of Management Bangalore
  2. 2. Theory of C.B. & approaches to study C.B . <ul><li>Consumer behaviour refers to the study of consumer while engaged in the process of consumption. </li></ul><ul><li>The theory of consumer behaviour is based on the assumption that the consumer is a rational human being. </li></ul><ul><li>Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction of utility. </li></ul><ul><li>There are two basic approaches to the problem of comparison of utilities and hence to determine consumer’s equilibrium : </li></ul><ul><li>Cardinal Approach </li></ul><ul><li>Ordinal Approach </li></ul>
  3. 3. Cardinal Approach <ul><li>Consumer’s equilibrium is a situation in which a consumer has allocated his given income on different available commodities in such a manner that he gets the highest possible utility. </li></ul><ul><li>Utility can be measured in monetary units (i.e. the amount of money) that the consumer is prepared to pay for another unit of the from unit to unit, place to place and time to time. </li></ul><ul><li>Conceptually commodity. </li></ul><ul><li>Utility varies we measure utility in units called utils, and as utils are not defined properly, so, it is not possible to measure utility in terms of units but it helps to understand consumers behaviour. </li></ul><ul><li>There are two concepts of utility : </li></ul><ul><ul><ul><li>Total Utility </li></ul></ul></ul><ul><ul><ul><li>Marginal Utility </li></ul></ul></ul>
  4. 4. Cardinal Approach <ul><li>Total Utility: </li></ul><ul><li>The total utility refers to the sum total of satisfaction which a consumer receives by consuming the various units of the commodity. </li></ul><ul><li>Marginal Utility: </li></ul><ul><li>The marginal utility of a good is defined as the change in the total utility resulting from 1 unit of change in the consumption of good, i.e. </li></ul><ul><li>MUx = TU/ Qx = d/dQx (TUx). </li></ul><ul><li>Assumptions of Cardinal Utility Theory: </li></ul><ul><li>Rationality: </li></ul><ul><li>Consumers are rational & aims at the maximization of his/her utility subject to the given income constraints. </li></ul><ul><li>Cardinal Utility: </li></ul><ul><li>The utility of each commodity is measurable. </li></ul><ul><li>Constant marginal utility of money: </li></ul><ul><li>If the monetary unit is used as the measure of utility, it should be constant. </li></ul><ul><li>Diminishing marginal utility: </li></ul><ul><li>The utility gained from successive units of a commodity diminishes. </li></ul><ul><li>The total utility of a ‘Basket of goods’ depends on the individual commodities, i.e. if there are n commodities in the bundle with quantities X1, X2, ……… Xn the total utility is U = f (X1, X2, ……. Xn).As it is assumed that the total utility is addictive, so, U = U1(X1) + U2(X2) + …………… + Un(Xn). This additivity assumption was dropped later. </li></ul>
  5. 5. Law of Diminishing Marginal Utility <ul><li>The diminishing marginal utility is the basic hypothesis of Cardinal Utility Theory, which states that the Marginal Utility of a good diminishes as an individual consumes more units of a good. </li></ul><ul><li>Here the marginal Utility Declines and the total utility increases at a decreasing rate. </li></ul><ul><li>The law is based on two important facts : </li></ul><ul><ul><li>When an individual no longer wants anymore units of goods, marginal utility of the good become zero. </li></ul></ul><ul><ul><li>The different goods are not perfect substitutes for each other in the satisfaction of various particular wants. </li></ul></ul><ul><li>Assumptions: </li></ul><ul><li>Goods are homogeneous. </li></ul><ul><li>No time gap between the consumption of the different units. </li></ul><ul><li>Consumers are rational. </li></ul><ul><li>Taste, Preferences Fashions remain unchanged. </li></ul><ul><li>Income of the consumer is constant. </li></ul>
  6. 6. Law of Diminishing Marginal Utility (Contd…) <ul><li>Table Showing the total & the marginal Utility: </li></ul>12 10 08 06 04 00 -02 -05 12 22 30 36 40 40 39 34 1 2 3 4 5 6 7 8 Marginal Utility Total Utility Units
  7. 7. Law of Diminishing Marginal Utility (Contd…) <ul><li>Graphical Representation of Law of DMU </li></ul>
  8. 8. Law of Diminishing Marginal Utility (Contd…) <ul><li>Application & Uses: </li></ul><ul><li>Helps in explaining the paradox of Value. </li></ul><ul><li>Explains the law of demand and why demand curve slopes downwards. </li></ul><ul><li>Marshallian concept of “Consumer’s Surplus” is based on it. </li></ul><ul><li>Used in Fiscal Policy </li></ul><ul><li>Used in redistribution of wealth, in order to raise the economic welfare. </li></ul>
  9. 9. Law of Equimarginal Utility <ul><li>Suppose there are only two goods X & Y on which the consumers has to spend a given income. </li></ul><ul><li>The consumer behaviour will governed by two factors : </li></ul><ul><ul><li>Marginal Utility of goods and </li></ul></ul><ul><ul><li>Price of goods. </li></ul></ul><ul><li>The law of Equimarginal utility states that the consumer has to spend his income between the two goods in such a way that the utility derived from the last rupee spent on each good is equal. </li></ul><ul><li>So marginal utility of money expenditure on a good is equal to the proportion of marginal utility of a good and the price of the goods: </li></ul><ul><ul><ul><li>MUe = MUx / Px </li></ul></ul></ul>
  10. 10. Law of Equimarginal Utility (Contd…) <ul><li>The Equimarginal utility theory can be stated as: </li></ul><ul><li>“ The consumer will spend his / her money income on different goods in such a way that marginal utility of each good will proportionate to its price.” </li></ul><ul><li>i.e. MUx / Px = MUy / Py </li></ul><ul><li>Generalising it we can write that, </li></ul><ul><li>MU1/P1 = MU2/P2 = …………. = MUn/Pn </li></ul><ul><li>If MUx/Px = MUy/Py and MUx/Px > MUy/Py, then the consumer will substitute good X for Good Y and as a result of this substitution, The MU of good X will fall and MU of 2 will raise and will continue untill MUx/Px = MUy/Py </li></ul>
  11. 11. Ordinal Approach <ul><li>As utility is subjective it is not possible to measure it in real life and though cardinal approach prompted economists to give sight into consumer behaviour, but due to the limitation economists develop an alternative approach called Ordinal Approach or Ordinal Utility theory. </li></ul><ul><li>The theory deals with the fact that utility from different goods can be rankable but not measurable. </li></ul><ul><li>The assumptions of this theory are: </li></ul><ul><li>Rationality : </li></ul><ul><li>Aim to maximize utility under condition of certainty. </li></ul><ul><li>Complete Ordering: </li></ul><ul><li>All possible goods can be offered into preferred. </li></ul><ul><li>Consistency: </li></ul><ul><li>If consumer prefers bundle B to bundle A at the same time he does not prefer bundle A to bundle B. </li></ul><ul><li>Trasivity: </li></ul><ul><li>If Commodity basket A is preferred to B is preferred to C implies that, A is preferred to C. </li></ul><ul><li>Non Satiety: </li></ul><ul><li>Bigger is preferred to a small bundle. </li></ul><ul><li>N.B. : This theory can be described with the help of Indifference Curve Approach. </li></ul>
  12. 12. Indifference Curve <ul><li>An Indifference curve is the locus of points indicating particular combinations of goods or the baskets of two commodities from which the consumer derives the same level of utility or satisfaction. </li></ul><ul><li>The I.C. is the locus of successive indifferent points or combinations which yield equal level of satisfaction. </li></ul><ul><li>This curve is also known as Iso Utility curve and the different point on the curve represents the same level of satisfaction. </li></ul><ul><li>The equation Indifference curve can be written as : U = f(x,y) </li></ul><ul><li>Total Differentiation of the equation represents : </li></ul><ul><ul><li>dU = df/dx.dx + df/dy.dy </li></ul></ul><ul><ul><li>= MUx.dx + MUy.dy </li></ul></ul><ul><ul><li>Along in the I.C curve satisfaction is constant, so, </li></ul></ul><ul><ul><li>dU = 0, so dy/dx = - (MUx/MUy), So slope of the I.C. curve is < 0. </li></ul></ul>
  13. 13. Indifference Curve <ul><li>Properties of Indifference Curve: </li></ul><ul><ul><li>Indifference curve is down wards sloping. </li></ul></ul><ul><ul><li>It is Convex to the origin. </li></ul></ul><ul><ul><li>Higher Indifference curve represents higher level of satisfaction. </li></ul></ul><ul><ul><li>Two Indifference curves never intersect each other. </li></ul></ul><ul><ul><li>Indifference curve never intersect the axis. </li></ul></ul><ul><ul><li>The collections of Indifference curves is known as indifferent Map. </li></ul></ul>
  14. 14. Indifference Curve <ul><li>Assumptions of Indifference Curve: </li></ul><ul><li>Existence of two products X and Y in a commodity space where both the products are normal and the consumption combinations are positive definite. </li></ul><ul><li>The utility function are dependent which can be written as U = f (x,y) and I.C considers related product where both the products are substitute to each other. </li></ul><ul><li>The level of satisfaction is ordinarily measurable which means ranking of different combinations is possible according to the preference of the consumer. </li></ul><ul><li>The relationship may be indifferent, i.e. if the combinations on A & B or B & C is equally preferable then the combination of A & C must be equally preferable to the consumer. </li></ul><ul><li>The relation may be transitive. </li></ul><ul><li>Application of the diminishing marginal rate of substitution. </li></ul><ul><li>(The marginal rate of substitution of X for Y (MRSx,y) is defined as the no of units of good Y that must be given up in exchange for an extra unit of good X, so that the consumer maintains the same level of satisfaction.) </li></ul>
  15. 15. Indifference Curve <ul><li>Exceptions of I.C. </li></ul><ul><li>Concave to the origin (Product Y is Inferior). </li></ul><ul><li>Straight Line (Products are Perfectly Substitute ). </li></ul><ul><li>L shaped (Products are Complementary ) </li></ul><ul><li>Budget Line / ISO Expenditure Curve: </li></ul><ul><li>Definition: </li></ul><ul><li>The budget line is the locus of different combinations of 2 products say, X and Y by which the expenditure (E) is constant. </li></ul><ul><li>Along the B.L. level of Income is constant and expenditure function can be written as : </li></ul><ul><li>E = f ( X,Y ) </li></ul>
  16. 16. Budget Line <ul><li>Assumptions: </li></ul><ul><li>Existence of 2 products which are close substitute and divisible in small nos. </li></ul><ul><li>Income (M) of the Consumer is constant. </li></ul><ul><li>Price of the products (Px and Py) are constant and market determined. </li></ul><ul><li>Total income spend on 2 products so, “No savings” and “No Loan demand”. </li></ul><ul><li>Derivations of Budget Line: </li></ul><ul><li>M = Px.X + Py.Y </li></ul><ul><li>Y = {(Px/Py).X + M/Py} (In the form of Y = mx + c) </li></ul><ul><li>The above equation has the following characteristics: </li></ul>
  17. 17. Budget Line <ul><li>As the equation is in a linear form so B.L. must be a straight line. </li></ul><ul><li>Slope of the B.L. is – (Px/Py), negatively sloped. </li></ul><ul><li>Intercept of the B.L. is M/Py > 0, so B.L. starts from positive vertical intercept. </li></ul><ul><li>Movement of the consumer is restricted along the B.L. </li></ul><ul><li>Change in the income means parallel shifting of the B.L. in upward or downward direction. </li></ul><ul><li>Change in the price of a single product implies change in the slope of the B.L., either steeper or flatter. </li></ul>
  18. 18. Consumer’s Equilibrium <ul><li>Consumer shall be in equilibrium where he / she can maximize his / her utility subject to his budget constraint. </li></ul><ul><li>This equilibrium considers 3 basic problems of the consumer behaviour: </li></ul><ul><ul><li>Equilibrium satisfaction level. </li></ul></ul><ul><ul><li>Equilibrium commodity combination. </li></ul></ul><ul><ul><li>Distribution of income between two products. </li></ul></ul><ul><li>Conditions: </li></ul><ul><li>Necessary Condition: </li></ul><ul><li>At the equilibrium point, Slope of I.C. = Slope of B.L. </li></ul><ul><li>i.e. MUx / Px = MUy/Py </li></ul><ul><li>Sufficient Condition: </li></ul><ul><li>At equilibrium I.C must be convex to the origin. </li></ul>
  19. 19. Consumer’s Equilibrium <ul><li>Assumptions: </li></ul><ul><li>Existence of the 2 products in the commodity space say X and Y, where both the products are normal, close substitutes, divisible in small units and consumption combinations are positive definite. </li></ul><ul><li>Utility levels are ordinarily measurable and ranking of the different combinations are possible where the utility functions are dependent, i.e. U = f ( X,Y ) </li></ul><ul><li>Level of income (M) and prices of the products (Px and Py) are constant. </li></ul><ul><li>Consumer spends his entire income for the 2 products represents the Income – Expenditure equality. </li></ul><ul><li>Consumers taste and preference is constant. </li></ul><ul><li>The relation ship or the choice of the product combinations may be indifferent or transitive. </li></ul><ul><li>Application of diminishing marginal rate of substitution and principle of substitution. </li></ul>
  20. 21. The Revealed preference Theory <ul><li>Revealed preference theory is given by Prof. PAUL A. SAMUELSON, after criticizing utility analysis given by Marshall and indifference curve analysis by Hicks. </li></ul><ul><li>According to him, utility cannot be measured and preference of an individual cannot be obtained. </li></ul><ul><li>The main merit of this theory is that, Law of demand can be directly derived from this revealed preference axioms with out using indifference curves and most of the restrictive assumptions. </li></ul>
  21. 22. The Revealed preference Theory <ul><li>Assumptions: </li></ul><ul><li>Rationality </li></ul><ul><li>Consistency (A > B, B> A) </li></ul><ul><li>Transitivity </li></ul><ul><li>Taste & Preference of the consumer are given and remain constant during the period of analysis. </li></ul>
  22. 23. The Revealed preference Theory
  23. 24. Consumer’s Surplus <ul><li>Consumer’s surplus is the difference between the total amount of money the consumer would be willing to pay for a quantity of a commodity and the amount he /she actually had to pay for it and this concept is based on DMU. </li></ul><ul><li>CS = TU – (P * Q), otherwise, </li></ul><ul><li>CS = Price prepared to pay – Actual price paid. </li></ul>114 80 194 4 Units 50 40 24 00 20 20 20 20 70 60 44 20 1 2 3 4 CS MP MU Units