Principles of Micro Economics (BBA 1st)

Chapter # 1 The Theory of Consumer Behavior

The word behavior means way of action. It also means anything a person does that can be
observed in some way.

Consumption:
Consumption means the use of goods and services for direct satisfaction i.e. drinking of water,
treatment from doctor etc.

Consumer Behavior:
The behavior of the people with regard to selection, purchase and consumption of goods and
services for satisfaction of their wants is known as consumer behavior.

Utility:
“The power or ability of any good or service to satisfy human want is called utility”. Hence
utility means satisfaction which a person derives from the consumption of any good or service.
For example water has the power to satisfy thrust, bread has the power to satisfy hunger etc.

Utility and Usefulness:

Utility does not mean usefulness. Many goods are harmful to human health but they have
utility i.e. wine, opium, cigarette, heroin etc.

Initial Utility:
Utility of the first unit of commodity consumed is called Initial Utility.

Positive Utility:
Utility obtained from the use of the units of a commodity before the point of satiety is called
Positive Utility. In other words as long as use of any commodity gives satisfaction, its utility is
called Positive Utility.

Zero Utility or Point of Saturation:

When desire of good is fully satisfied and the use of commodity does not provide any
satisfaction it is called point of satiety or zero utility.

Negative Utility:
Utility obtained from the use of the units of a commodity after the point of satiety is called
Negative Utility. In other words when the use of any commodity gives dissatisfaction then its
utility is called Negative Utility.
[Link].1
What is the relationship between Total Utility and Marginal Utility?
Explain with schedule and diagram.
Ans:
Total Utility:
Utility which is attained from the use of all units of a commodity in a specific time is called total
utility. Total utility is the addition of marginal utility.

Marginal Utility:
Utility of the additional unit consumed is called Marginal Utility. Marginal utility is the rate of
change in total utility. ∆TU
MU =
∆Q
Relationship between Total Utility and Marginal Utility:
The relationship between TU and MU are as under.
1. When MU is positive TU increases.
2. When MU is zero TU is maximum.
3. When MU is negative TU decreases.

Explanation with Schedule: Units of Marginal Total

It is clear from the schedule that marginal utility decreases Good Utility Utility
1 20 20
as a consumer continuously use the units of goods. Total
2 15 35
utility, in the beginning, increases, reaches to maximum
3 10 45
point and then starts decreasing. Up to 4th unit marginal 4 5 50
utility is positive while total utility increases. At 5th unit 5 0 50
marginal utility is zero. At this point total utility is maximum. 6 -5 45
This is saturation point. Here the consumer desire is fully
satisfied. At 6th unit marginal utility become negative and
here the total utility starts decreasing.

Explanation with Diagram:

Diagram also shows the above mention relationship
between marginal utility and total utility. When marginal
utility is positive, total utility increases. When marginal
utility is zero, total utility is maximum and when marginal
utility is negative, total utility starts decreasing.
[Link].2
Explain the law of Diminishing Marginal Utility with the help of
schedule and diagram. Also describe its assumptions and limitations.
Ans:
Introduction:
Classical gave the concept of “measurable utility” and made it obvious with the attainment of
cardinal approach. This approach is based on the notion “utility can be measured into numbers
like 10, 20, and 30 with utilo-meter”. Mr. H. Gossen, a German economist, was first to explain
this law in 1854. Later on Alfred Marshall restated this law.

Law of Diminishing Marginal Utility:

According to Chapman:
The more we have of a thing, the less we want additional increment of it.
In simple words:
Other things remaining the same, continuous use of units of a commodity gives less and less
satisfaction (Marginal Utility) till it reaches to zero and then become negative.

Schedule: Units Marginal Total

(Glass of water) Utility Utility
This law can be explained by taking a very simple example.
Suppose a person starts drinking water. The first glass of 1 10 10
water gives him great pleasure (10 utils), the second glass 2 8 18
3 6 24
of water gives him less satisfaction (8 utils) and the
4 4 28
satisfaction of the third glass of water (6 utils) is less than
5 2 30
the previous one and so on. The marginal utility 6 0 30
diminishes with every next glass of water till it goes down 7 -2 28
to zero and then become negative.

Diagram:
In the figure, the marginal utility of different glasses of
water is measured on the y-axis and the units (glasses
of water) on X-axis. With the help of the schedule, the
points A, B, C, D, E, F and G are derived by the different
combinations of units of the commodity and the
marginal utility. By joining these points, we get the
marginal utility curve. The marginal utility curve has the
downward negative slope. It intersects the X-axis at the
point of 6th unit of the commodity. At this point "F" the marginal utility becomes zero. When
the MU curve goes beyond this point, the MU becomes negative.
Assumptions:
Law of diminishing marginal utility is based on the following assumptions.
1. Cardinal Measurement:
The utility is measurable and a person can express the utility in numbers such as 2 Utils, 4 Utils,
6 Utils, etc.
2. Continuous Use:
The law holds only when units of a commodity are consumed continuously. There should be no
gap or interval between using the units of commodity. A gap or delay in use may loss the
concept of diminishing marginal utility.
3. Suitable Units:
The law applies when units consumed are of suitable size e.g. when a person is thirsty and he
starts drinking water drop by drop, the utility of water will increase instead of decrease because
the units consumed are not suitable.
4. Homogeneous Units:
It is assumed that the units consumed should be homogeneous. If the lateral units are superior
to the previous units, the utility of lateral units will increase instead of diminishing.
5. Taste, Fashion, Customs and Habits Remain the Same:
The taste, fashion and habits of a consumer is assumed to be constant during consumption of a
commodity i.e. a student is eating an apple and during consumption, he is told that apples are
more useful for his memory, the utility will increase rather than decrease.
6. Consumer’s Income Remain the Same:
The law holds when the income of consumer remains constant i.e. if income of consumer
increase, his purchasing power increase and demand for goods and services increase which
shows more value i.e. greater utility.
7. Rationality:
It is assumed that the consumer is rational and his aim is maximum utility.

Exceptions or Limitations:
Following are the limitations of the law.
1. Rare Collections:
The law does not hold in the case of rare collection and antiques. If a man is collecting rare
collection, the more he is able to collect, the greater will be his satisfaction e.g. collection of
ancients coins, stamps, paintings etc.
2. Money, Income and Wealth:
The law does not apply to wealth because wealth gives us purchasing power and we like to get
as much wealth as we can.
3. Knowledge:
The law does not apply on knowledge. As a person acquire more and more knowledge his
desire for getting more knowledge increases.
4. Narcotics and Intoxicants:
The law does not hold well in case of narcotics and intoxicants. A person who is addicts of
intoxicants his utility for successive units increase instead of decrease.
5. Fashion and Demonstration:
Utility of a commodity depends upon fashion. A dress in fashion or used to snob and
ostentation has a greater utility and a dress out of fashion has less utility.

Importance of the Law:

The importance of the law is shown by the following points.
1. Guidance to consumers. 2. Base of law of demand.
3. Guidance to finance minister for taxation.

[Link].3
Explain the law of Equi-marginal utility with the help of schedule and
diagram. Also describe its assumptions and limitations.
Ans:
Introduction:
Classical gave the concept of “measurable utility” and made it obvious with the attainment of
cardinal approach. This approach is based on the notion “utility can be measured into numbers
like 10, 20, and 30 with utilo-meter”.

Law of Equi-Marginal Utility:

According to Marshall:
If a person has a thing, which he can put to several uses, he will distribute it among these uses
in such a way that it has the same marginal utility in all.
In simple words:
Other things remaining the same, equilibrium position reaches when marginal utility of all the
commodities purchased are exactly equal.

Consumer’s Equilibrium:
A consumer attains equilibrium when he spends his limited income on different goods in such a
way that MU and their price ratio become equal.
MUA MUB MUC MUX
= = = ----------------- =
PA PB PC PX
Schedule:
Law of Equi-marginal utility can be explained with the help of schedule.
Here we can assume that Units of M.U M.U
1. Consumer has a given income of Rs.5 money of X of Y
2. He purchases only two commodities X and Y. 1 12 10
3. Prices of both commodities are Rs.1 for a unit. 2 10 8
4. Marginal utility of both commodities are given. 3 8 6
5. Consumer is rational. 4 6 4
It is clear for the table that Consumer has various combinations in 5 4 2
his mind. Total 40 30
Combination 1:
If the consumer spends whole of his income (Rs.5) on commodity X, total satisfaction is
12+10+8+6+4 = 40.
Combination 2:
If he spends whole income (Rs.5) on commodity Y, the total satisfaction is 10+8+6+4+2 = 30.
Combination 3:
But if the consumer spends 3 units of money on commodity X and 2 units of money on
commodity Y, his total satisfaction will be maximum 12+10+8+10+8=48 because marginal
utilities of last units of both commodities are equal and if consumer spends his income except
this, his total satisfaction will not be maximum. It means that consumer gets maximum
satisfaction when he purchases 3 units of X and 2 units of Y.
This is the reason that this law is called “law of maximum satisfaction”. This law is also called
“law of substitution” and “law of indifference”.

Diagram:
In diagram the units of money are
taken on x-axis and marginal utility at
y-axis. Consumer is in equilibrium
position when he is spending 3 units on
commodity X and 2 units on
commodity Y but if spend 4 units on
commodity X and 1 units on
commodity Y than the gain in utility is
less than loss in utility, so satisfaction
will not be maximum. The only single
position where consumer gets maximum satisfaction is that when marginal utilities of both
commodities are equal.
Exceptions or Limitations:
Following are the limitations of the law of Equi-marginal utility.

1. Measurement of Utility is Impossible:

Utility is a mental phenomenon so it is not possible for a consumer to show utility in numerical
values, so we can neither add, nor compare and equalize utility.

2. Indivisibility of Goods:
The law is not applicable in case of indivisible goods e.g. motorcycle, tractor, cow, and fan etc.
Therefore utility of individual parts cannot be compared.

3. Ignorance of Consumer:
Some consumers are not aware of the useful alternatives. Therefore no substitution taken
place and law does not hold true.

4. Snobbery, Ostentation and Fashion:

The law does not hold well when people spend money under the influence of ostentation and
fashion. In such causes they do not equalize marginal utility or tries to attain maximum
satisfaction.

5. Time Period:
The utility of a good is measured by its duration of use. Some commodities are consumed
before the expected period while some goods are used more than the expected period. So the
idea of utility becomes wrong i.e. either we under estimate or over estimate utility.

Importance of the Law:

1. Guidance to consumers.
2. Guidance to Producers.
3. Guidance to finance minister for taxation.
4. Guidance for government expenditures.
5. Guidance for distribution of wealth.

[Link].4
What is an indifference curve? Explain its Properties.
Ans:
Introduction:
Classical thought on utility was criticized by neo-classical economists. They said, “Utility is
immeasurable”. It can be imagined only and not be expressed in numbers like 10, 20 and 30.
Therefore they named their approach “Ordinal approach on utility”.
Definition of Indifference Curve:
According to Rees:
“A curve showing a series of bundles of two goods between which a consumer is indifferent”.
In simple words:
“An indifference curve represents the combinations of two goods which give equal level of
satisfaction to consumer”.

Assumptions:
Following conditions shows the right position of indifference curve.
1. There are two goods only as X and Y.
2. The prices of two goods are given.
3. The consumer is rational and he wants to maximize satisfaction.
4. The taste, habits and income of consumer remain constant.
5. The consumer has complete information about market.
6. The consumer prefers more of X to less of Y.
7. He arranged the two goods in a scale of preference.
8. The preferences and indifferences are transitive.
9. The consumer can order all possible combination of two goods.

Indifference Schedule:
Commodities Units of X Units of Y MRS = ∆X/∆Y Satisfaction
A 1 12 -------- Same
B 2 8 1:4 Same
C 3 5 1:3 Same
D 4 3 1:2 Same
E 5 2 1:1 Same
According to schedule, the consumer has four pairs of two goods which will give him equal level
of satisfaction. As the consumer increase the units of X, he has to decrease the units of Y for same
satisfaction. As the consumer substitute one good with other, this process is known as marginal
rate of substitution.

Diagram:
In the diagram good X has been taken on X-axis and good Y has
been taken on Y-axis. IC has been drawn by joining the point A, B,
C, D and E. Indifference curve is downward sloping and convex to
the origin which shows decreasing marginal rate of substitution.
The shadowed area shows MRSXY = ∆X/∆Y
Characteristics or Properties of an Indifference Curve:
The indifference curves possess the following properties.

1. High indifference curve represents high satisfaction:

“The set of indifference curves, representing different level of
satisfaction is called indifference map”. A higher IC represents
higher level of satisfaction than a lower IC because on a higher IC
consumer can get more of both commodities as shown in diagram.
Here at IC2 consumer can get more of both commodities as
compared to IC1.

2. Indifference Curve is download Sloped:

IC falls downward from left to right. That is why they are negative
sloped. Which denotes that if the quantity of one commodity
increase (X), the quantity of other commodity must decrease (Y), if
the consumer is to stay on same level of satisfaction. We can prove
this property by following ways.

3. Indifference Curve is Convex to the Origin.

The indifference curves are convex to the origin. It is due to the
fact that as consumer has more units of commodity X, the
marginal rate of substitution of X for Y goes on decreasing as
shown in the diagram.

4. Indifference Curves do not intersect Each Other:

The third property of indifference curve is that ICs do not intersect
each other. To prove this property, we suppose that there are two
indifference curves IC1 and IC2 and both intersect each other as
shown in the diagram. At point A consumer is on IC1 while at point
B consumer is on IC2. We know that higher IC has higher level of
satisfaction than lower one. But if the two ICs intersect each other
at point C which means that level of satisfaction of both ICs
become equal which is not possible. Therefore two ICs cannot
intersect each other at any point.
5. Indifference Curves do not touch Either Axis:
Another property of IC is that they do not intersect either X-axis
or Y-axis because if IC intersects X-axis or Y-axis, it shows one
commodity model while IC is a representation of two commodity
model. At point A consumer only buys commodity X and at point
B consumer only purchase commodity Y. hence it is not possible
for an IC to touch either of the axis.

6. Not Parallel to Each Other:

Indifference curves need not to be parallel to each other. When
there are substitutes or complementary goods, indifference
curves are not parallel. Under normal circumstances ICs touch on
both sides to one another.

[Link].5
Define Consumer’s Equilibrium. Show with the help of Indifference
Curve, how a Consumer reaches equilibrium.
Ans:
Consumer’s Equilibrium:
A consumer is said to be in equilibrium position when he maximizes his satisfaction under given
income and market prices.
“A consumer is in equilibrium when the budget line becomes tangent to the highest possible
indifference curve”.

Basic Tools of Consumer’s Equilibrium:

There are two basic tools of the consumer’s equilibrium.

 Indifference Curve:
“An indifference curve represents the various combinations of
two goods which give equal level of satisfaction to the
consumers”.
The slope of IC is called the marginal rate of substitution
(MRSXY) that is how many units of commodity Y, the consumer
is will to give up to achieve one more unit of commodity X i.e. MRSXY = ∆X/∆Y
MRSXY is diminished as the consumer get more units of commodity X as shown in the diagram.
 The Budget Line:
“The budget line represents the various combinations of two
commodities X and Y that the consumer can purchased by
spending all his income at given prices of two commodities”.
PXQX + PYQY = I
Suppose consumer has Rs.100 as disposable income. Price of
X is Rs.20 per unit and price of Y is Rs. 10 per unit. So the
consumer either purchases 5 units of X or 10 units of Y with
Rs.100. Budget line has been drawn by joining these two
possible points. The absolute slope of budget line gives the
number of units Y that the consumer must give up in order to
purchase an additional unit of X i.e.
∆QY PX
=
Assumption: ∆QX PY
In order to explain how a consumer reaches equilibrium position we shall make the following
assumptions.

1. Rationality:
The consumer is assumed to be rational and he wants to maximize his utility with given income
and market prices of goods.

2. Indifference Map:
The consumer has an indifference map showing his scale of preferences for various combinations
of two commodities X and Y.

3. Constant Income:
It is assumed that consumer has constant amount of money which he has to spend on the goods.
If he does not spend it on one good he must spend it on the other good.

4. Constant Prices:
It is further assumed that the prices of the commodities X and Y are given and remain constant.

5. Two Commodities Model:

It is assumed that consumer purchases only two commodities X and Y.

6. Goods are Homogeneous and Divisible:

The goods that a consumer purchases are assumed to be homogeneous and divisible.

7. Perfect Competition:
The condition of perfect competition prevails in the market from where consumer is purchasing
goods.
Conditions for the Equilibrium:
The following conditions must be fulfilled for the consumer to be in equilibrium position.
1. Necessary Condition:
The first order condition is that budget line becomes tangent with highest possible indifference
curve that means the slope of budget line (PX/PY) must equal to the slope of indifference curve
MRSXY i.e. MRSXY = PX/PY
2. Sufficient Condition:
The second order condition is that IC must convex to the origin at the point of tangent. The
convex shape of IC shows that
1. The consumer prefers averages to extremes.
2. Decreasing marginal rate of substitution.

Diagram:
The consumer’s equilibrium position is represented
by point E where the budget line BL becomes
tangent to IC2. He the consumer buys OX1 units of
commodity X and OY1 of commodity Y with his given
income. Point E represents the optimal choice of
the consumer as at this point both conditions for
consumer’s equilibrium are fulfilled i.e.
i. MRSXY = PX/PY
ii. IC2 is convex to the origin.
Points C and D represent attainable combinations of
X and Y but yield less satisfaction as they are at
lower IC1. Point F gives more satisfaction than point
E but it requires a greater income than that
represented by budget line BL.