INTRODUCTION TO CONSUMER BEHAVIOUR

 

UNIT STRUCTURE

1. Learning Objectives
2. Introduction
3. Utility: Cardinal and Ordinal Approaches
4. The Cardinal Utility Theory
5. The Indifference Curve Technique
6. Price Effect, Substitution Effect and the Income Effect
7. Let Us Sum Up
8. Further Readings
9. Answers to Check Your Progress
10. Possible Question

LEARNING OBJECTIVES

 
After going through this unit, you will be able to:
appreciate the difference between cardinal and ordinal utility
determine the equilibrium of the consumer on the basis of the cardinal utility theory
explain the concepts of indifference curve and the budget line
derive the equilibrium of the consumer using these above two concepts and
indicate the price effect and split it up into substitution effect and income effect.

INTRODUCTION


The Theory of Consumer Behavior studies how a consumer spends his income so as to attain the highest satisfaction or utility. This utility maximisation behaviour of the consumer is subject to the constraint imposed by his limited income and the prices of the various commodities he desires to consume. The consumer compares the different “bundles of goods” that he can consume given his income and the prices of the goods in the bundles. And in the process, he attempts to determine the bundle that will give him the maximum satisfaction.
 
 

UTILITY : CARDINAL AND ORDINAL APPROCHES


Utility is the satisfaction that a consumer derives by consuming a commodity. Thus, it is that property of a commodity that satisfies the wants of the consumers. Utility is a subjective concept and its perception varies among different individuals. In fact, the extent of desire for a commodity by an individual depends on the utility that he associates with it.

Cardinal Approach to Utility :

The Cardinalist school asserts that utility can be measured and quantified. It means, it is possible to express utility that an individual derives from consuming a commodity in quantitative terms. Thus, a person may express the utility he derives from consuming an apple as 10 utils or 20 utils.Moreover, it allows consumers to compare and define the difference in utilities perceived in two commodites. Thus, it allows an individual to state that commodity A (accruing an utility of 20 utils) gives double the utility of commodity B ( which accrues an utility of 10 utils).

Ordinal Approach to Utility :

The ordinalist school asserts that utility cannot be measured in quantitative terms. Rather, the consumer can compare the utility accruing from different commodities (as a combination of them) and rank them in accordance with the satisfaction each commodity (or combination of commodities) gives him.

Thus, the cardinal approach to the measurement of utility believes that utility derived from the consumption of a commodity can be expressed in quantitative terms. The ordinalist approach rejects this and states that the consumer at best can rank the various commodities (or combination of them) in accordance with the satisfaction that he expects from their consumption.

Total Utility and Marginal Utility :

Total utility (TU) is the aggregate utility derived by a consumer after consuming all the available units of a commodity. Thus, it is the sum of all the utilities accruing from each individual units of the commodity.

Marginal utility (MU), on the other hand, is the utility flowing from an additional unit of a commodity, over and above what had been consumed.

Graphically, this relation of marginal utility and total utility can be presented as follows:

Figure 2.1: Total Utility & Marginal Utility Curves

(The above Activity-1 and the above figure 2.1 have been adapted from Ahuja, H.L.(2006): “Modern Economics”, Twelfth Ed., S.Chand & Co., New Delhi)
From the activity 1 and from the figure 2.1 , we can see that total utility rises upto a certain limit (upto consumption of the 6th apple). Then it tends to diminish. The marginal utility, on the other hand, keeps on declining. And after the consumption of the 6th apple, the marginal utility of the consumer in fact becomes negative.
From the above discussion, we have seen that:

Theory of consumer behaviour studies how a consumer spends his income so as to attain the highest satisfaction or utility.
Utility is a subjective concept and its perception varies among different individuals.
The Cardinalist school asserts that utility can be measured and quantified, while the ordinalist school asserts that utility cannot be measured in quantitative terms.

CHECK YOUR PROGRESS


1. Define total Utility.
2.Define Marginal utility


THE CARDINAL UTILITY THEORY


The Cardinal Utility Theory developed over the years with significant contributiions from Gossen (1854), Jevons (1871), Walras (1874) and finally Marshall (1890). The theory is constructed on the basis of the following assumptions.

The consumer is rational in the sense that given his income constraints, he would always attempt to maximise his utility.
Utility is a cardinal concept and it can be measured and expressed in quantitative terms. For convenience, it is expressed in terms of the monetary units that a consumer is willing to pay for the marginal unit of the commodity.
The law of diminishing marginal utility operates. This implies that as a consumer increases his consumption of a commodity, the utility accruing from successive units of the commodity decreases. In other words, the marginal utility of a commodity will keep falling as a consumer goes on increasing its consumption (this is what we have seen in Activity 2.1 and figure 2.1)
Marginal utility of Money is constant. That is, as one acquires more and more money, the marginal utility of money will remain unchanged. This assumption is critical because money is used as a standard unit of measurement of utility, and, hence, cannot be elastic.
The total utility of a ‘bundle’ of goods depends on the quantities of the individual commodities. Thus: U = f (x1 , x2 ,...............,xn)
where U means total utility; x1, x2 ....................xn are the quantities of n number of commodities.

Equilibrium of the Consumer :

Initially we derive the equilibrium of the consumer when he spends his money income M on a single commodity x. Here, the consumer will be at equilibrium when the marginal utility of x is equal to its market price .
Symbolically: MUx = Px


If:
MUx > Px , then the consumer can increase his welfare by consuming more of x. He will continue to do that until his marginal utility for x falls sufficiently, to be equal with its price.
MUx < Px , then the consumer can enhance his welfare by cutting down on his consumption of x. He will be persisting on doing this, until his MUx increases to equal the price Px. If more commodities are introduced into the model, then the consumer will attain equilibrium when the ratios of the marginal utilities of the individual commodities to their respective prices are equal for all commodities. That is,

Where, x,y,....................z are different commodities; and
l = marginal utility of money income.


This state is defined by the “Law of equi-marginal utility”, which states that a consumer will distribute his money income among different commodities in such a way that the utility derived from the last rupee spent on each commodity is equal.

Now if:
(I) (MUx/Px)>( MUy/Py) then the consumer will start substituting commodity y with commodity x, causing MUx to fall and MUy to rise. This he will continue until MUx / Px equals MUy / Py

(ii) Conversely, if ( MUx / Px) < (MUy/Py) , then the consumer will substitute commodity x with commodity y until the equilibrium is restored.


Limitations of the Theory:

The cardinal utility theory has three basic limitations as follows :

Utility cannot be cardinally measured. Hence, the assumption that utility derived from the consumption of various commodities can be measured and expressed in quantitative terms is very unrealistic.
As income increases the marginal utility of money changes. Hence the assumption of constant marginal utility of money is not realistic.
Finally, the law of diminishing marginal utility is a psychological law, which cannot be empirically established and has to be taken for granted.
From the above discussion, we have seen that:

The law of equi-marginal utility states that a consumer will attain equilibrium when the ratios of the marginal utilities of the individual commodities to their respective prices are equal for all commodities.
The theory has been criticised on the grounds that utility can not be measured cardinally and utility of money does not remain constant. The law of diminishing marginal utility is also unrealistic as this is a psychological law, and cannot be established empirically.


CHECK YOUR PROGRESS


1.Mention the important contributors of the theory of Cardinal Utility.
2.Mention the concept of total utility in the theory of cardinal utility.


THE INDIFFERENCE CURVE TECHNIQUE


The Indifference Curve Technique was conceived as an alternative to the cardinal utility approach to the theory of consumer behaviour. A number of economists have contributed to this technique as it has evolved over the years, with the latest refinements attributed to Slutsky(1919), J.R. Hicks and R.G.D. Allen (1934).

The indifference curve technique rejects the concept of cardinal utility and asserts that utility cannot be measured in quantitative terms. Instead, it adopts the principle of ordinal utility which states that, while the consumer may not be able to indicate exactly the amount of utility that he derives from the consumption of a commodity or a combination of commodities, he is perfectly capable of comparing and ranking the different levels of satisfaction that he derives from them.


Assumptions of the Theory:

The indifference curve technique is based on the following assumptions.

Utility can be ordinally measured: The consumer can rank various commodites or combination of commdoties in accordance with the satisfaction that he derives from them.
The consumer is rational: Given the market prices and his income, a consumer will attempt to maximise his satisfaction when he undertakes consumption.
Additive Utilities: The quantities of the commodities that is consumed determines the total utility of the consumer.
Consistency of choices:The choice of the consumer is consistent in the sense that if he chooses combination A over B in one period, he will not choose B over A in another period.
Symbolically : if A > B, then B < A.
Transitivity of consumer choice: If a consumer prefers combination A to B, and prefers B to C, then, it can be concluded that he prefers A to C.
Symbolically : If A > B, and B > C, then A > C.

Equilibrium of the Consumer :

The equlibrium of the consumer is determined using indifference curves and the budget line. Now, before discussing equilibrium of the consumer, we shall discuss these two important concepts first.

Indifference Curves: An indfference curve is defined as the locus of the various combinations of two commodities that yield the same satisfaction to the consumer, so that he is indifferent to any one particular combination. In other words, all combinations of the two commodities in the indifference curve are equally desired by the consumer.


An indifference curve is based on the indifference schedule, which represents the various combinations of two commodities that give the consumer the same level of satisfaction. Given below is an indifference schedule representing various combination of commodity x and y that gives the consumer the same amount of satisfaction.


Putting the various combinations of the indifference schedule from the above table 2.A, we obtain the IC1 indifference curve as in the following figure 2.2.

Figure 2.2: Indifference Curve

In the above figure 2.2, the slope of the indifference curve is indicated by the “marginal rate of substitution”. The marginal rate of substitution of x for y is defined as the numbers of y that has to be given up by the consumer to get an additional unit of x, so that his satisfaction remains unchanged.
Thus, [slope of the indifference curve] = MRSxy.

It can be seen from the table 2.A that as the consumer gets more and more of x, the number of y he is willing to give up for an additional unit of x successively falls. This is known as the “principle of diminishing marginal rate of substitution” which states that the marginal rate of substitution of x for y falls as more and more of x is substituted for y. This implies that the indifference curve always slopes downwards to the left and is convex to the origin.

Indifference Map
:

An indifference map, on the other hand, shows all the indifference curves which rank the preference of the consumer. While combinations of commodities on the same indifference curve yield the same satisfaction, combinations on a higher indifference curve yield greater satisfaction and combinations on a lower curve yield less satisfaction. In the following figure 2.3, an indifference map has been shown.



In the above figure, we see an indifference map of a consumer. It is needless to say that the rational consumer would prefer to be on a higher indifference curve (i.e. he would prefer to be on IC2 than being on IC1 and on IC3 than on IC1 and IC2) rather than on the indifference curve which is positioned lower (IC2 or IC1).


The Budget Line
:

The budget line is an important concept in the indifference curve technique. It is defined as the various combination of the two commodities (x and y) that a consumer can consume, given his income (M) and the price of the two commodities (Px and Py).
The Budget line can be algebraically expressed as :
M = Px X + Py Y.
where X and Y indicates the quantities of x and y respectively.
If y = 100, Px = 10 and Py = 20, then -


(a) if the consumer spends all his income on x, then he can consume
X = M / Px = 100 /10 = 10


(b) and if he spends all his income on y, then the number of units of y that he can consumed is:
Y = M / Py = 100 /20 = 5

Thus , 10x and 5y are the two extreme limits of the consumer’s expenditures. However, he usually prefers a combination of the two commodities within these two limits. In fact, the budget line joins the two extreme consumption limits of the consumer, and the points within those two limits indicate the combinations available to the consumer, given his income and the prices of the two commodities.
The concept of budget line has been shown with the help of the following figure 2.4. In figure 2.4, AB indicates the budget line. In this budget line AB,



the consumer have the option of consuming 10x(0B) or 5y (0A) or some combination of the two.

The slope of the budget line is the ratio of the prices of the two commodities. Geometrically,


Consumer’s Equilibrium:

Given his budget line, a consumer would like to maximise his satisfaction by climbing on to the highest indifference curve. This has been shown in the following figure 2.5





It can be seen from the above figure 2.5 that the consumer is at equilibrium at point e, where his budget line is tangent to the indifference curve Id2. He has the option of consuming at ‘a’ and ‘b’ , but those combinations are rejected as they would place him on a lower indifference curve Id1. The consumer would like to be on the indifference curve Id3, but his budget line does not allow him to do that.


Thus, at equlibrium,
[slope of the indifference curve] = [slope of the budget line] .


From figure 2.5, it can be seen that at equilibrium the consumer consumes 0x amount of x and 0y amount of y.

Indifference Curve Technique Vs Cardinal Utility Analysis:

The indifference curve technique is considered to be surperior to the Cardinal Utility Analysis on the following grounds :

It avoids the unrealistic assumption of cardinal utility and instead adopts the concept of ordinal utility.
It can be used to split the price effect into the substitution and income effects.
It is not based on the unrealistic assumption of constant marginal utility of money.

Limitations of the Indifference Curve Technique :

The indifference curve technique has been crticised on the following grounds:

The indifference curve technique does not tell us anything new, and it is only “old wine in new bottle”.
It assumes that the consumer is very familiar with his entire preference schedule, which is not the case in actual life.
The technique can be efficiently applied only to two commodities. Once more than two commodities are introduced, the analyais become very complicated to illustrate.

ACTIVITY


1. Based on the definition and the discussion , try to determine the properties of an indifference curve.



From the above discussion, we have seen that:

An indifference curve is the locus of the various combination of two commodities that yield the same satisfaction to the consumer, so that he is indifferent to any one particular combination.
An indifference map shows all the indifference curves which rank the preference of the consumer. While combinations of commodities on the same indifference curve yield the same satisfaction, combinations on a higher indifference curve yield greater satisfaction and combinations on a lower curve yield less satisfaction.
A consumer is in equilibrium at the point where his budget line is tangent to the indifference curve. Symbolically:

CHECK YOUR PROGRESS


1. What do u mean by 'consistency of consumer choices' and transivity of consumer choices' in case of indifference curve analysis ?
2.What does an indifference schedule represent ?
3.Define ' Budget Line' .





THE PRICE EFFECT , SUBSTITUTION EFFECT AND THE INCOME EFFECT


If a consumer consumes two commodities x and y, and given the price of y, the price of x falls then the real income of the consumer increases. This is because he now can consume more of x with his same, given income. The increase in the consumption of a commodity due to a fall in its price is referred to as the ‘Price Effect’.

In terms of the indifference curve technique,we have illustrated the income effect with the help of figure 2.6 in the next page. It can be seen from the figure that as a result of a fall in the price of x, given the price of y, the budget line of the consumer pivots anticlock wise from AB to AB’. This enables the consumer to move from the initial equilibruim at e, on IC1, to e2 on the higher indifference curve IC2. In the process the consumer increases his consumption of x from 0X1 to 0X2, due to a fall in its price. This is the ‘ price effect’.

The price effect has two components: the substitution effect and the income effect. These two components can be derived using either the Hicksian compensating variation method or the Slutsky’s cost- difference method. In the following discussion we shall use the compensating variation method to determine the substitution and the income effect of a fall in price. The following figure 2.6 shows these two components of the price effect.




In the above figure 2.6, a fall in the price of x has allowed the consumer to move to a higher indifference curve IC2 which accrues him greater satisfaction. Now, to remove the income effect of the price fall, we use the technique of compensating variation to take away a part of the consumer’s income so that he is forced back to his old indifference curve IC1, where he enjoys the initial level of satisfaction. Thus, given his new budget line AB’, a reduction in his income by AC (or DB’) results in a parallel downward shift of AB’ to CD. The compensated budget line CD is tangent to the earlier indifference curve IC1, but at point e0 instead of e1. Thus , the movement of the consumer from e1 to e0 on the indifference curve IC1, results in an increase in the consumption of x from 0 x1 to 0x2. This increase in the consumption of x (by the amount x1 x2) is brought about by substituting the relatively cheaper x for y; and hence, is referred to as the substitution effect. Hence, the ‘substitution effect’ takes place when the relative prices of the two commodities change in such a manner that the consumer concerned is neither better nor worse off than he was before, but is obliged to rearrange his purchases in accordance with the new relative prices.

Although the compensating variation tool allows us to isolate the substitution effect, it does not indicate the ultimate equilibrium of the consumer. If the income is given back to the consumer, he no longer remains on the conspensated budget line CD, but moves on to the new budget line AB’. Here he is at equilibrium at point e2 on the higher indifference curve IC2. The movement of the consumer from e0 to e2 , entails an increase in his consumptions of x by x2x3. This, in fact, is the income effect; which is caused by the increase in his purschasing power (i.e. real income ) due to a fall in the price of x.

From the above discussion, we have seen that:

The substitution effect and the income effect are two componts of the price effect.
These two components can be derived using either the Hicksian compensating variation method or the Slutsky’s cost- difference method.

CHECK YOUR PROGRESS


1. What do u mean by price effect ?
2.What is the substitution effect ?





LET US SUM UP


Theory of consumer behaviour studies how a consumer spends his income so as to attain the highest satisfaction or utility.
Utility is a subjective concept and its perception varies among different individuals.
The Cardinalist school asserts that utility can be measured and quantified, while the ordinalist school asserts that utility cannot be measured in quantitative terms.
The law of equi-marginal utility states that a consumer will attain equilibrium when the ratios of the marginal utilities of the individual commodities to their respective prices are equal for all commodities.
The theory has been criticised on the ground that utility can not be measured cardinally and utility of money does not remain constant. The law of diminishing marginal utility is also unrealistic as this is a psychological law, and cannot be established empirically.
An indifference curve is the locus of the various combination of two commodities that yields the same satisfaction to the consumer, so that he is indifferent to any one particular combination.
An indifference map shows all the indifference curves which rank the preference of the consumer. While combinations of commodities on the same indifference curve yield the same satisfaction, combinations on a higher indifference curve yield greater satisfaction and combinations on a lower curve yield less satisfaction.
A consumer is in equilibrium at the point where his budget line is tangent to the indifference curve. Symbolically:
The substitution effect and the income effect are two components of the price effect.
These two components can be derived using either the Hicksian compensating variation method or the Slutsky’s cost- difference method.

FURTHER READINGS


1. Dewett, K.K (2005): Modern Economic Theory, S.Chand & Sons, 22nd Ed.
2. Chopra, P.N (2008) : Micro Economics, Kalyani Publishers, 2nd Ed.
3. Ahuja, H L (2006): Modern Economics, S. Chand, 12th Ed.
4. Sundharam, K.P.M. & Vaish, M.C.(1997): Microeconomic Theory, 20th Ed.
5. Baumol, W.J & Blinder, A.S.(2007) :Microeconomics - Principles and Policy,Thomson South-Western, 9th Ed., Indian Ed. (1st).
6. Koutsoyiannis, A (1979): Modern Microeconomics, Macmillan, 2nd Edition.


ANSWERS TO CHECK YOUR PROGRESS


Check Your Progress 2.1
Q. No. 1:
Total utility (TU) is the aggregate utility derived by a consumer after consuming all the available units of a commodity. Thus, it is the sum of all the utilities accruing from each individual units of the commodity.
Q. No. 2 :
Marginal utility (MU) is the utility flowing from an additional unit of a commodity, over and above what had been consumed.

Check Your Progress 2.2
Q. No. 1:
Some of the important contributors of the Cardinal Utility Theory are: Gossen (1854), Jevons (1871), Walras (1874) and finally Marshall (1890).
Q. No. 2 :
According to the theory of cardinal utility, the total utility of a ‘bundle’ of goods depends on the quantities of the individual commodities.
Thus: U = f (x1 , x2 ,...............,xn)
where u means total utility : x1, x2 .....................,xn are the quantities of n
number of commodities.

Check Your Progress 2.3
Q. No. 1:
Consistency of choices in cardinal utility theory means that the choice of the consumer is consistent in the sense that if he chooses combination A over B is one period, he will not choose B over A in another period.
Symbolically: if A > B, then B < A.
Again, transtivity of consumer choice in cardinal utility theory means that if a consumer prefers combination A to B, and prefers B to C, then, it can be concluded that he prefers A to C.
Symbolically: If A > B, and B > C, then A > C.
Q. No. 2 :
An indifference schedule represents the various combinations of two commodities that give the consumer the same level of satisfaction. An indifference curve is drawn based on a indifference schedule.
Q. No. 3 :
A budget line is defined as the various combination of two commodities (say, x and y) that a consumer can consume, given his income (M) and the price of the two commodities (Px and Py).
Thus, a Budget line can be algebraically expressed as:
M = Px X + Py Y.
where X and y indicates the quantities of x and y respectively.

Check Your Progress 2.4
Q. No. 1:
If a consumer consumes two commodities x and y, and given the price of y, the price of x falls then the real income of the consumer increases. This is because he now can consume more of x with his given income. The increase in the consumption of a commodity due to a fall in its price is referred to as the ‘Price Effect’.
Q. No. 2 :
The increase in the consumption of x is brought about by substituting the relatively cheaper x for y is referred to as the substitution effect. Hence the ‘substitution effect’ takes place when the relatvie prices of the two commodities changes in such a manner that the consumer concerned is neither better nor worse off than he was before, but is obliged to rearrange his purchases in accordance with the new relative prices.

POSSIBLE QUESTIONS


1. Dislinguish between cardinal and ordinal utility. Which one of the concept is more realistic?
2. State the law of Equi- marginal utility. How does it explain consumer’s equilibrium?
3. Derive the consumer’s equilibrium using the indifference map and the budget line as your tools.
4 Derive the “Price Effect” of a price fall. Disintegrate the price effect into the substitution effect and the income effect.