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Management and Planning

Management and planning

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28 views52 pages

Management and Planning

Management and planning

Uploaded by

subankhan119
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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UNIT 2

CONSUMER BEHAVIOR AND DEMAND ANALYSIS


CONTENT

• Cardinal Utility Approach: Diminishing Marginal Utility, Law of Equi-Marginal


Utility
• Ordinal Utility Approach: Indifference Curves, Marginal Rate of Substitution,
Budget Line and Consumer Equilibrium
• Theory of Demand, Law of Demand, Movement along vs. Shift in Demand
Curve
• Concept of Measurement of Elasticity of Demand, Factors Affecting Elasticity
of Demand, Income Elasticity of Demand, Cross Elasticity of Demand,
Advertising Elasticity of Demand.
• Demand Forecasting: Need, Objectives and Methods (Brief)
UTILITY
• The main objective of the consumers is to get maximum satisfaction from spending his income on
various goods and services.
• Utility is the want satisfying power of the commodity.
• There was no standard unit for measuring utility therefore economist derive imaginary units
which are used to measure satisfaction known as 'Utils'.
• Utility can also be measured in terms of money or price, which the consumer is willing to pay.
• The advantage of using monetary values instead of utils is that it allows easy comparison
between utility and price paid, since both are in the same units.
• It is impossible to measure the satisfaction of a person as it differs greatly from person - to -
person.
• Still, the concept of utility is very useful explaining and understanding the behavior of consumer.
MEASUREMENT OF UTILITY Total Utility (TU): After consuming various units
of the commodity, the sum total of satisfaction
is the total utility. The total utility or the
satisfaction of a consumer to a certain point
will be greater on the consumption of more
Initial Utility: After consuming first units of a commodity. If the consumer
unit of a commodity the utility continues to consume more units of a
derived is the initial utility. The commodity, the total utility begins to decline
satisfaction of the thirst by taking
first glass of water is the utility
gained which is described as initial
utility that is always positive.
Marginal Utility (MU): When a single unit is
added to the total utility in the rate of
consumption or the stock of goods possessed
is defined as marginal utility which is the net
additional unit. For or a given unit of time, it
is the increment or decrement in total utility
that is proportionately caused by increment
or decrement of one unit of a commodity.
RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL
UTILITY
RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL
UTILITY
RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL
UTILITY
• As long as MU (marginal utility) is positive, the TU (total utility)
increases with an increase in the consumption of a commodity.
As MU from each successive unit diminishes, at that time TU
increases but at a diminishing rate.
• When TU is maximum, the MU reaches zero. TU stops growing in
this phase, this point is known as the point of satiety.
• When consumption increases beyond the point of satisfaction,
then the MU becomes negative and TU starts falling.
APPROACHES TO CONSUMER BEHAVIOUR

Approaches to
consumer
behaviour

Cardinal Utility Ordinal Utility


Approach Approach
CARDINAL UTILITY APPROACH

Cardinal measurement of utility is contributed by Marshall where the


consumer pays the higher price for a commodity, the higher is the
utility and vice-versa.
The utility of a commodity can be measured by price.
Therefore, under the assumption, a consumer is capable to assign a
number to every commodity that represents the measure of utility
associated with it.
Likewise, weights, utility numbers can also be manipulated. Law of
diminishing marginal utility and law of equi-marginal utility have an
access to cardinal utility.
ASSUMPTIONS OF CARDINAL UTILITY APPROACH
1) The consumer is a rational person.
2) Consumers are perfectly aware of the price in the market
3) There is variety of choices of the goods in the market.
4) There are various commodities whose prices are not affected by variations in their supply.
5) Utilities are measured in terms of money as there are no substitutes.
6) Due to price of the commodity being very low or very high, the consumer is unable to
purchase it.
7) Law of Diminishing Marginal Utility is being assumed.
8) The units of the commodity must be suitable.
9) There is no change in the tastes of the consumer.
10) The utilities of the commodities do not depend upon one another.
LIMITATIONS OF CARDINAL UTILITY APPROACH
1) It is assumed that utility is cardinal. In reality, it is subjective and it is difficult to put a specific value on the
utility that one gets from the consumption of a good. One can certainly compare the utilities from two
goods but one cannot give a definite value to the utility derived from the two goods.
2) Utility is assumed to be additive and thus to arrive at total utility, the utility from the different goods was
added together. This is not true because utility is not carding and also because one derives different types of
utility or satisfaction from different types of goods. An individual cannot enhance the different kinds of
utility or satisfaction derived from the various products and services.
3) The utility derived from the consumption of a good was assumed to be independent of the utility from
the consumption of another good. However, this is not true as the different goods are interrelated and the
utility from one good often depends upon the utility from another good.
4) The marginal utility of money was assumed to be constant. This is not true and it is often a subject to
much debate as to whether the law of diminishing marginal utility applies to money.
5) The utility analysis is unable to explain the existence of the Giffen goods.
6) The utility theory does not analyze the effect of a change in the price in terms of the income effect and
substitution effect.
CRITICISMS OF CARDINAL UTILITY APPROACH
Cardinal Every Commodity
Measurement of is not an
Utility is Subjective
Utility is not Independent
Possible Commodity

Marginal Utility
Marginal Utility of Income Effect and
cannot be
Money does not Substitution Effect
Estimated for all
Remain Constant not Separated
Commodities

Consumer is Utility Analysis


Does not Explain
regarded as a Breaks-down in a
Giffen Paradox
Computer Planned Economy:
APPROACHES TO CARDINAL UTILITY

Approaches to
Cardinal Utility

Law of Diminishing Law of


Marginal Utility Equi-Marginal
(LDMU) Utility
LAW OF DIMINISHING MARGINAL UTILITY (LDMU)

• According to this law, as the consumer consumes more and more units of
a commodity, there is a steady decline in the additional utility derived.
Thus, more the consumer consumes, there is an increase in his total utility
but at a diminishing rate. It being very natural that on consuming
additional units of a particular good at a point of time by a consumer, his
intensity of desire diminishes for every additional unit resulting in the
decrease in the utility derived from each additional unit.
• According to Marshall, "The additional benefit which a person derives from
a given increase of a stock of a thing diminishes, other things being equal,
with every increase in the stock of that he already has.”
ASSUMPTIONS OF LAW OF DIMINISHING MARGINAL
UTILITY

1) All Other Factor Constant


2) Size of the Commodity is Reasonable
3) Successive Consumption
4) Uniformity of Units
5) Measurement
6) Product or Commodity is Divisible
7) Only Single Use
8) Normal or Rational Behaviour
LAW OF DIMINISHING MARGINAL UTILITY
LIMITATIONS OF LAW OF DIMINISHING MARGINAL
UTILITY
• The units being consumed are very small.
• The units being consumed are of different sizes.
• There are long breaks in between consuming the units.
• The consumer is thinking or behaving irrationally, or the
consumer is suffering from a mental illness or addiction.
• The units being consumed are part of a collection or are
rare objects
MEANING OF LAW OF EQUI-MARGINAL UTILITY
• According to Samuelson, "A consumer gets maximum satisfaction when the ratio of marginal
utilities of all commodities and their prices is equal".
• According to Hicks, "Utility will be maximised when the marginal unit of expenditure in each
direction brings the same increment of utility". It means:
• MU1 = MU2 = MU3
• The behaviour of the consumer is described by the Law of Equi-marginal Utility on spending
the limited income on various commodities and services. To derive maximum satisfaction and
equilibrium every consumer properly allocates the resources on various items of expenditure.
On buying one unit of commodity the consumer is in equilibrium whose marginal utility is at
par with the marginal utility of the rupee that is represented by the price.
• The consumer is in the state of equilibrium when the marginal utility of the goods consumed is
zero. On the consumption of an economic commodity by the consumer, the consumer is in
equilibrium when the price paid by consumer is equal to the marginal utility of the commodity.
ASSUMPTIONS OF LAW OF EQUI-MARGINAL
UTILITY
1) It is a desire of every consumer to maximise the satisfaction.
2) There is no change in the prices of substitutes or complementary goods and the
price of the commodity remains unchanged.
3) There is no change in the income of the consumer.
4) There can be further divisions and sub-divisions of the commodities into necessary
commodities.
5) The behaviour of the consumer is logical.
6) There is no change in the marginal utility of money.
7) The income, taste, fashion, habits and customs of the consumer are unchanged.
FUNCTIONAL REPRESENTATION OF LAW OF
EQUI-MARGINAL UTILITY

• Practically, the consumer spends his income on many available goods and services
but he can only achieve equilibrium of maximum satisfaction or utility if he acts
according to the equi-marginal utility as he is having a fixed income and is facing the
market prices of different goods.
• There should be a correlation between the marginal utilities of different goods and
their prices according to the requirement of the principle of equi-marginal utility.
The basic condition of consumer equilibrium that can be written in terms of
marginal utilities and price of different goods is as follows:
ORDINAL UTILITY
APPROACH
• The number of pairs of two commodities that a consumer keeps in his mind to achieve
equal level of satisfaction is the fundamental idea behind ordinal utility approach. This
infers that the utility can only be ranked in a qualitative manner.
• According to the assumption of cardinal theory, utility is measurable on the contrary;
utility is not measurable according to the ordinal theory. The limitations of the
usefulness of this approach is because, in real life utility is subjective and cannot be
measured.
• The limitations of the cardinal approach that offers valuable awareness to consumer
behaviour motivated economists to develop ordinal utility theory whose approach is
completely different from the states about consumer's behaviour on the assumption
that utility from different units of a good or between different goods can only be rank
able but not measurable. Supposing a consumer gains more utility from good X than
from good Y then he will rank good X above good Y irrespective of the knowledge by
how much X has been given preference.
APPROACHES TO ORDINAL UTILITY

Approaches to
ordinal Utility

Revealed
Indifference
preference
curve
theory
INDIFFERENCE CURVE

An indifference curve is a graphical representation of a


combined products that gives similar kind of satisfaction to a
consumer thereby making them indifferent. Every point on the
indifference curve shows that an individual or a consumer is
indifferent between the two products as it gives him the same
kind of utility.
ASSUMPTIONS OF INDIFFERENCE CURVE
Rationality
Assumption
Ordinal
of
Continuity Utility

Assumption
Non
of
Transitivity satiety

Assumptions

Weak
Consistency
Ordering
Scale of
Preferences
is Transit of
Independent Choice
of Market Diminishing
Prices MRS
INDIFFERENCE CURVE AND INDIFFERENCE SCHEDULE
INDIFFERENCE CURVE AND INDIFFERENCE SCHEDULE
PROPERTIES OF INDIFFERENCE CURVE

Higher Indifference curve


Indifference curves are Indifference curves are
represents Higher level of
negative sloped always convex to origin
Satisfaction

Indifference curve Indifference curve need


Two Indifference curves
neither touches X-axis not be parallel to each
can never cut each other
nor Y-axis other
1. INDIFFERENCE CURVES ARE NEGATIVE SLOPED

• An indifference curve slopes downward


from left to right, ie, it has a negative
slope. A negative slope implies that the
two goods are substitutes for one
another. Therefore, if the quantity of
one commodity decreases, the quantity
of the other commodity must increase if
the consumer has to stay at the same
level of satisfaction.
2. INDIFFERENCE CURVES ARE ALWAYS CONVEX TO
ORIGIN
• They are convex to the origin. This is equivalent to
saying that as the consumer substitutes commodity X
for commodity Y, the marginal rate of substitution
diminishes of X for Y along an indifference curve.
• In this figure as the consumer moves from A to B to C
to D, the willingness to substitute good X for good Y
diminishes.
• This means that as the amount of good X is increased
by equal amounts, that of good Y diminishes by
smaller amounts. The marginal rate of substitution of
X for Y is the quantity of Y good that the consumer is
willing to give up to gain a marginal unit of good X.
The slope of IC is negative. It is convex to the origin.
3. HIGHER INDIFFERENCE CURVE REPRESENTS
HIGHER LEVEL OF SATISFACTION

• Higher Indifference Curve Represents Higher


level of Satisfaction: Higher the indifference
curves, higher will be the level of satisfaction.
This means any combination of two goods on
the higher curve give higher level of
satisfaction to the consumer then the lower
one.
4. TWO INDIFFERENCE CURVES CAN NEVER CUT
EACH OTHER

• Each indifference curve is a representation of


particular level of satisfaction. The level of
satisfaction of the consumer for any given
combination of two goods is same
throughout the curve, that's why indifference
curve cannot intersect each other.
5. INDIFFERENCE CURVE NEITHER TOUCHES X-AXIS
NOR Y-AXIS

• Indifference curve continuously


approaches the two axis but never
touches them. This is because of the
assumption that the consumer wants to
consume both the goods. If the IC
touches the x-axis it means that
consumer wants to consume only one
good (say, good-1) and his demand for
other good (say, good-2) is zero.
6. INDIFFERENCE CURVE NEED NOT BE PARALLEL TO EACH
OTHER
• It is not necessary that two indifference curves are parallel to each other. Two
indifference curves can parallel to each other when both the commodities are shown
on the horizontal axis and the vertical axis is independent of both commodities. In that
case, the commodities can neither be substituted for each other nor they can be
complementary to each other. Moreover, none of the commodities is inferior’ or
'superior' in relation to each other whatever the price of each commodity.
• The two indifference curves may be parallel to each other when the assumption of
independence and absence of income effects introduced by Dr. Marshall is applied in
the representation of indifference curves. In this case, the two curves are always
equidistant from each other. But, it is a very rare case in reality. This is so because the
consumer normally purchases those goods that are related to each other, especially
for which the income effect is positive. Hence, the normal position of indifference
curves occurs when the curves do not meet and converge on both sides to one
another on going left upward and right downward.
MARGINAL RATE OF SUBSTITUTION (MRS)
• When total utility remains constant and the quantity of one good is given-up as the
consumption of other good increases by one unit, it is called marginal rate of substitution
(MRS).
• According to Professor Bilas, "The marginal rate of substitution of X for Y is defined as the
amount of Y the consumer is just willing to give up getting one more unit of X and
maintaining the same level of satisfaction.”
• The slope of indifference curves is determined by Marginal Rate of Substitution (MRS). is
the rate at which one good is substituted for another good by a consumer without
changing the level of satisfaction.).
BUDGET LINE/PRICE LINE

• According to Prof. Salvatore, "The budget line shows all the


different combinations of the two commodities that a consumer
can purchase, given his or her income and the price of the two
commodities"
CONSUMER EQUILIBRIUM

• According to Scitovosky, "A consumer is in equilibrium when he


regards his actual behaviour as the best possible under the
circumstances and feels no urge to change his behaviour as long as
circumstances remain unchanged".
• 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."
ASSUMPTIONS OF CONSUMER EQUILIBRIUM

1) Logical action of the consumer.


2) Cardinal number like 1,2,3,4 etc., are the measures
of utility.
3) Consumer is completely knowledgeable.
4) Marginal utility of money remains constant.
5) The price of the commodity and the income of the
consumer are fixed.
6) There is no change in the tastes of the consumer.
CONDITIONS OF CONSUMER EQUILIBRIUM

• The indifference curve must be convex to the


origin
• i) The consumer would not like to choose a
combination of X and Y represented by point
T or W (although they lie on the budget line
RS), because he will be on a lower
indifference curve IC1 and would thus be
getting less satisfaction vis-à-vis point e*,
which is on the same budget line RS but on a
higher indifference curve, IC2.
• ii) The consumer cannot move to indifference
curve IC3, as this is beyond his means
(money income) given by the budget line.
• iii) Even on the indifference curve IC2, all
other points, except e*, are beyond his
means.
INDIFFERENCE MAP
• An Indifference Map is a set of Indifference
Curves.
• Following are the features of indifference
curve:
1) The combination of two goods providing the
same utility is represented as an indifference
curve.
2) The pattern of preference is represented by
the indifference map. The higher the
indifference curve, higher is the level of
satisfaction.
SIGNIFICANCE OF INDIFFERENCE CURVE

• In the Theory of Production


• In the Theory of Exchange
• In the Field of Rationing
• In the Measurement of Consumer’s Surplus
• In the Field of Taxation
CRITICISM OF INDIFFERENCE CURVE
• Unrealistic assumptions
• No Novelty
• Indifference Curve is Non-Transitive
• Fails to Explain Risky Choice
• Absurd and Unrealistic Combinations
• Does not Provide Behavioristic Explanation of Consumer
Behaviour
• Based on Weak Ordering
DIFFERENCE BETWEEN CARDINAL AND ORDINAL
APPROACH
REVEALED PREFERENCE THEORY
Samuelson accurately analyses the way a consumer responds to the change in price
and income based on the real observations. The objective approach is taken into
consideration.

Hence, the revealed preference theory assumes to provide an accurate and


systematic description about the consumer demand.
ASSUMPTIONS OF REVEALED PREFERENCE THEORY
The theory of revealed preference which is developed by Samuelson are based on
the assumptions as follows:

• Two commodity model


• Given price-income situation
• Consistency of tastes
• Rationality
• Revealed preference axiom
• Strong ordering
• Transitivity condition
• Postive income elasticity of demand
The revealed preference theory is a way of understanding people’s preferences based on their observable
behavior, such as buying decisions. People often depict the theory graphically using a simple budget
constraint diagram.

The diagram consists of two axes: the horizontal axis represents the quantity of one good, and the vertical
axis represents the quantity of another good. The budget constraint is a straight line that shows all the
combinations of the two goods that can occur with a given income level and the prices of the goods. The
slope of the budget constraint represents the relative prices of the two goods.

The area under the budget constraint represents all the available feasible consumption bundles, given the
income level and prices of the goods. Any point on the budget constraint represents a particular
consumption bundle that exhausts the consumer’s income. The area above the budget constraint
represents unaffordable consumption bundles, given the income level and prices of the goods.

Overall, the revealed preference theory graph provides a visual representation of how consumers choose to
allocate their limited income among different goods based on their preferences and the prices of the goods.
TYPES OF ORDERING : BY HICKS
SIGNIFICANCE OF REVEALED PREFERENCE THEORY
• Behavioristic approach
• More realistic, objective and scientific
• Establishes the law of demand directly
• Requires no restrictive assumptions
• Does not require the assumption of continuity
• Simpler analysis
• Provides a new vista in welfare economics
LIMITATIONS OF REVEALED PREFERENCE THEORY
• Not a general theory of demand
• Bias towards strong ordering
• Over-stresses the consistency condition of rationality
• Imperfect theory
• More an academic exercise
• It has limited scope of applicability

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