The document discusses the theory of consumption, defining consumption as the final purpose of economic activity and exploring various determinants like income, prices, and consumer preferences. It outlines key concepts such as consumption functions, utility analysis, the law of diminishing marginal utility, and the indifference curve analysis. The document also evaluates the relationship between consumption, consumer behavior, and economic measures in both cardinal and ordinal perspectives.

1. THEORY OF CONSUMPTION
A STUDY
20/02/15
1

2. MEANING
• Consumption is a broader term and it is the essence of economics.
Economists generally consider consumption to be the final purpose of
economic activity, hence consumption per person is a central measure of
an economy’s productive success.
• Consumption in economics means utilization of a product or a commodity
and to derive benefits from the same. The utility of a product will help us
in satisfying our needs and hence it is consumption.
• Consumption can be defined in different ways, but is usually best
described as the final purchase of goods and services by individuals. The
purchase of a new pair of shoes, a burger at the fast food restaurant, or
the service of getting your house cleaned are all examples of
consumption.
2

3. Contd…
• It is also often referred to as consumer spending. Many topics in
economics explore how the income of families and individuals
affects consumption and spending habits.
• Consumption is distinct from consumption expenditure, which is the
purchase of goods and services for use by households.
Consumption differs from consumption expenditure primarily
because durable goods, such as automobiles, computers, mobiles
etc. generate an expenditure mainly in the period when they are
purchased, but they generate “consumption services” (for example,
an automobile provides transportation services) until they are
replaced or scrapped. 3

4. FRAMEWORK
• It deals with the household consumption and household budget.
• Basis of household expenditure and income
• Basis for the study of aggregate demand and supply (macro economics)
• It tries to focus on root level problems of poverty and unemployment.
• Study of consumption behavior helps in studying household functions.
• It is a test for other theories like production, price, market structure and
retail competition of firms.
• It is based on common human rational
• Consumers choice, preference and further utility from a product is
interrelated with each other.
4

5. DETERMINANTS OF
CONSUMPTION
5

6. • INCOME- current real income is the most important determinant of
consumption in the short run. We spend according to the income coming
in. This is the basis for most consumption theory. The term 'real' refers to
how our income is affected by inflation, or the natural rise in prices of
goods and services. Inflation and disposable income are interrelated with
each other.
• PRICES - if prices are higher, then a person's total level of consumption
will be lower, because consuming will use up a higher percentage of a
person's income.
• TAXES - as taxes on goods and services rise, people may not be able to
afford as much as they used to and as a result will consume less. The
income tax rates will also affect our ability and decision to consume.
Higher tax rates lead to less disposable income left.
6

7. • SAVING - people generally have two things they can do with their money.
They can save or they can spend. The more money people save, the less
they have to consume in the short-run.
• CONSUMER PREFERENCES- consumer choice, taste and preferences
also affects our consumption pattern. Sudden panic, rumours also affects
our consumption pattern.
• CONSUMER CONFIDENCE - if people are worried about the economy or
their own future income, they may delay making purchases in order to
provide some safety and extra cash for future expenses. They will save or
delay their consumption until they feel better about what lies ahead.
7

8. • SOCIAL ARRANGEMENTS- Distribution of income by business units,
regional framework, social events and behavioural practices adopted by
units also affects our arrangement of consumption.
• GOVERNMENT POLICIES- Various policies can also affect our
consumption pattern.
• OTHERS- age, family status, sex, family size etc. can also determine
consumption.
8

9. CONSUMPTION FUNCTION
“ Consumption is the sole end and purpose of all
production”
ADAM SMITH
It is a functional relationship between two aggregates-
consumption and income. As income increases so is the
consumption level.
The consumption function is also derived by setting a
relationship between various variables/ determinants of
consumption.
C = a+ b (Y-T) 9

10. EXAMPLE
S.NO DISPOSAB
LE
INCOME IN
Rs.
CONSUMPTI
ON IN Rs.
APC (in%) SAVINGS
1 100 40 40% 60
2 180 80 44.44% 100
3 250 160 64% 90
4 400 210 52.5% 190
5 750 360 48% 390
10

11. PROPERTIES OF CONSUMPTION FUNCTION
 Average propensity to consume (APC)
 Expressed in percentage or in ratio with income
 The total APC starts declining as income increases
 The average propensity to save increases
 APS= 1- APC
 The marginal propensity to consume (MPC) is
MPC= ∆C/∆Y
 The economic significance of MPC lies in filling the gap between
income and consumption through planned investment to maintain a
desired level of income.
11

12. DIVISION
THEORY OF
CONSUMPTION
UTILITY
ANALYSIS
CARDINAL
APPROACH
ORDINAL
APPROACH
12

13. UTILITY ANALYSIS
A STUDY
24/02/15
13

14. MEANING
• It is the ultimate advantage a person receives from consuming a commodity
• Utility is an observable quantity which have a relative value. Total utility is
the aggregate sum of satisfaction or benefit that an individual gains from
consuming a given amount of goods or services in an economy. Usually,
the more the person consumes, the larger his or her total utility will be.
Marginal utility is the additional satisfaction, or amount of utility, gained
from each extra unit of consumption.
• Although total utility usually increases as more of a good is consumed,
marginal utility usually decreases with each additional increase in the
consumption of a good. This decrease demonstrates the law of diminishing
marginal utility. In other words, total utility will increase at a slower pace as
an individual increases the quantity consumed.
• Economist turn to consumer demand theory to understand utility.
14

15. VARIOUS UTILITIES
15

16. APPROACHES
UTILITY ANALYSIS
Cardinal
analysis
Ordinal
analysis
 Law of
diminishing
marginal utility
 Law of equi-
marginal theory
 Propounded:
Marshall, Pigou,
Robertson
 Measurable
 Law of
indifference
curve
 Propounded by
J.R. Hicks, R.G.D
Allen
 Non- measurable
but comparable 16

17. CARDINAL UTILITY ANALYSIS
 It is one of the methodologies to measure the consumer satisfaction.
Cardinal utility states that the satisfaction the consumer derives by consuming
goods and services can be measured with numbers. Cardinal utility is measured in
terms of ‘utils’ (the units on a scale of utility or satisfaction) on a device named
utilometer.
According to cardinal utility the goods and services that are able to derive a higher
level of satisfaction to the customer will be assigned higher scale rate and goods
that result in a lower level of satisfaction will be assigned lower scale rate. Cardinal
utility is a quantitative method that is used to measure consumption satisfaction.
It is assumed that the level of satisfaction will be measured by the income spent
on consumption of certain goods and services.
 EXAMPLE; A fruit, pulses, vegetables will have measurable utility which will
determine the satisfaction level of the consumers.
17

18. EXPLANATION OF THE THEORY
 It is an oldest theory which provides an explanation of
consumer demand for a product.
It stresses on law of demand which establishes an inverse
relationship between price and quantity demanded of a
product.
The demand for a product is affected by various determinants,
which affects the consumption and in return affects the level of
utility (satisfaction)
Developed by Marshall hence it is neo-classical in nature and
is subjected to severe criticisms.
It is a quantitative measure (based on cardinal scales).
It is also based on certain assumptions. 18

19. ASSUMPTIONS
• The consumer is assumed to be rational. He tries to maximize his total utility
under the income constraint. A consumer tries o get maximum satisfaction
from a set up income slab.
• The utility of each commodity is measurable. Utility is cardinal concept. The
most convenient measure is money. Thus utility can be measured
quantitatively in monetary units or cardinal units.
• The utility derived from commodities are measured in terms of money. So,
money is a unit of measurement in cardinal approach. Hence, marginal utility
of money should be constant.
• If the stock of commodities increases with the consumer, each additional
stock or unit of the commodity gives him less and less satisfaction. It means
utility increases at a decreasing rate.
• Utility from a commodity remains static. It is not affected by the consumption
of other commodities.
19

20. RATIONALITY MEASURABILITY
CONSTANCY INDIVIDUAL
UTILITIES
INDEPENDENCE
20

21. LAW OF DIMINISHING MARGINAL UTILITY
A STUDY
25/02/15
21

22. LAW OF DIMINISHING MARGINAL UTILITY
“ THE ADDITIONAL BENEFIT WHICH A PERSON DERIVES FROM A GIVEN
INCREASE OF HIS STOCK OF A THING DIMINISHES WITH EVERY
INCREASE IN THE STOCK THAT HE ALREADY HAS”
MARSHALL
MEANING
The law states that the marginal utility of a good or service diminishes as
an individual consumes more units of a same good or service.
A law states that as a person increases consumption of a product - while
keeping consumption of other products constant - there is a decline in the
marginal utility that person derives from consuming each additional unit
of that product.
22

23. DESCRIPTION
• An individual's wants are unlimited in number yet each individual's want is
satiable. Because of this, the more we have a commodity, the less we want to
have more of it.
• This law state that as the amount consumed of a commodity increases, the
utility derived by the consumer from the additional units, i.e. The marginal
utility goes on decreasing.
• It is based on general psychological, physical and emotional satisfaction of a
human being. The moving averages in satisfaction will be related to the
marginal satisfaction of the human being.
• Example: consumption of pizza will give us highest utility at the first bite but
consequently the utility level will come down with further bites. Same with the
use of services of like banking etc. Induction of employees in the
organization. Use of their services etc. 23

24. ASSUMPTIONS
• All the units of a commodity must be homogeneous.
• The unit of the good must be standard
• There should be no change in taste, preferences or fashion
during the process of consumption
• There must be continuity in consumption
• There should be no change in the price of the substitute goods
• Consumer is rational
• Utilities of various products are interrelated with each other
24

25. EXPLANATION
• As more and more quantity of a commodity is consumed the intensity of
desire decreases and also the utility derived from the additional unit.
• Let’s take an example of coco-cola
No. of bottles/ cans Total utility Marginal utility
1 100 utils 100
2 140 utils 40
3 150 utils 10
4 135 utils -15 25

26. APPLICATIONS
DETERMINATION OF PRICES
CONCEPT OF ‘PARADOX OF WEALTH’ IS RESOLVED (WATER AND
DIAMOND)
LAW OF DEMAND
ECONOMIC POLICIES, FISCAL POLICIES, ECONOMIC PROBLEMS ETC.
THEORY OF SOCIAL WELFARE
 REGIONAL GROWTH
FINANCIAL STABILITY AND GROWTH
26

27. CRITICISM/ CRITICAL EVALUATION
Measurability of utility is unrealistic
More subjective
Individual utility of goods is not possible
Assumption of constancy is not possible
The concept of ‘human greed’ cannot be overlooked
Intoxicants
Giffen paradox
27

28. LAW OF EQUI-MARGINAL UTILITY
26/02/15
28

29. MEANING
The law states that the consumer will distribute his money income
between the goods in such a way that the utility derived from the
last rupee spent on each good is equal.
This principle states that to get maximum utility from the
expenditure of his limited income, the consumer purchases such
amount of each commodity that the last unit of money spent on
each of them affords him the same marginal utility.
A person is given an amount of money, he will spend it in such a
way where is satisfaction is maximum and marginal utility will
match up in proportion with the income spent. 29

30. EXPLANATION
• Most urgent wants needs to be satisfied first as resources are
limited and scarce.
• Limited supply of money or income
• Commodities which satisfies us the most and least will have
different marginal utilities. Hence, a consumer will have to come at
an equi level to get maximum satisfaction
• Also known as Law of Substitution, Law of Marginal Satisfaction or
Gossen’s second law (as propounded by H. H. Gossen)
• We obtain maximum satisfaction when we equalize marginal
utilities by substituting some units of the more useful for the less
useful commodity. 30

31. ASSUMPTIONS
The marginal utilities of the different commodities are
independent of each other and diminish with more and
more purchases
Limited income to spend
Measurability is cardinal
Marginal utility of money remains constant as the
consumer purchases more or less of a commodity
The goods are neither complements nor substitutes
31

32. EXAMPLE
Units of money (in Rs.) Marginal utility of
oranges (in utils)
Marginal utility of grapes
(in utils)
50 30 35
60 28 32
70 22 28
80 18 23
90 15 18 32

33. DIAGRAMMATIC REPRESENTATION
33

34. GENERALIZATION
• THE MARGINAL UTILITY OF EXPENDITURE OF THE LAST UNIT OF MONEY ON
ALL OF THEM MUST BE SAME.
• IT IS ALSO KNOWN AS WEIGHTED MARGINAL UTILITY
MARGINAL UTILITY OF A = MARGINAL UTILITY OF B = MARGINAL UTILITY
OF C
PRICE OF A PRICE OF B PRICE OF C
• THE ECONOMIC MEANING OF THIS EQUATION MEANS THAT UTILITY OF
COMMODITY A MUST BE EQUAL FOR OTHER COMMODITY WHICH A CONSUMER
IS PURCHASING. HENCE,
MARGINAL UTILITY OF A = PRICE OF A
MARGINAL UTILITY OF B PRICE OF B 34

35. IMPORTANCE
• ALLOCATION OF SCARCE RESOURCES
• FACTORS OF PRODUCTION OR PRODUCTION THEORY
OF SUBSTITUTES PRODUCT
• THEORY OF DISTRIBUTION
• SAVINGS
• BALANCE OF CONSUMPTION, INCOME AND PRICE
• MULTIPLE GAINS
• VALID FOR REAL WORLD
35

36. LIMITATIONS
• ROLE OF TASTE AND PREFERENCE, FASHION AND
CUSTOMS
• ALL GOODS ARE NOT DIVISIBLE ALWAYS
(COMPLEMENTARY GOODS)
• SCARCITY OF SOME GOODS
• CONTINUOUS INCOME AND PRICES
• DURABLE GOODS
• UTILITY IS PSYCHOLOGICAL ASPECT
36

37. INDIFFERENCE CURVE ANALYSIS
AN ORDINAL APPROACH
27/02/15
37

38. INTRODUCTION
• The theory is earlier propounded by classical theorist and
economist Edgeworth.
• Later on J. R. Hicks and R.G.D. Allen have criticized Marshall’s
cardinal approach theory. In 1939 hicks reproduced the
indifference curve theory in his book ‘ value and capital’
• It focusses on ordinal approach
• The utility is termed to be ‘psychic’ in nature and so is not
measurable
• The theory is consumer based or consumer centered. The
consumer can only decide what, how, when, where
• It can said be said to be judge mental theory 38

39. MEANING
This ordinal analysis starts with rejecting the idea that utility can be
cardinally measured. The consumer always acts logically and he will
make a choice over the various combinations of commodities.
The consumer can actually rank up the various combinations of
commodities according to their taste, preference, habits or choice.
It is supposed to be more realistic compared to Marshall’s law because
commodities of same nature are actually related with each other
rather than independent in nature.
‘That means a consumer will remain indifferent with various
combinations of products. Thus, an indifference curve is the locus of
all those points representing various combinations of two
commodities giving the same satisfaction to the consumer’
39

40. ASSUMPTIONS
• Rational consumer
• Assumption of consistency
• Preferences or indifferences of a consumer are transitive. Scale of
preference
• Concept of ordinal utility
• Diminishing marginal rate of substitution
• Scales of preferences is independent of the market prices
• Weak ordering
• Transitivity
• Continuity
• More is better
40

41. EXAMPLE
a
b
c
d
e
f
a combination can be a only
a+b
a+b+d
or e+d
and so on
41

42. AN INDIFFERENCE SCHEDULE
VARIOUS
COMBINATIONS
CANS OF COKE (IN
UNITS)
BURGERS (IN UNITS)
A 5 20
B 10 15
C 15 12
D 20 10
E 25 07
42

43. DIAGRAMMATIC REPRESENTATION
Y
20
BURGERS
15
10
IC
05
0 5 10 15 20 25 30 X
CANS OF COKE
43

44. PROPERTIES OF INDIFFERENCE CURVE
02/03/2015
44

45. ‘PREFERENCE’ V/S ‘ INDIFFERENCE’
• Consumer behavior is sufficient enough to rank up the
preferences. Known as scale of preferences
• A consumer is able to mark up the various combinations
according to his preference but cannot exactly tell us ‘how
much he prefers’. Hence, he’s being indifferent.
• A consumer cannot tell us the ‘quantitative differences’
between various levels of satisfaction
• A consumer is capable enough to tell us which goods give
him greater, equal or less satisfaction
• Preference and indifferent relations are transitive 45

46. MARGINAL RATE OF SUBSTITUTION
• It states the rate at which the consumer is prepared to exchange
goods from A to B
• It focusses on the loss of one product to the another product’s
gain
• Marginal rate of substitution of A will diminish as more of good A
is substituted for good B
• E.G. It is quite possible that increase in price of Colgate will
motivate people to purchase more of pepsodent. If it continues
over a period of time, then the marginal rate of substitution of
Colgate will diminish as more and more people will purchase
Pepsodent.
46

47. PROPERTIES OF INDIFFERENCE CURVE
I. III.
II. IV.
INDIFFERENCE
CURVE SLOPE
DOWNWARD TO
THE RIGHT
INDIFFERENCE
CURVES ARE
CONVEX TO THE
ORIGIN
INDIFFERENCE
CURVES CANNOT
INTERSECT EACH
OTHER
A HIGHER INDIFFERENCE
CURVE REPRESENTS A
HIGHER LEVEL OF
SATISFACTION THAN A
LOWER INDIFFERENCE
CURVE
47

48. I. INDIFFERENCE CURVE SLOPE DOWNWARD
TO THE RIGHT
• This property implies on that an indifference curve has a negative
slope.
• This property is based on the assumption that if the amount of one
commodity is increased in one combination the amount of other
one will reduce.
• The commodities in one combination will give the same
satisfaction as of the combination of another one.
• This curve represents those combinations which give the same
amount of satisfaction to the consumer at a same level, hence,
making him indifferent between them.
48

49. ASSUMPTIONS/ REASONS
• The consumer prefers to have more of a commodity
• Other things given remains unchanged or constant
• A consumer being rational remains indifferent with various
combinations of goods
49

50. EXCEPTIONS OF PROPERTY NO.1
a) Indifference curve cannot be straight or horizontal : if a
consumer prefers larger amount of good x, then he will not
prefer the same amount of good y, but will prefer various
combinations of x series. E.G. Food(x) with various combinations
like cereals, pulses, sweets etc. And drinks(y) like water, juice,
cold drinks etc.
Y
A B C D E IC
0 X 50

51. EXCEPTIONS OF PROPERTY NO.1
b) Indifference curve cannot be vertically straight : if the amount of y
increases the amount of good x remains same. The combinations in good x
will not give the same amount satisfaction. i.e. increase in drinks (good y)
will lower down the satisfaction level of combinations of good x
y IC
d
c
b
a
0 M x
51

52. EXCEPTIONS OF PROPERTY NO. 1
c) The indifference curve cannot move upwards : a consumer being
rational and the two different products (x and y ) will not give him the same
satisfaction level. I. E. A consumer will take smaller portion of various
combination of two goods x and y and will get good satisfaction from both,
which itself held invalid with our indifference curve theory.
y
IC
d
c
b
a
0 x
52

53. II. INDIFFERENCE CURVES ARE CONVEX TO THE
ORIGIN
 The marginal rate of substitution between the commodities
diminishes as we move from left down to right. The consumer can
move from product to other one (substitution effect)
 It deals with the fact that consumer will have the same product in
large quantity rather than having variety of goods.
y y
c
concave b convex
a IC ii
ICi
0 IC x 0 x
53

54. A HIGHER INDIFFERENCE CURVE REPRESENTS A
HIGHER LEVEL OF SATISFACTION THAN A LOWER
INDIFFERENCE CURVE
• Higher the curve, higher the satisfaction levels. Shift from one curve to another
shows preferred combination of commodities, which will give us high
satisfaction.
y
Commodity (B)
B
IC ii
IC i
0 A1 A2 x
commodity (A)
54

55. INDIFFERENCE CURVES CANNOT
INTERSECT EACH OTHER
• Indifference curve can never meet or intersect so that only one
indifference curve can pass through any one point in the curve. One
combination of commodities can lie only on one indifference curve.
y
Good (B)
0 A B x
good (A)
55

56. CONSUMER SURPLUS
04/03/2015
56

57. MEANING
“ Excess of price which a consumer would be willing to pay rather than
go without a thing over that which he actually does pay is the economic
measure of this surplus satisfaction……it may be called as consumer
surplus”
Marshall
First formulated by Dupuit in 1844.
Greater the payment, highest the utility and highest the satisfaction
People get more satisfaction from goods rather than they actually pay
for them
57

58. CONCEPTUAL FRAMEWORK
• The total of utilities which a person gets from a good is given by the sum
of marginal utilities of the units of a good purchased and the total price
he actually pays is equal to the price per unit of the good multiplied by
the number of units of it purchased.
Consumer surplus = what a consumer is willing to pay – what he actually
pays
i.e.
Consumer Surplus = ∑ Marginal Utility- Amount spent
• Derived from diminishing marginal utility 58

59. EQUILIBRIUM LEVELS
• The consumer will be in equilibrium when marginal utility from a
commodity becomes equal to its given price.*
*The margin that a consumer is ready to pay is at par or equal level
when he actually pays the price
59

60. CONSUMER SURPLUS AND ITS VARIATIONS
In the context
of demand
curve
In the
context of
change in
price
60

61. In the context of change in price
Y Y
CS-D
P S P CS- P S
P1 T MU
MU
0 MQ X 0 MQ MQ1 X
In the context of demand curve
61