ECONOMIC ANALYSIS

Lesson 5. THEORY OF CONSUMER BEHAVIOUR

Module 1. Basic concepts of economics

Lesson 5
THEORY OF CONSUMER BEHAVIOR

5.1 Introduction

A law of economics stating that as a person increases consumption of a product while keeping consumption of other products constant there is decline in the marginal utility that a person derives from consuming each additional unit of that product. This chapter describes these phenomena by explaining the law of diminishing marginal utility.

5.2 The Law of Diminishing Marginal Utility

This is a universal law based upon common consumer behavior that, as one goes on utilizing a commodity, the utility of each next unit (Marginal Utility) go on reducing. It is generally experienced by each person that as one goes on consuming any specific commodity, with each next unit of consumption satisfaction go on decreasing. The reason is that as person starts consuming a commodity to satisfy want, the intensity also starts diminishing and usefulness of commodity also starts decreasing. If the process of consumption of commodity is not stopped then a stage will reach when the consumer will not receive any satisfaction from the consumption of more units of that commodity. If the consumption of commodity is still continued beyond this stage than a dislike for the commodity will be generated resulting in negative marginal utility.

Dr. Alfred Marshall states the law as “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. The law highlights that it is only the additional benefit that decreases and not the total benefit.

5.2.1 Diagrammatic explanation of law

Following Table 5.1 and depicts the marginal and total utility derived by consumer by consuming ice - cream cups.

Table 5.1 Relation between Marginal and Total utility

As can be seen from graph and table, as consumer starts consuming ice cream cups, the additional or marginal utility starts decreasing. The seventh ice cream cup does not provide additional satisfaction. Further consumption beyond seventh cup lead to dissatisfaction. The marginal utility decreases and total utility increases both at diminishing rate.

In the graph, X axis represents number of ice cream cups and Y axis marginal utility. The marginal utility curve slopes downward from left to right indicating, the marginal utility decreases as consumption of ice cream cups increases. When the consumption reaches seventh cup, marginal utility becomes zero and after that it turns negative.

5.2.2 Exceptions to the law of diminishing marginal utility

1. The law is applicable for consumption of similar units only. If after first ice cream cup, the consumer consumes a larger size ice cream cup then first one, the satisfaction also will be more than first cup.

2. For full and through application of the law, appropriate quantity of units should be consumed. If ice cream is fed in terms of spoons, then initially the marginal utility will also increase. Contradicting the law. But finally the marginal utility will also decrease according to the law if consumption is continued with spoon also.

3. The law applies with only reasonable gap between the consumption. If the gap is too long the law does not hold true.

4. The law is applicable to ordinary household items only. For rare items such as old stamps, the satisfaction and marginal utility goes on increasing as consumption increases.

5.2.3 Significance of the law of diminishing marginal utility

The law is helpful to the government to frame tax policy. According to the law utility of money is less for rich man compared to poor. This helps the governments to adopt policy of progressive taxation.

1. The law is helpful to businessmen to set the price of their product. According to the law as the quantity of units of commodity increases with a person, the satisfaction also decreases. Thus he may be inclined to purchase lesser and lesser which can be then induced by reducing the price.

2. The law is helpful to individual to make their routine purchase considering limited money at the disposal. One thus tries to manage the purchase of household items till the utility of money spent is equal to the utility of the last unit of the commodity purchased.

5.3 Law of Equimarginal Utility

The law states that the utility maximizing market basket is one for which the consumer allocates income so that the marginal utility divided by the goods price is equal for every good purchased.

5.3.1 Description of the law

Human wants are unlimited and resources to satisfy them are limited. A rational consumer spends money to get maximum satisfaction by substituting one commodity with other based upon their marginal utilities. This law is therefore also referred to as law of maximum satisfaction or law of substitution. In order to derive maximum satisfaction, a rational consumer analyzes the satisfaction derived from his expenditure. If on analysis it is found that expenditure on a particular item derives more satisfaction then other, then he continuous to purchase that commodity till satisfaction derived from last rupee spent on both the commodity is equal. The law is helpful to all rational consumers, business and service organization, government to allocate the limited resources wisely in the most optimal manner to gain maximum satisfaction

5.4 Cardinal and Ordinal Utility Approach

Theories of consumer behavior are based on the measurement of utility. The two approaches used by economists for measurement of utility are cardinal and ordinal.

5.4.1 Ordinal utility approach

Many economists, notable among them Engene Slutsky, Vilfredo, Pareto, John and Hicks and Kenneth Arrow were of the opinion that consumer cannot measure utility as it is subjective concept. Thus it is not possible to say that a cup of ice cream will give 9 utils (unit to measure the utility) and a gulabjamun will give 4 utils and so on. But it is possible to give the rank for their preferences according to the utility it provides, which is referred to as ordinal measure of utility. The concept of ordinal utility states that “The rational consumer is able to arrange different preferences of goods and services in a scale of preferences”. This implies that consumer is able to state his preference among commodities or state whether he is indifferent among given two commodity bundles. In case of difference in preference, the utility function provides higher numerical score to most preferred choice and lower score to less preferred choice. In case of indifference between two choices same numerical score is assigned to both of them.

5.5 Indifference Curve

Indifference curve indicates the combination of goods between which a person is indifferent.

The important characteristics of indifference curves are as follows:

(1) Indifference Curves are Negatively Sloped: As the consumer increases the consumption of X commodity, he has to give up certain units of Y commodity in order to maintain the same level of satisfaction. Therefore indifference curve slopes downward from left to right. This means that an indifference curve is negatively sloped.

Fig. 5.2 Indifference curve

In Figure 5.2 the two combinations of commodity milk and commodity rice is shown by the points a and b on the same indifference curve. The consumer is indifferent towards points a and b as they represent equal level of satisfaction.

At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and OD units of rice. He is equally satisfied with OF units of ghee and OK units of rice shown by point b on the indifference curve. It is only on the negatively sloped curve that different points representing different combinations of goods X and Y give the same level of satisfaction to make the consumer indifferent.

(2) Higher Indifference Curve Represents Higher Level

A higher indifference curve that lies above and to the right of another indifference curve represents a higher level of satisfaction and combination on a lower indifference curve yields a lower satisfaction.

In other words, we can say that the combination of goods which lies on a higher indifference curve will be preferred by a consumer to the combination which lies on a lower indifference curve.

Fig. 5.3 Higher indifference curve

In this diagram (5.3) there are three indifference curves, IC¹, IC² and IC³ which represents different levels of satisfaction. The indifference curve IC³ shows greater amount of satisfaction and it contains more of both goods than IC² and IC¹ (IC³ > IC² > IC¹).

(3) Indifference Curve are Convex to the Origin

This is an important property of indifference curves. They are convex to the origin (bowed inward). This is equivalent to saying that as the consumer substitutes commodity X for commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference curve.

Fig. 5.4 Indifference curve vonvex to origin

In this figure (5.4) as the consumer moves from A to B to C to D, the willingness to substitute good X for good Y diminishes. This means that as the amount of good X is increased by equal amounts, that of good Y diminishes by smaller amounts. The marginal rate of substitution of X for Y is the quantity of Y good that the consumer is willing to give up to gain a marginal unit of good X. The slope of IC is negative. It is convex to the origin.

(4) Indifference Curve Cannot Intersect Each Other

Given the definition of indifference curve and the assumptions behind it, the indifference curves cannot intersect each other. It is because at the point of tangency, the higher curve will give as much as of the two commodities as is given by the lower indifference curve. This is absurd and impossible.

Fig. 5.5 Indifference curves cannot intersect

In Figure 5.5, two indifference curves are showing cutting each other at point B. The combinations represented by points B and F given equal satisfaction to the consumer because both lie on the same indifference curve IC₂. Similarly the combinations shows by points B and E on indifference curve IC₁ give equal satisfaction top the consumer.

If combination F is equal to combination B in terms of satisfaction and combination E is equal to combination B in satisfaction. It follows that the combination F will be equivalent to E in terms of satisfaction. This conclusion looks quite funny because combination F on IC₂ contains more of good Y (rice) than combination which gives more satisfaction to the consumer. We, therefore, conclude that indifference curves cannot cut each other.

(5) Indifference Curves do not Touch the Horizontal or Vertical Axis

One of the basic assumptions of indifference curves is that the consumer purchases combinations of different commodities. He is not supposed to purchase only one commodity. In that case indifference curve will touch one axis. This violates the basic assumption of indifference curves.

Fig. 5.6 Indifference curves do not touch the horizontal or vertical axis

In Figure 5.6, it is shown that the in difference IC touches Y axis at point C and X axis at point E. At point C, the consumer purchase only OC commodity of rice and no commodity of rice, similarly at point E, he buys OE quantity of rice and no amount of rice. Such indifference curves are against our basic assumption. Our basic assumption is that the consumer buys two goods in combination.

5.6 Consumer Equilibrium

"The term consumer’s equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market".

The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map. "A consumer is said to be in equilibrium at a point where the price line is touching the highest attainable indifference curve from below".

Conditions

Thus the consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRS_xy) must be equal to the price ratio of the two goods. i.e.

MRS_xy = P_x/ P_y

Second: The second order condition is that indifference curve must be convex to the origin at the point of tangency.

Assumptions:

The following assumptions are made to determine the consumer’s equilibrium position.

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods.

(iv) Perfect competition: There is perfect competition in the market from where the consumer is purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

Explanation:

The consumer’s consumption decision is explained by combining the budget line and the indifference map. The consumer’s equilibrium position is only at a point where the price line is tangent to the highest attainable indifference curve from below.

(1) Budget Line should be Tangent to the Indifference Curve:

The consumer’s equilibrium in explained by combining the budget line and the indifference map.

Fig. 5.7 Consumer's equilibrium

In the Figure 5.7 there are three indifference curves IC¹, IC² and IC³. The price line PT is tangent to the indifference curve IC² at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R and S lie on lower indifference curve IC¹ but yield less satisfaction. As regards point U on indifference curve IC³, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. The consumer’s equilibrium position is only at point C where the price line is tangent to the highest attainable indifference curve IC² from below.

(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:

The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is only at a point where the price line is a tangent to the highest possible indifference curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve IC² at point C. The point C shows the combination of the two commodities which the consumer is maximized when he buys OH units of good X and OE units of good Y.

Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio P_x / P_y. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and Y (MRS_xy) is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition being P_x / P_y being satisfied at the point C is:

Price of X / Price of Y = MRS of X for Y

The equilibrium conditions given above states that the rate at which the individual is willing to substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a given price.

(3) Indifference Curve should be Convex to the Origin:

The third condition for the stable consumer equilibrium is that the indifference curve must be convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be diminishing at the point of equilibrium. It may be noticed that in Figure 3.11, the indifference curve IC² is convex to the origin at point C. So at point C, all three conditions for the stable-consumer’s equilibrium are satisfied.

Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the indifference IC². The market basket OH of good X and OE of good Y yields the greatest satisfaction because it is on the highest attainable indifference curve. At point C:

MRS_xy = P_x / P_y