Consumer Theory and Utility Analysis

Unit II: Consumer Theory
BBA/BA-LLB/BA I SEMESTER Principles of Microeconomics

Topics
• Ordinal Utility theory: (Indifference curve approach)
• Consumer’s preferences;
• Interference curves;
• Budget line;
• Consumer’s equilibrium;
• Income and substitution effect;
• Price consumption curve
• derivation of demand curve for a commodity;
• Criticisms of the law of demand

Meaning of
Consumer Behaviour & Utility
• Consumer Behaviour refers to the phenomenon of consumer’s reaction
reflected in the market through the instrumentality of price by way of
preferences and likings.
• The consumer buys a commodity because it gives him satisfaction. In technical
term, a consumer purchases a commodity because it has utility for him.
• Utility of a good is its expected capacity to satisfy a human want. To a
consumer, the utility of a good is the satisfaction which he expects from its
consumption. It is the extent to which it is expected to satisfy his want(s).

Utility Analysis
• The cardinal approach or utility analysis is the neo-classical theory built up by
Marshell, Pigou and others.
• Utility means the want satisfying power of a commodity or service.
• Following are the features of utility.

1) Utility and satisfaction are
different – Utility is the
satisfaction level which a
consumer expects to get from a
commodity while satisfaction
here means actual satisfaction
derived by a consumer.
2. Actual satisfaction may be
more or less than then utility –
Utility is the expected level of
satisfaction which can be more
or less than the actual
satisfaction level.
3. Utility is neutral – It does
not comment or criticize
the consumption of any
commodity (for example,
alcohol, cigarette, etc). It
has nothing to relate with
usefulness.
4. Utility is a subjective concept
– It can differ from person to
person or even for a same
person, from time to time.
5. It is dependent upon
qualities of commodities,
mental level of consumer, time
period.
6. Measurability of utility –
Marshell states that utility
can be measured in
numerical terms. Prof
Boulding provided the unit
of measuring utility –
“utils”.
Features of Utility

Approaches to Consumer Behavior
Cardinal Utility Analysis Ordinal Analysis – Indifference Curve
(Alfred Marshell) (Hicks and Allen)

Cardinal Measurement of Utility
• Cardinal utility approach assumes that utility can be measured in cardinal numbers such as 1,
3, 10, 15, etc.
Total, Marginal & Average Utility
• Total Utility means the sum of utility derived by consuming all the units of a commodity.
• Marginal Utility means the additional utility derived from every successive unit of
consumption of any commodity. It can be defined as the increase in total utility derived every
next unit of consumption.
• Average Utility means per unit Total Utility derived by the consumer.
Formulae
TU = 𝛴MU
MU(n) = TU(n) – TU(n-1) OR ΔTU / ΔQ
AU = TUn / N

Law of Diminishing Marginal Utility
The law of diminishing Marginal Utility states that the additional utility (satisfaction)
derived by every successive unit of consumption of a standard units of a commodity
decreases.
As per Prof. Boulding, “As a consumer increases the consumption of one
commodity, keeping constant the consumption of all the other commodities, the
marginal utility of the variable commodity must eventually decline.”

Tabular Presentation of utilities
X Units TU MU AU
1 10 10 10
2 18 8 9
3 24 6 8
4 28 4 7
5 30 2 6
6 30 0 5
7 28 -2 4

Diagrammatic Presentation of Utilities
-5
0
5
10
15
20
25
30
35
1 2 3 4 5 6 7
TU
MU
AU
TU
Maximum
MU Zero

When MU is positive TU increases
When MU is zero TU is maximum
When MU is negative TU decreases
Relation between MU and TU
Following points are noteworthy in this regard-
▪ As long as MU decreases but remains positive, The TU increases
▪ When MU becomes zero, TU reaches its maximum.
▪ When MU becomes negative, TU starts declining.

Ordinal Approach to Consumer Utility
Ordinal approach is also known as Indifference Curve Analysis. It is the modern version
of the cardinal approach.
Concept of Ordinality –
This concept tells that utility is purely psychological concept which cannot be measured
numerically (cardinally). Consumer can rank goods in order of his preference according
to the psychological satisfaction he/she can derive from them. It is noted that there are
a combinations of two (or more) goods whose combined consumption provides a
certain satisfaction level. This satisfaction level is analysed through ordinal approach.
Indifference curve means that curve which depicts the combinations of two good,
whose consumption provides a same level of satisfaction.

Assumptions
Rational
Behaviour
The consumer is rational. He has full knowledge about the market
conditions and decides the consumption pattern accordingly.
Utility is
ordinal
Utility cannot be numerically measured. It is a psychological concept
which can be measured in order of preference.
Diminishing
MRS
The MRS shall be diminishing. This concept has been discussed in the
following paras.
Two goods There are two goods X and Y.

Indifference Schedule and Indifference Curve
A Schedule means tabular representation and a curve means diagrammatic
representation of combinations of two goods having same level of satisfaction.

Indifference Map
An indifference map is a collection of many indifference curves where
each curve has a separate level of satisfaction.

Features/ Properties of an IC
An IC Slops downward from left to
right.
It is convex to the point of origin. An IC neither touches X or Y
axis nor is be parallel to X or
Y axis.
A higher IC shows higher
level of satisfaction.
Two Indifference curves never cuts
each other as different ICs represent
different levels of satisfaction.
It is generally in the shape of
rectangular hyperbola.

Marginal Rate of Substitution (MRS)
It is defined as the amount of one good, the consumer is
ready to give up for an additional unit of another good
MRS = Loss of good 1/ Gain of good 2

Concept of Diminishing MRS
As we increase the consumption of one commodity, the quantity
sacrificed of another commodity decreases, keeping the satisfaction
level same.

The above example clearly explains the concept. The decreasing gap
between the vertical lines shows the diminishing MRS.

Concept of Budget Line
• It is also known as Price line. A budget line shows all combinations of
two goods which a consumer can buy spending his given income on
the two goods.
• For example, a consumer has Rs. 1000 and he wants to spend it either
on books or movies. Either he can buy 20 books of Rs. 50 each, or he
can watch 40 movies having a ticket of Rs. 25 each.
• The budget line always slopes downward as for purchasing every
additional unit of one good, a consumer has to sacrifice some units of
other goods.

Consumer Equilibrium under IC-Budget line approach
• Consumer Equilibrium is struck at a point where Budget line is tangent to IC curve.
• An IC inside the budget line shows under utilization of budget while an IC outside the budget line cannot be
achieved with the given set of resources (budget).
Conditions for the consumer equilibrium
1) The total amount of money spent on two commodities should be equal to the amount of income available.
• Px.Qx + Py.Qy = Income
2) The budget line is tangent to the IC. At that point, the slope of IC and the slope of Budget line is equal.

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