Theory of Consumer

Behaviour
Utility and Satisfaction

Cardinal utility-Alfred Marshall –UTILITY IS

MEASURABLE cardinally
 Law of Diminishing Marginal Utility

Ordinal Utility-J.R. HICKS AND R.G.D. ALLEN

Utility not measurable cardinally and it is not
necessary for analysis consumer behaviour
Indifference Curve analysis
 Utility theory
Utility is defined as want satisfying power of the
commodity. Utility is the capacity of a commodity to
satisfy particular human want.
 Marginal Utility- Increase in the total utility as
a result of consumption of additional unit of
commodity.
MUn = TUn – TUn-1 MU = TU/Q
 Total Utility – Sum of the utilities an individual
derives from the total consumption of his
commodity
TU n = U1 + U2 + U3 +………… Un

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Approaches to measurement of utility-
Cardinal Utility approach

Ordinal Utility approach

 Indifference Curve Approach
 Revealed Preference Hypothesis

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CARDINAL UTILITY APPROACH
Utility can be measured in monetary units by the
amount of money consumer is ready to sacrifice for
another unit of commodity.
Measurement of utility can be done in subjective unit
called utils

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ORDINAL UTILITY APPROACH
The utility is not measurable.
Consumer should be able to determine the order of
preferences among different bundle of goods.
Consumer need not know in specific units the utility
of various commodity to know his preferences.

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CARDINAL - Assumptions
 Rationality
 Cardinal Utility
 Diminishing Marginal Utility
 Constant Utility of Money
 Utility is additive

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LAW OF DIMINISHING MARGINAL UTILITY
This law states that as the quantity
of a commodity increases per unit
time, the utility derived by the
consumer from the successive units
goes on decreasing, provided the
consumption of all other goods
remain constant
Law of diminishing Marginal Utility
(Diagram)
Consumer Equilibrium
When a consumer pays price for the commodity he
is consuming, he compares the utility he derives
from the additional unit of commodity with the
utility he sacrifices in terms of price paid for the
unit of commodity
MU = P
In case there are more than two commodities the
equilibrium condition may be expresses as
MU A MU B MU C MU n
   ...........
PA PB PC Pn

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Consumer’s Equilibrium: Cardinal Utility
approach
A consumer is in equilibrium when he maximizes his
TU given his income, consumption expenditure and
prices of the commodities he consumes.
Consumer’s equilibrium tell us how a consumer
allocate his money income to the various goods and
services so that he maximises his satisfation
Consumer’s equilibrium in case of single
commodity
For a consumer his money income and commodity X has
utility for him,
If he has total money and no commodity of X , then
MUm<MUx, MUm =1
So long MUx > MUm, TU can be increased by
exchanging money for the commodity.

MUx is subject to DMR, whereas MUm remains

constant. Therefore consumer will exchange money
income for commodity X as long as MUx > MUm.
The consumer will be in equilibrium at point where MU
x = MU m
In case of single commodity a consumer is in
equilibrium :
MUx = Px (MUm), where MUm= 1
 MUx/Px(MUm)= 1
Horizontal line Px(MU m)
shows constant utility of money
MUx =diminishing MU of X
Px(MU m) intersects MU x at pt. E
where MUx = Px (MUm)
 Law of Equi-Marginal Utility
(Consumer Equilibrium in case of multiple commodity)
Incase a consumer consumes 2 commodities X and Y,
given prices of 2 commodities , Px and Py
The consumer distributes his money income between 2
commodities X and Y , so that
MU x= Px (MU m) and MU y = Py(MU m)
Equilibrium condition incase of
multiple commodities
Derivation of Demand Curve
The basic purpose of consumer behaviour is to derive
demand curve.
We will use single commodity X to derive demand
curve using Marshallian consumer equilibrium
analysis,
MUx =Px. This equilibrium condition is used to derive
demand curve for commodity X as shown in the fig.
below:
 Explanation
Suppose the consumer is in equilibrium at pt. E, where
given price of X at P3, MU x =Px, here equilibrium
Quantity is OQ1.
Now if the price of X falls to P2, the equilibrium
condition will be disturbed making MU x > P3.
Since Mum is constant, the only way to attain
equilibrium is to reduce MUx. This is done only by
buying more of X. thus by consuming Q1Q2 additional
units of X he reduces MU x to E2Q2 and thereby
restores equilibrium condition i.e., MUx =Px.
Panel A shows that when price is P3 equilibrium
quantity is OQ1, When the price decrease to P2, the
equilibrium point shifts downwards to point E2 where
equilibrium quantity is OQ2. similarly when price falls
to P1, equilibrium point shifts to E3 and equilibrium
output is OQ3.
So we find that as price falls quantity demanded
increases. In panel B, the price-quantity combination
corresponding to point E1, E2, and E3 is shown by
pints J, K, L.
By joining the points J.K and L , we get demand curve
Dx, for commodity X, as shown in the diagram. Dx is
the downward Marshallian demand curve
 Criticism of Cardinal Approach

 Satisfaction derived from various commodities

cannot be measured objectively
 Money used for measurement is not correct as it
is not constant and the value of money keeps
fluctuating.
 It is psychological concept, therefore the very law
is questionable.
 The cardinal approach considers the effect of
price changes on the demand curve ( price
effect). This assumption is unrealistic as the
price effect may include income and substitution
effect
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Theory of consumer demand
(Ordinal Approach)
Theory of consumer demand based on Ordinal utility
was developed by tw0 British economists namely, J.R.
Hicks and R.G.Allen in 1934. This approach is also
known as Hicks-Allen approach
Meaning of ordinal utility
The term ordinal utility indicates the consumer’s
preference or choice for one commodity or basket of
goods over another of the same. It is not expressed in
terms of a quantity or in a numerical value.
Ordinal Utility Approach- assumptions
 Rationality
 Utility is Ordinal
 Diminishing Marginal Rate of Substitution
 The total utility of the consumer depends on the
quantity of the commodity consumed i.e.
U=f (q1 q2 ….qn)
 Consistency and transitivity of choice
 Non satiety

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 Indifference Curve
An indifference curve may be defined as the locus of
points each representing a different combination of two
goods yielding the same utility or level of satisfaction.
Therefore the consumer is indifferent between any two
combinations of goods when it comes to making
choice between them.

When such combinations are plotted graphically it

results in a curve called indifference curve or equal
utility curves
Indifference Schedule of Commodities X
and Y
Combinatio Commodity Commodity Utility
n Y X
a 25 5 =U
b 15 7 =U
c 10 12 =U
d 6 20 =U
e 4 30 =U
The IC analysis can be explained with the help of
Schedule and indifference curve

Let us assume that a consumer forms five

combinations a, b, c, d and e of two commodities X
and Y as presented in the Table. All these
combinations yield the consumer the same level of
satisfaction (U). The consumer is therefore
indifferent to the choice between them. The five
combinations of the two commodities X and Y may
be called as an indifference schedule
Indifference curve
 Explanation
When the combinations a, b, c, d and e given in the
table are plotted and joined by a smooth curve (as
shown in the diagram), the resulting curve IC is
known as the indifference curve.
 This curve represents many points showing many
other combinations of X and Y, which yields the same
level of satisfaction.
Therefore the consumer is indifferent to the above
choice between the points on the indifference curve.
Indifference Curve Map
A number of indifference curves representing various
levels of satisfaction form an indifference map

Figure : Indifference Map

Y
Q u a n tity o f Y

IC4
IC3
IC2
IC1

O Quantity of X X

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Marginal Rate of Substitution (MRS)
MRS is the rate at which one commodity can be
substituted for another, the level of satisfaction
remaining the same. The MRS is given by the slope of
the IC curve
MRS FORMULAE
Combination
Commodity X
Commodity Y
Utility
a
Combination Commodity Y Commodity X
25

a 25 5
5
=U
b
15
7
=U
c
10
12
=U
d
6
20
=U

b 15 7
e
4
30
=U

c 10 12
d 6 20
e 4 30
DIMINISHING MRS (DMRS)
Properties of Indifference Curve

 Indifference curve have negative slope

 Indifference Curve are Convex to Origin
 Indifference cannot touch or Intersect each other
 Higher Level of Indifference Curve Represents Higher
Level of Satisfaction

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DIFFERENT SHAPE OF INDIFFERENCE CURVE
Perfect Substitutes Perfect Complimentary
Figure : Perfect Substitutes
Figure ) Perfect Complimentary Commodity

Commodity Y
Y1

Y1

Y1

Y1 IC2
B
IC1
A
0 X1 X2 X3 X4 Commodity X
Commodity X

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Budget Line or Price Line
Budget line shows all the different combinations of the
two commodities that a consumer can purchase, given
his/her income and price of the two commodities

Px.Qx +Py.Qy = M
Where,
 Px=price of good X,
Py = price of good Y
Qx= quantity of good X
Qy= qyantity of good Y
M= consumer’s income
Consumer Equilibrium
IC
Price line
 Figure : Consumer Equilibrium

A
Commodity Y

C IC3
N
IC2
IC1
0 M B
Commodity X

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 Two conditions must be fulfilled for the consumer to be
in equilibrium
 Scope of Indifference Curve (MRS) should be equal
to the slope of budget line

Px MU
MRS xy  MRS xy  x
Py MU y

MU Px
 x

MU y p y

At the point of consumer equilibrium, indifference

curve is convex to the origin, i.e. MRS is
diminishing

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