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THEORY OF CONSUMER

BEHAVIOUR
CONCEPTS

• Demand arise due to utility

• Measurement of Utility:
 Cardinal Utility: Utility is objectively measurable
 Ordinal Utility: Consumers can rank their
preferences
TOTAL UTILITY(TU)

• Sum total of all the utilities derived from the total


number of all units consumed

• Sum of Marginal Utility (MU) of different units of the


commodity
TUn = MU1 + MU2 + ……..+ MUn
=∑ MU
MARGINAL UTILITY (MU)

Change in TU resulting from a one unit change in


consumption of good

MUn = TUn – TUn-1


RELATION B/W TU & MU

No of units TU MU
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
8 24 -4
RELATION B/W TU & MU

TU
MU

TU

o MU
No of units consumed
CARDINAL APPROACH TO
CONSUMER EQUILIBRIUM-
MARGINAL UTILITY ANALYSIS
ASSUMPTIONS OF MU ANALYSIS

• Cardinal measurement of Utility


• Hypothesis of Independent utility
• Constancy of marginal Utility of Money
• Rationality
• Limited Money Income
LAW OF DIMINISHING MU

Utility derived by consumer from the consumption


of each additional unit of a commodity keeps on
decreasing with every increase in the stock of the
commodity which he/she already has.

NOTE: TU continues to increase though at a


decreasing rate
EXAMPLE

Cups of tea consumed TU MU


per day
1 12 12
2 22 10
3 30 8
4 36 6
5 40 4
6 41 1
7 39 -2
8 34 -5
APLICATION OF CONCEPT OF
DIMINISHING MARGINAL UTILITY

Diamond Water Paradox: Water which is so


essential & useful to life has such a low price while
diamonds which are quite unnecessary have such a
high price….????

Water….available in abundance…relatively low


MU
LAW OF EQUI MARGINAL UTILITY

• Consumer will redistribute his money income b/w


goods in such a way that utility derived from last rupee
spent on each good is equal

• Consumer is in equilibrium when MU of money


expenditure on each good is the same

NOTE: does not mean spending of equal amount of


money on each commodity
LAW OF EQUI MARGINAL UTILITY

• Consumer will spend his money income between


goods in such a way that MU of each good is
proportional to its price

• If there are 2 goods ‘x’ and ‘y’


then MUx/Px = MUy/Py
LAW OF EQUI MARGINAL UTILITY

If MUx/Px > MUy/Py


then consumer will substitute good ‘x’ for good ‘y’

Reasoning:
• As a result of increase in the quantity of good ‘x’ MUx
will fall and because of a decrease in the quantity of ‘y’
MUy will increase
• Consumer will continue substitution till MUx/Px becomes
equal to MUy/Py
EXAMPLE ON CONSUMER EQUILIBRIUM
Given: Px = Re ; PY = Rs 2; Money Income= Rs 19

Units MUx MUy MUx/Px MUy/Py


1 20 24 10 8
2 18 21 9 7
3 16 18 8 6
4 14 15 7 5

5 12 9 6 3
6 10 3 5 1
CRITICAL EVALUATION OF MU ANALYSIS

• Unrealistic assumption of Cardinal measurability of


utility
• Wrong hypothesis of independent utility
• Invalid assumption of Constant Marginal utility of
money
• Failed to explain the giffen paradox
• Failed to explain the splitting of price effect into
income effect and substitution effect
ORDINAL UTILITY APPROACH TO
CONSUMER EQUILIBRIUM-
INDIFFERENCE CURVE ANALYSIS
ASSUMPTIONS

• Perfect Knowledge
• Rationality
• Ordinal Utility
• Transitivity
• Consistency
• Non satiety (MIB)
• Diminishing Marginal Rate of Substitution
MORE IS BETTER

• Bundles that have at least as much of Good Y


every good & more of some good are
III.
preferred to other bundles
• Bundle B is preferred to A- B contains II.
at least as much of good Y & strictly I.
more of good X.
• Bundle B is preferred to C- B contains 100
A B
at least as much of good X & strictly
more of good Y.
• More generally, all bundles on ICIII are 33.33
C

preferred to bundles on ICII or ICI.


And all bundles on ICII are preferred
1 3
to ICI. Good X
INDIFFERENCE CURVE (IC)

• Locus of points among which consumer is indifferent

• Each point on an IC yields the same TU as any other point


on the same IC

• Consumer is indifferent among all points on IC

• It does not indicate exactly how much satisfaction is


derived from these combinations
INDIFFERENCE SCHEDULE

COMBIN UNITS UNITS Good Y


ATION OF GOOD OF GOOD
X Y IC

A 3 21
B 4 15
C 5 11
D 6 8
E 7 6
Good X
INDIFFERENCE MAP

• Set of ICs corresponding Good Y


to different levels of III.
satisfaction II.
I.
• Higher IC represent
greater satisfaction

Good X
MARGINAL RATE OF SUBSTITUTION (MRS)

MRS of X for Y (MRSXY) Units of Y


measures the number of
units of Y that must be
sacrificed per unit of X
gained so as to maintain a Y1
constant level of
satisfaction.
Y2

MRSXY = (-1) ΔY/ ΔX

0 X1 X2 Units of X
EXAMPLE

COMBINATION GOOD X GOOD Y MRSxy

A 1 12
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
DIMINISHING MARGINAL RATE OF
SUBSTITUTION

The Convexity of an Units of Y


IC implies that MRS
diminishes as X is
substituted for Y Y1 P
along an IC.
Q
Y2
R
Y3
MRS at Q = Y1Y2 / X1X2
MRS at R = Y2Y3 / X2X3
0
X1 X 2 X3 Units of X
NOTE

The rate at which a consumer is willing to trade


good Y for good X is equal to the ratio of MU X to
MU Y

MRSXY = -ΔY/ ΔX = MU X / MU Y
CHARACTERSTICS OF IC

• negative slope (Slope downwards from left to right)


• convex to the origin (diminishing MRS)
• higher IC represents a higher level of satisfaction
• can not intersect each other
IMPOSSIBLE INDIFFERENCE CURVES

Horizontal
Units of Y

Units of X
IMPOSSIBLE INDIFFERENCE CURVES

Vertical
Units of Y

Units of X
IMPOSSIBLE INDIFFERENCE CURVES

Upward
Units of Y Sloping
b

Units of X
IMPOSSIBLE INDIFFERENCE CURVES

Intersection 

Units of Y

e
b
IC 1
a
IC 2

Units of X
EXCEPTIONAL SHAPES OF IC

PERFECT SUBSTITUTES . MRS between two


goods is constant and therefore the IC is linear.

PERFECT COMPLEMENTS: no possibility of


substitution so MRS will be 0. Satisfaction can not be
increased by increasing the units of one commodity at
the expense of the other so MRS will be infinity.
BUDGET LINE/ PRICE LINE/
CONSUMPTION POSSIBILITY LINE

Set of commodity bundles that can be purchased if the entire


money income is spent, given the prices of the two
commodities

I = xpx + ypy

y = 1/py . I – px/ py .x
Good Y BUDGET CONSTRAINT

25 = M / a
PB
b
20
L1 (Pz = Re 1, PB = Rs 2, M= Rs 50)

c
10
Opportunity set

d
0 10 30 50 = M / Pz
Good X
SHIFTS IN THE BUDGET LINE

INCREASE IN MONEY
INCOME : Budget line shift
outwards to the right
Units of Y

0 Units of X
SHIFTS IN THE BUDGET LINE

DECREASE IN
THE MONEY
INCOME : Budget
line shift inwards to
left
INCREASE IN THE PRICE OF GOOD X

Budget line pivots from AB to Units of Y


AC i.e. it will shift only at its
end touching the X axis. A

0 C B

Units of X
INCREASE IN THE PRICE OF GOOD Y

Budget line pivots from AB to


B
AC i.e. it will shift only at its
Units of
end touching the Y axis. Y
C

0 A

Units of X
SLOPE OF THE BUDGET LINE

Slope of the Budget Line is equal


to the ratio of prices of two goods.
Slope of Budget line = OA/OB = Units of Y
(I/Py) / (I/Px) = Px/Py

Units of X

0
B
CONSUMER EQUILIBRIUM

Consumer is said to be in
equilibrium where he
maximizes his
satisfaction subject to his
budget constraint. Units of Y
A

0 Units of X
CONDITIONS FOR CONSUMER
EQUILIBRIUM

FIRST ORDER CONDITION


(NECESSARY)
Slope of budget line should be
equal to the slope of IC
Units of Y
MRSXY = PX/ PY
P
SECOND ORDER CONDITION
(SUFFICIENT) Q
At the point of equilibrium, IC
must be convex to the origin.
0

Units of X
DECOMPOSITION OF PRICE EFFECT INTO
INCOME AND SUBSTITUTION EFFECT

PRICE EFFECT: total change in quantity demanded caused by a


change in the price

SUBSTITUTION EFFECT: change in quantity demanded resulting


from a change in price when the change is restricted to a movement
along the original IC, thus holding real income constant

INCOME EFFECT: change in quantity demanded resulting


exclusively from a change in real income, all other prices and money
income held constant
INCOME EFFECT

Positive I.E.
With an increase in the income the consumer consumes more
units of the good.

Negative I.E.
With an increase in income the consumption of the good
falls (inferior goods)
INCOME CONSUMPTION CURVE &
INCOME EFFECT (1)

ICC +VE I.E. for Good X


UNITS OF & Good Y
GOOD Y

UNITS OF GOOD X
INCOME CONSUMPTION CURVE &
INCOME EFFECT (2)

ICC
-VE I.E. for Good X
UNITS (inferior good)
OF
GOOD Y

UNITS OF GOOD X
INCOME CONSUMPTION CURVE &
INCOME EFFECT (3)

-VE I.E. for Good Y


UNITS (inferior good)
OF
GOOD Y
ICC

UNITS OF GOOD X
INCOME CONSUMPTION CURVE &
INCOME EFFECT (4)

Good X inferior

UNITS
OF
GOOD Y

Good Y inferior

UNITS OF GOOD X
SUBSTITUTION EFFECT

UNITS OF
GOOD Y

IC

UNITS OF GOOD X
HICKSIAN APPROACH: NORMAL GOODS

Units of Y
For a decline in price of good x

PE = SE(x1 x2) + IE (x2 x3)

P
R

Units of X
x1 x2 x3
HICKSIAN APPROACH: INFERIOR GOODS

Units of Y
PE = SE(x1 x2) + IE (-x2 x3)

R SE >Negative IE
P

Units of X
x1 x3 x2
HICKSIAN APPROACH: GIFFEN GOODS

Units of Y

R PE = SE(x1 x2) + IE (-x2 x3)

P Negative IE > SE

Units of X
x3 x1 x2
POSSIBLE COMBINATIONS OF INCOME EFFECT
AND SUBSTITUTION EFFECT OF A DECLINE IN
THE PRICE OF GOOD X

Case Substitution Income Total Nature of the


Effect Effect Effect commodity
A -ve +ve ↑ Normal

B -ve -ve but ↑ Inferior


smaller than
SE
C -ve -ve but larger ↓ Giffen
than SE
SIMILARITY B/W MARSHALLIAN
APPROACH & INDIFFERENCE CURVE
APPROACH

 Assume that consumers are rational


 Assumption of diminishing MU in some sense or the
other
SUPERIORITY OF IC ANALYSIS

• Ordinal measurement of utility


• Analysis of demand without assuming constant MU
of money
• Hypothesis of interdependent utility
• Greater insight into price effect
• Less restrictive & fewer assumptions
CRITIQUE OF IC ANALYSIS

• Includes most ridiculous combinations


• Suitable for two good case only
• Limited empirical nature.
EXERCISE: Textbook Page # 106

• Consider a world in which there are only 2 goods. An


individual has an income of Rs 30,000. Price of
deodorant is Rs 30 per can & price of mouthwash is Rs
40 per bottle.

• Expressing deo as dependent variable, write eq for


budget constraint.

• What is the slope of budget constraint?

• If P of mouthwash increases to Rs 50., write new eq for


budget constraint.