UPES Theory of Consumer Behaviour Dr. B.K.

Chaturvedi

| Jul 2012|

2012 UPES

Approaches to Consumer Behaviour

Approaches to consumer Behaviour

Cardinal Utility Approaches

Ordinal Utility Approaches

1-Propounded By Marshall 2-Known as Marshalling approaches

1-Propounded by J.R. Hicks & R.G.D. Allen 2-Known as indifference Curve analysis

Jul Jul2012 2012

2012 UPES

Cardinal Approaches

The cardinal approaches postulated the utility can be measured. Various suggestions have been made for the measurement of utility. It suggested that utility can be measured in monetary units, by the amount of money the consumer is willing to sacrifice for another units of a commodity. Other suggested measurement of utility in subjective units, called Utils

Ordinal Approaches

The ordinal approach postulated that utility is not measurable, but is an ordinal magnitude. It means the utility only measure in order or rank form.

Jul Jul2012 2012

2012 UPES

The Concept Utility

Utility is a want satisfying power of a commodity. Utility is a synonymous with pleasure, Satisfaction & a sense of fulfillment of desire. Utility is a psychological phenomenon. Utility refers to abstract quality whereby an object serves our purpose. (Jevons)

Utility is the quality of a good to satisfy a want. (Hibdon)

Utility is the quality in commodities that makes individuals want to by them. ( Mrs.Robinson)
Jul Jul2012 2012

2012 UPES

Features of Utility
Utility is the Subjective: Its deals with mental satisfaction of man. for example, Liquor has utility for a drunkard but for a teetotaler, it has no utility. Utility is Relative: Utility of a commodity never remains same. It varies with time, place and person. For example cooler has utility in summer but not during . Utility is not Essentially useful: A commodity having utility need not be useful. E.g., Liquor is not useful, but it satisfies the want of an addict thus have utility for him. Utility is Ethically Neutral : Utility has nothing to do with ethics. use of liquor may not be good from the moral point of view, but as these intoxicants satisfy want of drunkards, they have utility.

Jul Jul2012 2012

2012 UPES

Form of Utility
Total Utility :(TU) The total utility refers to the sum- total of satisfaction which a consumer receives by consuming the various units of the commodity. TU = U1 + U2 + U3 + U4 + . + Un Marginal Utility:(MU) Marginal utility of a good is defined as the change in total utility resulting from one unit change in the consumption of the good.

MUx = Change in total utility/ one unit change in consumption. Or

MU
MU TUn TUn-1
Jul Jul2012 2012

= TUn - TUn-1
= Marginal Utility = Total Utility of n units of a commodity = Total utility of n-1 units of a commodity
2012 UPES

Utility Schedule & Relationship Between TU and MU

Units of good X
0 1

Total Utility (TUx)

0 9

Marginal Utility (MUx)

9

2
3 4 5 6 7 8

16
21 24 25 25 24 21

7
5 3 1 0 -1 -3

Jul Jul2012 2012

2012 UPES

Law of Diminishing Marginal Utility

This is the basic hypothesis of cardinal utility theory. The law of diminishing marginal utility states that as the amount of good consumed increase, the marginal utility of that good tends to diminish.
Units of commodity (Bananas) 1 2 Total Utility (TU) 8 14 Marginal Utility (MU) 8 6

3
4 5 6
Jul Jul2012 2012

18
20 20 22

4
2 0 -2
2012 UPES

Meaning of Consumers Equilibrium

Consumers equilibrium refers to a situation wherein a consumer gets maximum satisfaction from the purchase of the commodity and he has no tendency to make any change in his existing purchase In short, consumers equilibrium represents the state of maximum satisfaction to the consumer from a given money-income. The law of consumers equilibrium is applied when marginal utility and price of a good will be same. There are two approaches to explain the consumers equilibrium. 1- Cardinal Approach (Utility Approaches) 2- Ordinal approach ( Indifference Curve approach)

Jul Jul2012 2012

2012 UPES

Consumers Equilibrium Through Cardinal Approach (Utility Approach)

The concept of consumer's equilibrium through utility approach is based on the following assumptions.

Assumptions
1- Rationality: The consumer is rational. he aims at the maximization of his utility subject to the constraint imposed by his given income. 2- Cardinal utility: The utility of each commodity is measurable. Utility is a cardinal concept. 3-Constant marginal utility of money: This assumption is necessary if the monetary unit is used as the measure of utility. (Mum = 1) 4-Diminishing marginal utility: The law of diminishing marginal utility operates 5- The price of commodities are given and remain constant
Jul Jul2012 2012

2012 UPES

Consumers Equilibrium through Utility approach (Cardinal Approach)

Under these conditions the consumer is in equilibrium when the marginal utility of x (MUx)is equated to its market price(Px). This is also called Equi- Marginal Utility.
In case of single commodity:
Consumers Equilibrium = Marginal Utility of commodity = Price Marginal Utility of a money = = MUx/ MUm MUx = Px = Px . Mum (Where Mum = 1) = MUx = Px
Jul Jul2012 2012

2012 UPES

The Law of Equi-Marginal Utility (In case of two commodities)

Now present the law of equi-marginal utility in a simple two commodity case.Let us suppose that a consumer consumes only two commodities X an Y, their prices being Px and Py, respectively. Following the equiloibrium rule of single commodity case, the consumer distributes his income between commodities X and Y so that MUx =Px (MUm) MUy = Py (MUm)
or alternatively, consumer is in equilibrium where MUx/ Px (MUm) = 1-------------1 and MUy/Py (MUm) = 1-------------2
Jul Jul2012 2012

2012 UPES

from equation 1 & 2 MUx/Px.MUm = 1 = MUy/PyMUm or MUx/MUy = Px (MUm)/Py (MUm) MUx/MUy = Px/Py MUx/MUy = Px/Py = MUM Two two commodity case provides the basis for generalizing the consumers equilibrium by cardinal utility approach. In fact, a consumer consumes a large number of goods and services his equilibrium condition may be expressed as follows. MU1/P1 = MU2/P2= MU3/P3 = MUn/Pn = MUm
Jul Jul2012 2012

2012 UPES

Assumption:
In ordinal approach we assume the consumer possess the following 1- Rationality: The consumer is rational. he aims at the maximization of his utility subject to the constraint imposed by his given income. 2- Utility is ordinal: It is taken axiomatically true that the consumer can rank his preferences according to the satisfaction of each commodity. 3-Diminishing marginal rate of substitution: Preferences are ranked in terms of indifference curve, which are assumed to be convex to the origin. The slope of the indifference curve is called the marginal rate of substitution of the commodities. 4- Consistency & Transitivity of choice: It is assumed that the consumer is consistent in his choice. The consistency assumption may be symbolically written as follows: if A > B, if B is not greater than A

Jul Jul2012 2012

2012 UPES

symbolically we may write the transitivity assumption as fallowsA > B and B > C, then A > C

Concept of Indifference Curve

A curve that shows different combinations of the two goods yielding the same level of utility to the consumer is known as an indifference curve or Equal- Utility curve.

Since all points on the curve yield equal satisfaction, the consumer likes equally all the combination, and is, therefore, indifferent between these combinations.
A table which lists all such combinations to which the consumer is indifferent is known as an indifference schedule.

Jul Jul2012 2012

2012 UPES

Indifference Schedule
Name of the combination Units of goods X Units of good Y

A B C D E F g

1 2 3 4 5 6 7

30 24 19 15 12 10 9

Jul Jul2012 2012

2012 UPES

Marginal Rate of Substitution: (MRS)

The marginal rate of substitution of X for Y (MRSxy) is defined as the number of units of good Y that must be given up in exchange for an extra units of good X so that the consumer maintains the same level of satisfaction. In other words, it shows the rate at which one good is substituted for another good, while remaining on the same indifference curve, thus
Slope of indifference curve = -dy/dx = MRSx,y
MRSxy = - dy/dx = - Change of y/Change of x = MUx/ MUy

Jul Jul2012 2012

2012 UPES

Concept of Budget Set & Budget line

Budget set : Budget set refers to all those bundles that the consumer can
purchase by his money income at the given prices

Budget line: A budget line represents the different combinations of two goods
(or bundles) that the consumer can purchase by spending all his money-income , given prices of the goods. Assume that the consumer has allocated some money to be spent on goods X and Y, whose prices are Px and Py. Then purchasing power can be represented in terms of a budget equation-

Y= Px.Qx + Py.Qy
Y= Px = Py = Qx = Qy = Expenditure on goods X and Y Price of X commodity Price of Y commodity Quantity of X commodity Quantity of Y commodity
2012 UPES

Jul Jul2012 2012

Graphical Presentation of Consumer Equilibrium Through Indifference Curve

Two conditions are essential for consumers equilibrium according to indifference cure analysis 1- Budget line should be tangent to the indifference curve 2- The slope of the indifference curve should be equal to the slope of the budget line. Consumers Equilibrium :

Slope of Indifference Cure MRSxy -dy/dx MUx/Muy

Jul Jul2012 2012

= = = =

Slope of Budget Line Px/Py Px/Py, Px/Py

2012 UPES