MODULE II - THEORY OF CONSUMER

BEHAVIOR

Cardinal Utility

Cardinal utility is the idea that the satisfaction (utility) a consumer derives from consuming a
good can be measured quantitatively.

According to the cardinal utility approach:

• Utility is measurable.
• Consumers can assign numerical values to the satisfaction obtained from goods.
• Marshall measured utility in terms of money (willingness to pay), while some later
economists used imaginary units called utils

Law of Diminishing Marginal Utility (DMU)

Meaning:

The Law of Diminishing Marginal Utility is one of the fundamental laws of consumer
behaviour. It states that as a consumer consumes more and more units of the same commodity
continuously, the additional satisfaction (marginal utility) obtained from each successive unit
gradually decreases, while other things remain constant.

Formula:

Marginal Utility (MU) = Change in Total Utility ÷ Change in Quantity

or

MU = ΔTU / ΔQ

Illustration

Suppose a person consumes cups of tea.

 Cups of Tea Total Utility (TU) Marginal Utility (MU)

1 12 12
2 22 10
3 30 8
4 36 6

5 40 4

6 41 1
7 39 –2
8 34 –5

Explanation:
• Total Utility increases up to the sixth cup but at a diminishing rate.
• Marginal Utility falls with each additional cup.
• Beyond the sixth cup, Marginal Utility becomes negative, causing Total Utility to
decline.

Assumptions of the Law

1. Consumption is continuous without long intervals.
2. All units of the commodity are identical in size and quality.
3. The consumer's tastes, habits and preferences remain unchanged.
4. The consumer behaves rationally.
5. Income remains constant.
6. Prices of goods remain constant.
7. Utility is measurable (cardinal utility).
Relationship between Total Utility and Marginal Utility
• When Marginal Utility is positive, Total Utility increases.
• When Marginal Utility decreases, Total Utility increases at a diminishing rate.
• When Marginal Utility becomes zero, Total Utility reaches its maximum.
• When Marginal Utility becomes negative, Total Utility begins to decline.
The law is based on two important facts:
1. Each individual want is satiable. As a consumer consumes more units of a commodity,
the intensity of that want gradually decreases.
2. Goods are not perfect substitutes for one another. A commodity mainly satisfies a
particular want, and once that want is largely satisfied, additional units provide less
satisfaction.
Importance of the Law
1. Explains the Law of Demand
Consumers buy more of a commodity only when its price falls because each additional unit
gives less satisfaction than the previous one.
2. Explains Consumer Equilibrium
A consumer allocates income among different goods so that maximum total satisfaction is
obtained.
3. Explains Diversification of Consumption
Consumers spend their income on a variety of goods instead of purchasing only one commodity
because the marginal utility of a single good keeps diminishing.
4. Basis of Progressive Taxation
As income increases, the utility derived from each additional rupee declines. Therefore, higher-
income individuals can bear a higher tax burden with a smaller loss of satisfaction.

Limitations
1. The law may not apply to rare collections such as antiques, stamps or works of art.
2. It may not hold in the case of addictive goods such as cigarettes or alcohol.
3. It assumes that tastes and preferences remain constant.
4. It assumes continuous consumption and identical units of the commodity.
5. Utility is subjective and cannot be measured accurately.

Law of Equi-marginal Utility (Second Law of Gossen)

Meaning
The Law of Equi-marginal Utility states that a rational consumer allocates his or her limited
income among different goods in such a way that the marginal utility obtained from the last
unit of money spent on each good is equal.

Assumptions
1. Utility is cardinal and can be measured in numerical units (utils).
2. Marginal utility of money remains constant.
3. Consumer behaves rationally and aims to maximise satisfaction.
4. Prices of goods are given and remain constant.
5. Consumer's income is fixed.
6. Goods are divisible.
7. Consumer's tastes and preferences remain unchanged.
8. Utilities obtained from different goods are independent.

Statement of the Law

A consumer reaches equilibrium when the marginal utility obtained from the last rupee spent
on each good is equal.
For two goods X and Y,
MUx/Px = MUy/Py = MUm
where:
• MUx = Marginal utility of good X
• MUy = Marginal utility of good Y
• Px = Price of good X
• Py = Price of good Y
• MUm = Marginal utility of money
If the consumer spends money in such a way that:
MUx/Px > MUy/Py
then the consumer obtains greater satisfaction from spending an additional rupee on good
X than on good Y. Therefore, the consumer will purchase more of X and less of Y.
As more units of X are consumed, its marginal utility falls due to the Law of Diminishing
Marginal Utility. At the same time, consuming fewer units of Y causes its marginal utility
to rise.
This process continues until:
 MUx/Px = MUy/Py
At this point, the consumer cannot increase total satisfaction by changing the allocation of
expenditure. Hence, the consumer is said to be in equilibrium.
For more than two goods, the equilibrium condition is:
MUx/Px = MUy/Py = MUz/Pz = ... = MUn/Pn = MUm
That is, the marginal utility per rupee spent on every good must be equal.

Importance
1) Explains how consumers allocate limited income.
2) Forms the basis of consumer equilibrium.
3) Explains the derivation of the demand curve.
4) Helps households allocate expenditure efficiently.
5) Useful in business decisions regarding advertising and product mix.
6) Provides a principle for allocating scarce resources in public finance.
Limitations
1) Utility cannot be measured objectively.
2) Marginal utility of money is unlikely to remain constant.
3) Consumer behaviour is influenced by habits, emotions, and social factors.
4) Utilities of different goods cannot always be compared.
5) Assumes complete rationality.
6) Ignores uncertainty and changing preferences.

Conclusion
The Law of Equi-marginal Utility explains how a rational consumer distributes expenditure
across different goods to maximise total satisfaction. Although based on restrictive
assumptions, it remains an important foundation of classical consumer theory.
Marshallian Consumer's Surplus
Meaning
Consumer's surplus is the difference between the maximum amount a consumer is willing to
pay for a good and the amount actually paid in the market. It measures the extra satisfaction or
benefit that consumers receive from purchasing goods at the prevailing market price.

Consumer's surplus arises because:

• Consumers are willing to pay different amounts for successive units of a good.
• Due to the Law of Diminishing Marginal Utility, willingness to pay declines as more
units are consumed.
• However, in the market, all units are purchased at the same price.

Consumer Surplus

Consumer's Surplus = Total Utility − Total Expenditure

or

CS = TU − (P × Q)

where:

• CS = Consumer's Surplus
• TU = Total Utility
• P = Market Price per unit
• Q = Quantity Purchased
• P × Q = Total Expenditure
 No. of Marginal Utility Market Price Consumer's Surplus (Net Marginal
Units (₹) (₹) Benefit) (₹)
1 20 12 8
2 18 12 6
3 16 12 4
4 14 12 2
5 12 12 0
Total 80 60 20
• Suppose the market price of the commodity is ₹12 per unit.
• For the first unit, the consumer is willing to pay ₹20 but pays only ₹12, obtaining a
consumer's surplus of ₹8.
• For the second unit, the consumer is willing to pay ₹18 but pays only ₹12, obtaining a
consumer's surplus of ₹6.
• For the third unit, the consumer is willing to pay ₹16 but pays only ₹12, obtaining a
consumer's surplus of ₹4.
• For the fourth unit, the consumer is willing to pay ₹14 but pays only ₹12, obtaining a
consumer's surplus of ₹2.
• For the fifth unit, the consumer is willing to pay ₹12, which is equal to the market price.
Therefore, the consumer's surplus is zero.
• The consumer purchases five units because the marginal utility of the fifth unit is equal to
the market price.
• Total Utility (TU) = ₹20 + ₹18 + ₹16 + ₹14 + ₹12 = ₹80
• Total Expenditure (TE) = ₹12 × 5 = ₹60
• Consumer's Surplus (CS) = Total Utility − Total Expenditure = ₹80 − ₹60 = ₹20.

Law of Demand
Meaning

The Law of Demand states that, other things remaining the same (ceteris paribus), the quantity
demanded of a commodity varies inversely with its price. Thus, when the price of a commodity
falls, the quantity demanded increases, and when the price rises, the quantity demanded
decreases.

The law expresses an inverse relationship between the price of a commodity and its quantity
demanded, assuming that all other determinants of demand remain constant.

Assumptions of the Law of Demand

The Law of Demand holds true under the following assumptions:

• Consumer's income remains constant.

• Prices of related goods (substitutes and complements) remain unchanged.
• Consumer tastes, preferences and habits remain unchanged.
• There is no change in consumer expectations regarding future prices.
• Population remains constant.
• Distribution of income remains unchanged.
• The commodity is not a prestige (Veblen) good or a Giffen good.
• Government policies such as taxes and subsidies remain unchanged.
• Consumers behave rationally.
Price (₹ per unit) Quantity Demanded (Units)

12 10
10 20
8 30
6 40
4 50
Explanation:

The curve indicates an inverse relationship between the price of a commodity and the quantity
demanded, assuming all other factors remain constant (ceteris paribus).

• DD is the demand curve.

• The Y-axis measures the price of the commodity.
• The X-axis measures the quantity demanded.
• At point Q, the price is ₹12, and consumers demand 10 units of the commodity.
• When the price falls to ₹10, the consumer moves to point R, and the quantity demanded
increases to 20 units.
• As the price further falls to ₹8, the consumer moves to point S, and the quantity
demanded increases to 30 units.
• Similarly, at point T, when the price is ₹6, the quantity demanded rises to 40 units.
• At point U, when the price falls to ₹4, consumers demand 50 units.

The Law of Demand forms the basis of the downward-sloping demand curve and explains
consumer behaviour by showing the inverse relationship between price and quantity demanded.

Extension and Contraction in Demand

• Extension and contraction of demand refer to changes in the quantity demanded of a

commodity due to changes in its own price, while all other factors affecting demand
remain constant.
• These changes are represented by a movement along the same demand curve and do
not involve any shift in the demand curve.
• Contraction of demand refers to a decrease in the quantity demanded of a commodity
due to a rise in its price, while all other factors remain constant.
• Initially, the price of the commodity is OP, and the quantity demanded is OM (Point A
on the demand curve).
• When the price falls from OP to OP', the quantity demanded increases from OM to ON.
This increase in quantity demanded is called extension of demand. The increase in
quantity demanded is represented by the distance MN.
• Conversely, when the price rises from OP to OP'', the quantity demanded decreases
from OM to OL. This decrease in quantity demanded is called contraction of demand.
The decrease in quantity demanded is represented by the distance ML.
• Thus, a fall in price leads to an extension of demand, while a rise in price leads to a
contraction of demand.
• Since only the price of the commodity changes and all other factors remain constant,
the consumer moves along the same demand curve. The demand curve itself does not
shift.
Changes in Demand

• A change in demand refers to a shift in the entire demand curve due to changes in
factors other than the price of the commodity.
• A rightward shift of the demand curve indicates an increase in demand.
• This means that consumers are willing and able to buy more of the commodity at every
price than before.
Example:
• Suppose the price of a T-shirt remains ₹500.
• Initially, consumers buy 100 T-shirts per month.
• Now assume consumers receive a salary increase. Since their income has increased,
they purchase 150 T-shirts at the same price of ₹500.
• Because the price has not changed but the quantity demanded has increased, the demand
curve shifts to the right.
Explanation

• Suppose DD is the original demand curve.

• Consumer income increases while the price of the commodity remains unchanged.
• As a result, consumers are willing and able to purchase more of the commodity at every
price.
• Therefore, the demand curve shifts to the right, from DD to D 'D '.
• At price P₁, the quantity demanded increases.
• At price P₂, the quantity demanded also increases.
• At price P₃, consumers again demand more of the commodity than before.
• Thus, a rightward shift of the demand curve indicates an increase in demand.
Leftward Shift in Demand Curve

• Suppose DD is the original demand curve.

• Consumer income decreases while the price of the commodity remains unchanged.
• As a result, consumers are willing and able to purchase less of the commodity at every
price.
• Therefore, the demand curve shifts to the left, from DD to D''D''.
• At price P₁, the quantity demanded decreases.
• At price P₂, the quantity demanded also decreases.
• At price P₃, consumers again demand less of the commodity than before.
Thus, a leftward shift of the demand curve indicates a decrease in demand.

Demand Function

The functional form of demand is a mathematical expression that shows the relationship
between the quantity demanded of a commodity and the various factors that influence it.
The individual demand function can be written as:
• Qd = f (Px, I, Pr, T, A)
• where:
• Qd = Quantity demanded of the commodity
• Px = Price of the commodity
• I = Consumer's income
• Pr = Prices of related goods (substitutes and complements)
• T = Tastes and preferences of the consumer
• A = Advertising expenditure by producers

A market consists of several individuals. Market demand function is obtained by summing up

the demand functions of the individuals constituting the market.