Contents: Chapter-3: The theory of Consumer behavior

1. What is Utility
2. Cardinal versus Ordinal Utility
3. The concept of Total, Average and Marginal Utility
4. Law of Diminishing Marginal Utility
5. Consumer Surplus
6. Indifference curve, its slope and properties
7. Budget line, Its slope and properties
8. Consumer Equilibrium /

Utility

The amount of happiness and pleasure created through the consumption of a good or a service is called
utility.

Cardinal vs Ordinal Utility

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Total Utility (TU)

Amount of satisfaction obtained from the consumption of a certain quantity of a good or

aservice is called total utility (TU).

Formula:

TU = U(Q)

where:

• TU is the total utility

• U is the utility function
• Q is the quantity consumed

Example:

Consider a consumer who gets 10 units of satisfaction from the first cup of coffee, 8 units from
the second, and 6 units from the third. The total utility from consuming three cups would be:

TU = U(1) + U(2) + U(3) = 10 + 8 + 6 = 24

Marginal Utility (MU)

Change in total utility due to one unit change in consumption in called Marginal utility.

Formula:

MU = ΔTU / ΔQ

where:

• MU is the marginal utility

• ΔTU is the change in total utility
• ΔQ is the change in quantity consumed

Example:

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Continuing with the coffee example, the marginal utility of the second cup would be:

MU = ΔTU / ΔQ = (24 - 10) / (3 - 1) = 7

Similarly, the marginal utility of the third cup would be:

MU = ΔTU / ΔQ = (24 - 17) / (3 - 2) = 3

Average Utility Explained

In economics, average utility refers to the total satisfaction or pleasure derived from consuming a
certain amount of a good or service, divided by that amount. It's a way to quantify and compare
the level of satisfaction gained from consuming different quantities of something.

Here's the mathematical formula for average utility:

Average Utility (AU) = Total Utility (TU) / Quantity Consumed (Q)

Where:

• Total Utility (TU) is the sum of the satisfaction gained from consuming each unit of the
good or service.
• Quantity Consumed (Q) is the total number of units consumed.

Law of diminishing marginal Utility

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4
Consumer Surplus

Consumer surplus is the difference between total satisfaction obtained by a consumer from agiven
quantity of a good or a service and total expenditure made for the good or service.

Indifference curve and its properties

An indifference curve shows the combinations of two goods that yield equal utility to
theconsumer.

In the following figure indifference curve is drown by considering two goods.

Properties of an Indifference Curve

Indifference curve has the following four properties.

1. Indifference curve slopes downward to the right.

2. Indifference curve is convex to the origin.

3. Indifference curves do not intersect.

4. Higher indifference curve represents higher utility.

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Budget line definition
The budget line, also known as the budget constraint, exhibits all the combinations of two
commodities that a customer can manage to afford at the provided market prices and within the
particular earning degree.

The budget line is a graphical delineation of all possible combinations of the two commodities
that can be bought with provided income and cost so that the price of each of these combinations
is equivalent to the monetary earnings of the customer.

The two basic elements of a budget line are as follows:

• The consumer’s purchasing power (his/her income)

• The market value of both the products

Equation of a Budget Line

To understand the concept of a budget line in a detailed manner, it is important to understand the
mentioned equation. The equation of the budget line equation can be represented as follows:

M = (Px × Qx )+ (Py × Qy)

Where,

Px is the price of product X.

Qx is the quantity of product X.

Py is the price of product Y.

Qy is the quantity of product Y.

M is the consumer’s income.

Example of a Budget Line

Radha has ₹50 to buy a biscuit. She has a few options to allocate her income so that she receives
maximum utility from a limited salary.

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 Budget schedule

Combination Cream biscuit Plain biscuit Budget allocation

(@ ₹5 per packet)
(@ ₹10 per packet)

A 0 10 10 × 0 + 5 × 10 =
50

B 1 8 10 × 1 + 5 × 8 =
50

C 2 6 10 × 2 + 5 × 6 =
50

D 3 4 10 × 3 + 5 × 4 =
50

E 4 2 10 × 4 + 5 × 2 =
50

F 5 0 10 × 5 + 5 × 0 =
50

To get an appropriate budget line, the budget schedule given can be outlined on a graph.

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The budget set indicates that the combinations of the two commodities are placed within the
affordability margin of a consumer.

Features of Budget Line

Some of the properties of the budget line are as follows:

Negative slope: If the line is downward, it shows a reverse correlation between the two products.

Straight line: It indicates a continuous market rate of exchange in individual combinations.

Real income line: It denotes the income and the spending size of a customer.

Tangent to indifference curve: It is the point when the indifference curve meets the budget line.
This point is known as the consumer’s equilibrium.

Assumptions of a Budget Line

The budget line is mostly based on the assumption and not reality. However, to get clear and
precise results and summary, the economist considers the following points in terms of a budget
line:

Two commodities: The economist assumes that the customers spend their income to purchase
only two products.

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Income of the customers: The income of the customer is limited, and it is designated to buy
only two products.

Market price: The cost of each commodity is known to the customer.

Expense is similar to income: It is assumed that the customer spends and consumes the whole
income.

A shift in Budget Line

A budget line includes a consumer’s earnings and the rate of a commodity. These are the two
important factors that shift the budget line.

Shift due to change in price: The amount of the product either increases or decreases from time
to time. For instance, if the price and income of product A remains constant and the price of
product B decreases, then the buying potential of product B automatically increases. Similarly, if
the price of B increases and the other factors remain steady, the demand for product B
automatically decreases.

Shift due to change in income: Change in income makes a huge difference that leads to a
change in the budget line. High income means high purchasing possibility and low income
means low purchasing potential, making the budget line to shift.