Unit 2 Demand Analysis - IObjectives:After going through this unit, you will be able to explain:The concept and application of utility and utility maximization in comprehendingconsumer behavior.Indifference curve analysis for figuring out consumer choices and allocation ofbudget between two commodities.Revealed preference theory and its applications in consumer decisionsFoundations of demand and consumer demand behaviorStructure:1.1 Introduction1.2 Concept of Utility1.3 Total Utility and Marginal Utility1.4 Consumer Utility analysis1.5 Law of Diminishing Marginal Utility1.6 Utility maximization and consumer equilibrium1.7 Indifference Curve analysis1.8. Assumptions of Indifference Curve analysis1.9 Concept of indifference curves1.10 Indifference Map1.11 Properties of indifference curves1.12 Budget Line1.13 Consumer’s equilibrium using indifference curves approach1.14 Revealed Preference Theory1.15 Summary1.16 Key words1.17 Self-assessment questions
1.1 IntroductionIn the earlier units we have established that the focus of economics and managerialeconomics is to understand the problems of Scarcity and Choice - the problems offulfilling the unlimited and constantly recurring wants of human beings and business withlimited resources which have alternative uses. Because of scarcity, economies andbusiness should allocate their resources efficiently and effectively. This leads us toconcept of utility, which explicates how individuals, businesses, and economies acquireoptimal satisfaction while dealing with scarcity.1.2 UtilityIn simple words, Utility can be understood as the want satisfying power of a commodity.When a consuming commodities – goods or services- the goal of the consumer is tomaximize the satisfaction. Before dwelling into analyzing consumer behavior based onthe economic concept of utility it is important to outline definitions of the conceptsassociated with consumer’s utility. a) Utility: A measure of the relative satisfaction gained from consuming different goods and services. b) Utility Measurement: A quantification of the satisfaction of wants and needs achieved through the consumption of goods and services. In principle, utility measurement can take one of two forms: Cardinal and Ordinal (i) Cardinal utility is the measurement of satisfaction using numerical values (1, 2, 3, etc.) that are comparable and based on a benchmark or scale. (ii) Ordinal utility is the ranking of preferences (first, second, third, etc.) that are only comparable on a relative basis. While the hypothetical instructional analysis of utility relies on cardinal utility, ordinal utility is a more realistic way to measure satisfaction.
c) Utility Analysis: A part of consumer demand theory that analyses consumer behavior and market demand using the concepts of total utility and marginal utility. The key principle of utility analysis is the law of diminishing marginal utility, which offers an explanation for the law of demand and the negative slope of the demand curve. d) Utility Maximization: The progression or ambition of obtaining the maximum level of gratification from the consumption of goods or services. The goal of maximizing utility is a basic postulation underlying consumer behavior studied in consumer demand theory. It is assumed that consumers make preferences among available alternatives in such a way that they obtain the highest possible level of satisfaction.1.3 Total Utility and Marginal UtilityTwo concepts which are relevant to Utility analysis for an insight into consumer behaviorare Total and Marginal Utility. a) Total Utility: Total utility is a measure of the total satisfaction of wants and needs obtained from the consumption or use of a good or service. b) Marginal Utility: Marginal utility is the additional utility, or extra satisfaction of wants and needs, obtained from the consumption or use of an additional unit of a good or service. Marginal utility is, in other words, the extra satisfaction gained from an extra unit of good. Marginal utility can be expressed as,Marginal utility = change in total utility change in quantity1.4 Consumer Utility Analysis:
The primary focus of utility analysis is on the satisfaction of wants and needs obtained bythe consumption of goods. The utility generated from consumption affects the decision topurchase and consume a commodity. The specific economic use of the term utility in thestudy of consumer behavior means the satisfaction of wants and needs obtained from theconsumption of a commodity. The good consumed need not be “useful” in the everydaysense of the term. It only needs to provide satisfaction. In other words, a frivolous goodthat has little or no practical use, can provide as much utility as a more useful good.Consumers will take into consideration a) How much satisfaction they get from buying and then consuming an extra unit of a good or service b) The price that they have to pay to make this purchase c) The satisfaction derived from consuming alternative products d) The prices of alternatives goods and servicesConsider the following table which describes the Total and Marginal Utility derived fromconsuming successive units of a commodity. No. of units of Total Marginal Utilitya commodity consumed Utility 0 0 0 1 70 70 2 80 10 3 85 05 4 88 03 5 87 -1In the above table shows the total and marginal utility derived by a consumer fromconsuming successive units of commodity show the following trends, a) As the consumer consumes more and more units of a commodity total utility or the total satisfaction derived may initially increase but the rate of increase declines with every next unit consumed.
b) As the consumer consumes more and more units of a commodity the marginal utility or additional satisfaction derived from consuming every next unit of the commodity declines. c) When total utility increases at a diminishing rate, marginal utility declines, and when total utility declines marginal utility becomes negative.In conclusion, the amount of a person’s total utility corresponds to the person’s level ofconsumption. This leads us to the well recognized Law of Diminishing Marginal Utility.1.5 Law of Diminishing Marginal utilityMarginal Utility, as defined earlier is the change in total utility or satisfaction resultingfrom the consumption of one more unit of a good. The premise of diminishing marginalutility states that the utility or additional satisfaction derived from consuming successiveunits of a commodity declines as more and more units of the commodity are consumed.In other words, marginal utility diminishes as more units of a commodity are consumed.Consider the following example,Example - A consumer enjoys successive glasses of his favorite juice. The total andmarginal utility gained from each extra glass of juice is shown in the table below. Totalutility is maximized when marginal utility = zero. Consuming the seventh glass wouldcreate negative utility as total utility falls (marginal utility becomes negative). Glasses of Juice Total Utility Marginal Utility (TU) (MU) 0 0 - 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2 6 30 0 7 29 -1Consider the following diagram,
Utility TU Quantity of a commodity MUThe above diagram presents The Law of Diminishing Marginal Utility diagrammatically.1.6 Utility Maximization and Consumer’s equilibrium a) With one commodity purchase:It is only logical to think that people are generally motivated to do what is best for them,to purchase the most satisfying goods, to make the decisions that do more good thanharm, to improve their overall living standards and well-being. In economic terms wewould say that in general all people tend to maximize their utility. Utility maximizationthen becomes the guiding notion underlying consumer choices.So how much of a commodity does the consumer purchase? The consumer equates thesatisfaction derived from a commodity with its price. He goes on consuming more andmore units of a commodity as long as the additional satisfaction or MU is more than theprice that he pays for the commodity and stops at a point where MU is equal to the price.Beyond this point of equality, because MU continues to diminish as a result of the law ofdiminishing MU, MU becomes less than the unit price of the commodity. Hence,
consumer equilibrium occurs at the point where MU is just equal to the price. This pointcan be expressed as the point at which, Px = MUx,Where, Px is the per unit price of commodity ‘X’ and MUx is the marginal utility derivedfrom consuming the commodity ‘X’. b) With two commodity purchase:Owing to the multiplicity of wants and scarcity of means, wants become competitive.Consumers constantly weigh in their minds whether to buy a little more one or a little lessof another commodity. They have to make a choice between how much to spend onbuying what quantities of various commodities. The concept of utility helps inunderstanding consumer’s equilibrium in such a situation.Suppose the consumer is buying two commodities X and Y. For arriving at consumer’sequilibrium, i.e., the point of maximum satisfaction, the consumer takes intoconsideration two factors, given the total money that he plans to spend on the twocommodities, a) MU of the two commodities b) Their PricesThe equilibrium position will be at a point where, MUx = MUy Px PyWhere,MUx – Marginal Utility of commodity XMUy – Marginal Utility of commodity YPx – Price of commodity XPy – Price of commodity Y1.7 Indifference Curves Analysis
A more advanced form of consumer demand theory involves the analysis of indifferencecurves. This model is used to analyze the choices that consumers make in spending theirlimited incomes on the various goods and services available. Indifference curve analysishas widespread applicability in many other areas, such as the choices employees makebetween work and leisure and the choices investors make among alternative investmentswith different risks and returns.1.8. Assumptions of indifference curves analysisThis analysis is based on the following assumptions about consumer behavior andpreferences, a) The consumer’s preferences are complete. For any two markets baskets, A and B, the consumer can provide an ordinal ranking of these market baskets, indicating one of the following: A is preferred to B (written A>B), B is preferred to A (A<B), or the consumer is indifferent between A and B (A=B). If A>B, this is interpreted to mean that the consumer gets greater utility or satisfaction from market basket A than from market basket B. If A=B, this means the two market baskets provide the same utility or satisfaction. b) The consumer’s preferences are transitive. Given three market baskets A, B and C, if the consumer prefers A to B and also prefers B to C, then the consumer must prefer A to C. If the consumer is indifferent between A and B and also between B and C, then the consumer must be indifferent between A and C. c) The consumer’s wants are insatiable. The consumer always prefers more of a good to less of it, given the quantities of other goods. d) The consumer’s marginal rate of substitution of one good for other goods diminishes as the consumer gets more of that good. That is, the amount of other goods a consumer is willing to give up to get one more unit of good X is lower the
more X she already has. An equivalent statement is that the marginal benefit from good declines as the consumer gets more of that good. e) The goal of the consumer is to maximize utility or satisfaction.Based on these assumptions the indifference curve analysis analyses how a rationalconsumer chooses between two goods. While doing so it combines two concepts;indifference curves and budget lines.1.9. Concept of indifference curvesAn indifference curve is a line or a locus of all those points that show all possiblecombinations of two goods between which a person is indifferent. In other words, it is aline that shows the consumption of different combinations of two goods that will give thesame utility (satisfaction) to the person.The following figure shows an indifference curve when a person is making a choicebetween how many hours of work and how many hours of leisure.In the above diagram the person would receive the same utility (satisfaction) fromconsuming 4 hours of work and 6 hours of leisure, as they would if they consumed 7hours of work and 3 hours of leisure.1.10. Indifference Map
A consumer’s preferences can be completely described by an infinite number ofindifference curves in two-dimensional space, each indifference curve representing adifferent level of utility. Each point in the two-dimensional space represents a particularcombination of good X and spending on other goods, and there will other points thatrepresent other combinations that provide that same utility level. Hence, every point inthe two-dimensional space lies on an indifference curve. An indifference map isillustrated in the following figure,1.11. Properties of indifference curvesGiven the assumptions about consumer behavior stated above, indifference curves havecertain properties, as discussed below. a) Indifference curves are negatively sloped. b) Indifference curves are convex to the origin. c) Indifference curves are non-intersecting. d) Higher indifference curves represent higher levels of satisfaction.1.12. Budget Line
The budget line is an important component when analyzing consumer behavior. Thebudget line illustrates combinations of two goods that can be purchased at given prices,for a given consumer budget. The amount of a commodity that a person can buy willdepend upon their income and the price of the good. The following figure shows a budgetline.The above budget line is constructed for a given budget of Rs.60, Rs.2 per unit of x andRs.1 per unit of y. With a limited budget the consumer can only consume a limitedcombination of x and y, the maximum combinations of the two commodities are the endpoints of the budget line.1.13. Consumer’s Equilibrium using the Indifference Curve approachA rational, maximizing consumer would prefer to be on the highest possible indifferencecurve given their budget constraint. This point occurs where the indifference curvetouches (is tangential to) the budget line. This point of optimum consumption point isillustrated in the following figure,
In the above figure, the optimum consumption point occurs at point A on indifferencecurve I3. It cannot lie below point A, for on all such points consumer does not maximizesatisfaction. The equilibrium cannot be beyond point A, for all such points are outside thebudget line, and hence not attainable. Consumer, hence, maximizes satisfaction at pointA.1.14. Revealed preference ApproachThis theory is associated with the name of Prof. Samuelson. Also called as behavioristordinal-utility theory, it is based on the proposition that the consumer is supposed toreveal his preferences. The theory makes the following assumptions, a) The consumer is rational seeking to maximize satisfaction from the available resources. b) The consumer’s choices are consistent. c) The consumer’s demand for commodities should have a positive relationship with income, i.e., his demand for goods and services should increase with increases in income. d) The consumer exhibits “strong ordering”. Strong ordering indicates that the consumer is very clear about the relative order of his preferences between various commodities, i.e., he clearly specifies his relative preference between
commodities. Strong ordering is distinguished from ‘weak ordering’ in which the consumer may not be able to specify preferences between some commodities.The theory postulates if a person chooses a certain bundle of goods (For e.g. 2 apples, 3bananas) while another bundle of goods is affordable (For e.g. 3 apples, 2 bananas), thenwe say that the first bundle is revealed preferred to the second. It then follows that thefirst bundle of goods is always preferred to the second. Therefore if the consumer everpurchases the second bundle of goods then it must be the case that the first bundle isunaffordable. Further theory states that preferences are transitive. In other words if wehave bundles A, B, C, ...., Z, and A is revealed preferred to B which is revealed preferredto C and so on then it can be concluded that A is revealed preferred to C through Z.1.15. SummaryIt has been established in the earlier unit that because of scarcity, economies and businessshould allocate their resources efficiently and effectively. This leads us to varioustheories that help us understand consumer’s behavior in this unit. An attempt is made toexplain consumer behavior using Utility analysis, Indifference Curves approach and thetheory of Revealed Preference. The key principle of utility analysis is the law ofdiminishing marginal utility, which offers an explanation for the law of demand and thenegative slope of the demand curve. A more advanced form of consumer demand theoryinvolves the analysis of indifference curves. This model is used to analyze the choicesthat consumers make in spending their limited incomes on the various goods and servicesavailable. The Revealed Preference theory, also called as behaviorist ordinal-utilitytheory, is based on the proposition that the consumer is supposed to reveal hispreferences.1.16 Key words a) Utility: A measure of the relative satisfaction gained from consuming different goods and services.
b) Utility Measurement: A quantification of the satisfaction of wants and needs achieved through the consumption of goods and services.c) Cardinal utility: A measurement of satisfaction using numerical values (1, 2, 3, etc.) that are comparable and based on a benchmark or scale.d) Ordinal utility: The ranking of preferences (first, second, third, etc.) that are only comparable on a relative basis.e) Utility Analysis: A part of consumer demand theory that analyses consumer behavior and market demand using the concepts of total utility and marginal utility.f) Utility Maximization: The progression or ambition of obtaining the maximum level of gratification from the consumption of goods or services.g) Total Utility: Total utility is a measure of the total satisfaction of wants and needs obtained from the consumption or use of a good or service.h) Marginal Utility: Marginal utility is the additional utility, or extra satisfaction of wants and needs, obtained from the consumption or use of an additional unit of a good or service.i) Diminishing marginal utility: Utility or additional satisfaction derived from consuming successive units of a commodity declines as more and more units of the commodity are consumed.j) Indifference curves: Locus of points that show different combinations of two goods that will give the same utility (satisfaction) to the person.
k) Indifference Map: A two-dimensional space that describes a consumer’s preferences by an infinite number of indifference curves. e) Budget line: Illustrates the combinations of two goods that can be purchased at given prices, for a given consumer budget.1.17 Self-assessment questions 1. Explain the concept of utility. Discuss utility maximization for explaining consumer behavior. 2. Explain the Law of diminishing marginal utility 3. What is an indifference curve? List its properties. 4. Explain consumer’s equilibrium using indifference curves analysis. 5. Write a brief note on the theory of revealed preference. 6. Utility can be understood as the a) Want satisfying power of a commodity b) Want dissatisfying power of a commodity c) Want revealing power of a commodity d) None of the above 7. Cardinal utility is the measurement of satisfaction using, a) Factual information b) Diagrams c) Ordinal comparisons d) Numerical values 8. The goal of maximizing utility is a basic postulation underlying consumer behavior studied in consumer demand theory. a) True b) False c) Both true and false d) Neither true nor false
9. Which law in economics explains that as the consumer consumes more and more units of a commodity the additional satisfaction derived from consuming every next unit of the commodity declines? a) Law of increasing satisfaction b) Law of increasing pace c) Law of neutrality d) Law of Diminishing Marginal Utility10. Consumers constantly weigh in their minds whether to buy, a) A little more one or a little less of few commodities b) A little more one or a little less of all commodities c) A little more one or a little less of another commodity d) None of the above11. An indifference curve is a line or a locus of all those points that show all possible combinations of two goods between which a person is a) Different b) Indifferent c) Both different and indifferent d) Can’t say12. Fill in the blanks: (i) A consumer’s preferences can be completely described by an ______________number of indifference curves in two-dimensional space. (ii) (iii) Indifference curves are ______________sloped. (iv) Indifference curves are ______________to the origin. (v) Higher indifference curves represent ______________levels of satisfaction (vi) The amount of a commodity that a person can buy will depend upon their ______________and the ______________of the good.
(vii) A rational, maximizing consumer would prefer to be on the ______________possible indifference curve given their ______________ constraint.(viii) Also called as ______________theory, revealed preference theory is based on the proposition that the consumer is supposed to reveal his preferences.