Theory of Consumer Behaviour

Start Up: A Day at the Grocery Store

You are in the checkout line at the grocery store when your eyes wander over to the ice cream display. It
is a hot day and you could use something to cool you down before you get into your hot car. The problem
is that you have left your checkbook and credit and debit cards at home—on purpose, actually, because
you have decided that you only want to spend $20 today at the grocery store. You are uncertain whether
or not you have brought enough cash with you to pay for the items that are already in your cart. You put
the ice cream bar into your cart and tell the clerk to let you know if you go over $20 because that is all
you have. He rings it up and it comes to $22. You have to make a choice. You decide to keep the ice
cream and ask the clerk if he would mind returning a box of cookies to the shelf.
We all engage in these kinds of choices every day. We have budgets and must decide how to spend them.
The model of utility theory that economists have constructed to explain consumer choice assumes that
consumers will try to maximize their utility. For example, when you decided to keep the ice cream bar
and return the cookies, you, consciously or not, applied the marginal decision rule to the problem of
maximizing your utility: You bought the ice cream because you expect that eating it will give you greater
satisfaction than would consuming the box of cookies.
Utility theory provides insights into demand. It lets us look behind demand curves to see how utility-
maximizing consumers can be expected to respond to price changes. While the focus of this chapter is on
consumers making decisions about what goods and services to buy, the same model can be used to
understand how individuals make other types of decisions, such as how much to work and how much of
their incomes to spend now or to sock away for the future.
Consumer Behaviour is the study of individual customers, organizations, or groups’ behaviour while
selecting, purchasing, using, and disposing of the goods, ideas, and services so they can meet their wants
and needs. In simple terms, consumer behaviour is the study of consumers’ actions and reactions in the
marketplace and the reason behind their actions.
Consumer
A consumer is a person who purchases goods and services for the satisfaction of needs and wants. A
consumer is the end-user of the goods and services and cannot resell them. The choice and need of the
consumer for a good and service have a great impact on various decisions of an organization.
Importance of Consumer
 A consumer creates demand for different products in the market. It means that the needs and
wants of a consumer for different goods and services create its demand in the market and hence,
the need to produce them.
 A consumer consumes not only goods, but also a variety of services. Hence, the consumers in a
market enhance the diversification of different services. Examples of services are banking, health
care, insurance, etc.
 A consumer also plays a crucial role in increasing demand for consumer goods. Consumer goods
are of two types: durable and non-durable goods. Durable goods are those consumer goods that
have a life span of more than three years, such as television, refrigerator, washing machine, etc.
However, non-durable goods are those consumer goods that have a life span of less than three
years or can be a single use goods such as drinks, snacks, fruits, etc.
Consumer Behaviour
The behavior of a person is the way they act or behave in a certain situation. Every individual has
different perspectives, opinions, views, wants, tastes and needs. Hence, consumer behaviour deals with
the way consumers spend their income on different services and goods. For example, if a consumer has
₹2,000 and has different options to spend the money, like movies, clothes and food, there are different
ways in which he can spend the money. He can either spend the whole amount on one option or distribute
the amount among two or more options. The way in which the consumer uses his money will show his
behaviour or consumer behaviour.

The Concept of Utility

Why do you buy the goods and services you do? It must be because they provide you with satisfaction—
you feel better off because you have purchased them. Economists call this satisfaction utility.

The concept of utility is an elusive one. A person who consumes a good such as peaches gains utility
from eating the peaches. But we cannot measure this utility the same way we can measure a peach’s
weight or calorie content. There is no scale we can use to determine the quantity of utility a peach
generates.

Francis Edgeworth, one of the most important contributors to the theory of consumer behavior.
When we speak of maximizing utility, then, we are speaking of the maximization of something we cannot
measure. We assume, however, that each consumer acts as if he or she can measure utility and arranges
consumption so that the utility gained is as high as possible.

Utility

Utility is the want satisfying power of a consumer for a specific commodity. A consumer decides the
demand for a good based on the utility he/ she derives from the consumption of that good.

In simple terms, utility is the satisfaction gained by the consumer after the consumption of a specific
good. Utility is subjective in nature, and hence, different individuals gain different levels of utility from
the same good. The more a consumer needs a commodity after its consumption, the more will be the
utility derived from that commodity. For example, a consumer who likes ice cream will derive more
utility from its consumption than some other consumer who is not fond of ice cream.

What is utility?

A customer is the one who usually determines his demand for goods on the basis of the satisfaction
(utility) that he procures from them. So, what is a utility?

Utility of goods is their want-satisfying capability. More is the aspiration to have the goods, the more is
the utility procured from them. Utility is instinctive. Distinct people can get different degrees of utility
from the same goods. For instance, someone who likes sweets will get much higher utility from a sweet
than someone who doesn’t like sweets.

The utility that an individual obtains from the goods can differ with the change in location and time. For
instance, utility from the use of an air conditioner certainly relies upon whether the person is in Srinagar
or Jaipur (location) or whether it is winter or summer (season).

In economics, utility is a term used to determine the worth or value of a good or service. More
specifically, utility is the total satisfaction or benefit derived from consuming a good or service.
Economic theories based on rational choice usually assume that consumers will strive to maximize their
utility.

The economic utility of a good or service is important to understand because it directly influences the
demand, and therefore price, of that good or service. In practice, a consumer's utility is usually impossible
to measure or quantify. However, some economists believe that they can indirectly estimate what is the
utility of an economic good or service by employing various models.

 Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a service or
good.
 Although the concept of utility is abstract, it is a useful way to explain how and why consumers
make their decisions.
 "Ordinal" utility refers to the concept of one good being more useful or desirable than another.
 "Cardinal" utility is the idea of measuring economic value through imaginary units, known as
"utils."
 Marginal utility is the utility gained by consuming an additional unit of a service or good.

The utility definition in economics is derived from the concept of usefulness. An economic good yields
utility to the extent to which it's useful for satisfying a consumer’s want or need. Various schools of
thought differ as to how to model economic utility and measure the usefulness of a good or service.
Utility in economics was first coined by the noted 18th-century Swiss mathematician Daniel
Bernoulli. Since then, economic theory has progressed, leading to various types of economic utility.
Total Utility
If we could measure utility, total utility would be the number of units of utility that a consumer gains
from consuming a given quantity of a good, service, or activity during a particular time period. The
higher a consumer’s total utility, the greater that consumer’s level of satisfaction.

Panel (a) of Figure 7.1 “Total Utility and Marginal Utility Curves” shows the total utility Henry Higgins
obtains from attending movies. In drawing his total utility curve, we are imagining that he can measure
his total utility. The total utility curve shows that when Mr. Higgins attends no movies during a month,
his total utility from attending movies is zero. As he increases the number of movies he sees, his total
utility rises. When he consumes 1 movie, he obtains 36 units of utility. When he consumes 4 movies, his
total utility is 101. He achieves the maximum level of utility possible, 115, by seeing 6 movies per month.
Seeing a seventh movie adds nothing to his total utility.
Mr. Higgins’s total utility rises at a decreasing rate. The rate of increase is given by the slope of the total
utility curve, which is reported in Panel (a) of Figure 7.1 “Total Utility and Marginal Utility Curves” as
well. The slope of the curve between 0 movies and 1 movie is 36 because utility rises by this amount
when Mr. Higgins sees his first movie in the month. It is 28 between 1 and 2 movies, 22 between 2 and 3,
and so on. The slope between 6 and 7 movies is zero; the total utility curve between these two quantities
is horizontal.
Marginal Utility
The amount by which total utility rises with consumption of an additional unit of a good, service, or
activity, all other things unchanged, is marginal utility. The first movie Mr. Higgins sees increases his
total utility by 36 units. Hence, the marginal utility of the first movie is 36. The second increases his total
utility by 28 units; its marginal utility is 28. The seventh movie does not increase his total utility; its
marginal utility is zero. Notice that in the table marginal utility is listed between the columns for total
utility because, similar to other marginal concepts, marginal utility is the change in utility as we go from
one quantity to the next. Mr. Higgins’s marginal utility curve is plotted in Panel (b) of Figure 7.1 “Total
Utility and Marginal Utility Curves” The values for marginal utility are plotted midway between the
numbers of movies attended. The marginal utility curve is downward sloping; it shows that Mr. Higgins’s
marginal utility for movies declines as he consumes more of them.
Mr. Higgins’s marginal utility from movies is typical of all goods and services. Suppose that you
are really thirsty and you decide to consume a soft drink. Consuming the drink increases your utility,
probably by a lot. Suppose now you have another. That second drink probably increases your utility by
less than the first. A third would increase your utility by still less. This tendency of marginal utility to
decline beyond some level of consumption during a period is called the law of diminishing marginal
utility. This law implies that all goods and services eventually will have downward-sloping marginal
utility curves.
One way to think about this effect is to remember the last time you ate at an “all you can eat” cafeteria-
style restaurant. Did you eat only one type of food? Did you consume food without limit? No, because of
the law of diminishing marginal utility. As you consumed more of one kind of food, its marginal utility
fell. You reached a point at which the marginal utility of another dish was greater, and you switched to
that. Eventually, there was no food whose marginal utility was great enough to make it worth eating, and
you stopped.
What if the law of diminishing marginal utility did not hold? That is, what would life be like in a world of
constant or increasing marginal utility? In your mind go back to the cafeteria and imagine that you have
rather unusual preferences: Your favorite food is creamed spinach. You start with that because its
marginal utility is highest of all the choices before you in the cafeteria. As you eat more, however, its
marginal utility does not fall; it remains higher than the marginal utility of any other option. Unless eating
more creamed spinach somehow increases your marginal utility for some other food, you will eat only
creamed spinach. And until you have reached the limit of your body’s capacity (or the restaurant
manager’s patience), you will not stop. Failure of marginal utility to diminish would thus lead to
extraordinary levels of consumption of a single good to the exclusion of all others. Since we do not
observe that happening, it seems reasonable to assume that marginal utility falls beyond some level of
consumption.
Types of Utility
It is basically of two types
Total
The sum of the total satisfaction from the consumption of specific goods or services. It increases as more
goods are consumed.
Total Utility (T.U.) = U1 + U2 + … + Un
Marginal
It is the additional satisfaction gained from each extra unit of consumption. It decreases with each
additional increase in the consumption of a good.
Marginal Utility (M.U.) = Change in T.U. / Change in Total Quantity = Δ TU/ Δ Q
Types of Economic Utility
 Form: It refers to the specific product or service that a company offers.
 Place: It refers to the convenience and readiness of the services available at a place to the
customer
 Time: It refers to the ease of availability of products or services at the time when a customer
needs.
 Possession: It refers to the benefit a customer derives from the ownership of a company’s
product.
Characteristic of Utility
 It is dependent upon human wants.
 It is immeasurable.
 A utility is subjective.
 It depends on knowledge.
 Utility depends upon use.
 It is subjective.
 It depends on ownership.

Measurement of Utility
Measurement of a utility helps in analyzing the demand behaviour of a customer. It is measured in two
ways
Cardinal Approach
In this approach, one believes that it is measurable. One can express his or her satisfaction in cardinal
numbers i.e., the quantitative numbers such as 1, 2, 3, and so on. It tells the preference of a customer in
cardinal measurement. It is measured in utils.
Limitation of Cardinal Approach
 In the real world, one cannot always measure utility.
 One cannot add different types of satisfaction from different goods.
 For measuring it, it is assumed that utility of consumption of one good is independent of that of
another.
 It does not analyze the effect of a change in the price.
Ordinal Approach
In this approach, one believes that it is comparable. One can express his or her satisfaction in ranking.
One can compare commodities and give them certain ranks like first, second, tenth, etc. It shows the order
of preference. An ordinal approach is a qualitative approach to measuring a utility.
Limitation of Ordinal Approach
 It assumes that there are only two goods or two baskets of goods. It is not always true.
 Assigning a numerical value to a concept of utility is not easy.
 The consumer’s choice is expected to be either transitive or consistent. It is always not possible.
 Cardinal Utility – Meaning, Assumptions, Advantages, and Disadvantages

Utility in economics means the satisfaction that a consumer gets from a commodity or service. There are
economists who believe that we can’t measure the utility; instead, we can just rank them. We call this
approach Ordinal Utility. On the other hand, some economists believe that it is possible to measure
utility in absolute terms. And we call this approach Cardinal Utility. In this article, we will be discussing
the Cardinal Utility approach.

What is Cardinal Utility?

Neo-classical economists are the proponents of the Cardinal Utility approach. As per this approach, it is
possible for a customer to measure and express satisfaction in absolute values. Thus, neo-classical
economists have come up with a unit to express utility, and it is “Utils.”

For example, a consumer can say that he got 7 utils from consuming the first unit, 6 utils from the
second, and so on.

Usually, one ‘Util’ usually equals one dollar. This is because many economists were of the opinion that
the amount of money that a consumer is ready to pay for a good is a good measure of the utility that
they get from the good.

Neo-classical economists argue that the utility that a consumer gets from one good is independent of
the consumption of other goods. Another name for the Cardinal Utility approach is marginal analysis or
neo-classical approach.

Assumptions of Cardinal Utility Approach

Following are the assumptions of the cardinal utility approach:

 Consumers act rationally to buy the goods that give the maximum and highest satisfaction. It
means they will first buy the commodities that give them the highest satisfaction and then the
product that gives them the second highest utility, and so on.

 Consumers’ income is limited to buying goods and services. And this is why they first purchase
the product that gives them the highest satisfaction.

 The utility is measurable. And one unit of utility equals one unit of money. Or, we can say that 1
Util = 1 unit of money.

 With the increase in consumption, the utility or satisfaction from each additional unit will go
down. Or, we can say that the cardinal utility approach depends on the Diminishing Marginal
Utility.

 The marginal utility (MU) of the money doesn’t change, irrespective of the change in the income
level of the consumer.

 The utility is additive. It means that the utility that a consumer gets after consuming different
commodities can be added to get the total utility. For instance, if a user receives 7 utils after
 consuming the first unit, 6 after the second unit, and 5 after the third, then the total utility (TU)
after consuming the three units is 18 utils (7+6+5).

 The utility that a consumer gets from consuming one product is independent of the number of
units that a consumer consumes of other products.

Advantages of Cardinal Utility

These are the advantages of the Cardinal Utility approach:

 It aims to quantify utility with the use of cardinal numbers or weights. This, in turn, tells the
value a commodity holds for a consumer.

 It helps in analyzing the combination of two commodities.

 This approach assists in better classification of commodities into substitutes and their
complements.

 This approach helps to explain the Law of Demand, as well as the Law of Diminishing Marginal
Utility.

 It makes it easier to know if a user prefers one product to another.

Disadvantages of Cardinal Utility

These are the disadvantages:

 Like any other concept, this approach also suffers from unrealistic assumptions.

 In reality, there is no accurate way to quantify the satisfaction that a consumer can get.

 It may get hard to assign an absolute value to the utility.

 It may be difficult to quantify the utility to establish its economic value.

 Different factors can impact the decision of a user when assigning a value to the utility.

Cardinal Utility is a useful approach to get an idea of the importance that a product holds for a user. Like
with most other economic approaches, this approach also depends on many assumptions. And many of
these assumptions may not always hold. This approach is widely used in explaining consumer behavior
despite the assumptions and drawbacks.
 Marginal Utility – Meaning, Importance, Factors, Types, and Graph
What is Marginal Utility?
Marginal Utility (or MU) is a concept in economics. It is a measure of additional satisfaction or benefits
that a user gets from consuming one extra unit of a commodity or a service. Economists primarily use this
concept to determine how many units a user could purchase of a particular item.
MU isn’t constant; it can be positive, negative, or zero. MU is positive when the consumption of
additional units increases the total utility. And MU is negative when consuming additional units reduces
the overall utility.
Usually, the MU for a consumer drops as they consume more units of that commodity. We call such a
phenomenon the diminishing marginal utility.
A point to note is that utility and marginal utility are two different terms. The former reflects the total
level of satisfaction that a user gets after consuming a specific amount of a commodity or service. And
MU tells about the extra satisfaction that a user gets after consuming one more unit of a commodity.
Importance of Marginal Utility
MU also helps to explain how consumers make choices to gain maximum from the money they have.
Usually, a consumer would continue to consume more of a commodity as long as the MU is more than
the marginal cost. In an efficient market, the price of a commodity or service is the same as the marginal
cost. This is the reason why consumers will continue to buy until their MU drops or equals to the price of
the commodity or service.
Thus, knowing MU could prove extremely helpful for companies as it would give them an idea of the
effectiveness of their products/services in satisfying the demand of a user. This, in turn, assists
management in determining the chances of a user re-buying their product or service.
Companies can use this information to design their strategies for the existing set of customers. Also, it
guides them on the efforts they need to put in so that a user gets the same level of satisfaction after every
purchase. In short, we can say that MU can help companies retain customers.
It won’t be wrong to say that along with helping companies to study customer behavior or consumer
equilibrium. MU also helps in identifying market trends and determining product prices.
Factors Affecting Marginal Utility
There are many factors that impact the utility, but the two most important ones are time and first use.
By time here, we mean the time when a user consumes a product or service. For example, if you prefer
having a coffee in the morning, then its MU will be less if you drink a coffee in the evening. Similarly,
when you are alone, you could read books. But when your friends are around, you may not feel the need
to read books. This means that a product or service available at the right time offers more satisfaction.
Talking about the first use factor, the first unit you consume is more likely to give you more satisfaction
than the remaining units. For instance, when you are hungry, the first unit of food, say a burger is likely to
give more happiness than the next consecutive unit.
Types of Marginal Utility
Three most common types of MU are:
Positive MU
When a user gets more happiness by consuming an additional unit of the same commodity, it means
positive MU. For instance, if you love eating pizza and the second slice gives you more happiness than
the first, it will result in a positive MU.
Zero MU
This means that consuming an additional unit doesn’t bring more or less, but rather the same level of
happiness or satisfaction. Taking the above example, if after the second slice, your stomach starts to fill,
then the third slice will likely give you the same level of satisfaction as the second. The MU, in this case,
will be zero.
Negative MU
If the happiness or satisfaction a user gets after consuming an additional unit is less than the previous unit,
then it is negative MU. In the pizza example above, the fourth slice may give less satisfaction than the
third because you are no more hungry. This would result in a negative MU.

Formula and Example of Marginal Utility

Below is the most popular formula to calculate the MU:
Marginal Utility = Change in Total Utility/ Change in no. of units
Let’s take an example to understand the calculation of MU.
Suppose Mr. A goes to a restaurant to have a burger. Though the burger costs $3, Mr. A is so hungry that
he is ready to pay $5 for it. So, the utility of the burger will be $5. Mr. A eats two burgers, but for the
second burger, Mr. A is ready to pay $4 as he isn’t that much hungry anymore. Thus, the utility cost
drops.
Total utility for Mr. A in this visit will be $9 ($5 plus $4).
Mr. A visits the same restaurant again after a few days. This time, however, he is even more, hungrier and
decides to eat four burgers. Mr. A is ready to pay $6 for the first and $5 for the second. But after the first
two burgers, Mr. A isn’t hungrier, thus can pay only $2 each for the last two burgers.
The total utility for Mr. A in this visit will be $15 ($6 plus $5 plus $2 plus $2).
Change in total utility between the two visits = $15 less $9 = $6
Change in the no. of units between the two visits = 4 less 2 = 2
So, MU will be = 6/2 = 3
Real-World Applications of MU
The following are the most popular application of MU:
Progressive Taxation System
Such a taxation system means that those with higher incomes should pay more in taxes than those with
lower incomes. In contrast, a flat tax rate system is disadvantageous to those with low income because the
marginal cost will be more than the MU. Thus, we can say that MU justifies the
progressive taxation system.
Consumer Behavior
We now know that consumers will buy the products that give them more MU. Thus, companies can use
this information to work on ways to enhance a user’s MU with their products or service.
Pricing of Goods
Companies can also use MU for pricing their goods. For example, a restaurant sells two burgers, A and B.
From the sales data, the restaurant found that most customers order 2 units of B and one unit of A. This
could mean that MU for 2 units of B is the same for most customers. Using this information, the
restaurant adds an option to get 2 units of B together. This allowed the company to reduce its packing
costs and serve more customers.
Product Innovation
Manufacturers come up with innovations to ensure the marginal utility of a consumer doesn’t go down.
For example, if a car model performs well, then the automakers usually update that model for a few years,
i.e., add new innovative features, to ensure consumer keep loving it. Adding more features also justifies
the rise in prices. We can also say that MU helps with customer retention as well.

Law of Diminishing Marginal Utility

What is the Law of Diminishing Marginal Utility?
The law of diminishing marginal utility is an economic concept that helps to explain human buying
behavior. As per this law, the amount of satisfaction from consuming every additional unit of a good or
service drops as we increase the total consumption. Or, we can say that as the consumption increases, the
additional or marginal utility goes down with each additional unit.
In economics, the term utility refers to satisfaction or happiness. Total utility is also an economic term
that tells the total satisfaction after consuming a unit of a product or service. Marginal utility is the change
(increase or decrease) in the total utility after consuming an extra unit of good or service.
Law of Diminishing Marginal Utility
In general, also, consuming the first unit of a commodity gives us the highest enjoyment or happiness.
But as we consume more of the same commodity, after some time, we don’t feel the urge to consume
more of it.
This is what the law of diminishing marginal utility is all about. The first unit of a product gives the
highest level of utility. But the marginal utility drops with each subsequent intake of the commodity.
Moreover, if the consumers want to know marginal utility by spending the same dollars on various
commodities, it is called the law of equi marginal utility, which is also called an extension of the law of
marginal utility.
We can also use a graph to explain the law of diminishing marginal utility. In the graph below, the X-axis
shows the amount of units of a commodity that a consumer consumes. And the Y-axis shows the marginal
utility of each unit.
The graph below shows the total utility and the marginal utility curves. The graph clearly shows that the
total utility is maximum when the marginal utility is zero. This is because the MU is the slope of the total
utility curve. After zero MU, the total utility starts to drop, and MU goes negative. A negative marginal
utility implies that consuming more units will lead to dissatisfaction for the consumer.

The law of diminishing marginal utility also has a direct relation with the concept of diminishing prices.
As the marginal utility of goes down, a consumer will be willing to pay a lower price for a product or
service. For example, a consumer is willing to pay $20 for the first burger, but since he is no more after

the first burger, they will be willing to pay a less amount for the second burger. Example of Law of

Diminishing Marginal Utility

Let us understand the law of diminishing MU with the help of a simple example.
Mr. A is very hungry, and he goes to a pizza store where he buys a very large pizza with 6 slices. The first
slice of pizza gives him the maximum satisfaction, say 10. However, with the subsequent slices, Mr. A’s
satisfaction keeps reducing as his stomach gets to fill. Or, we can say that the marginal utility for Mr. A
diminishes as he consumes more pizza slices.
The following table shows Mr. A’s total utility and marginal utility.
Law of Diminishing Marginal Utility: Assumptions
The law of diminishing marginal utility makes the following assumptions:
 Consumers need to behave rationally to maximize their utility with their limited income. It means
that a consumer always makes sound decisions.
 Consumers need to continuously consume each extra unit of a commodity. It means that there
shouldn’t be a pause between consumption. This is because if there is a gap in the consumption of
two units, then the marginal utility may not drop. For example, if in the above pizza example,
suppose Mr. A eats the third slice after a break or when he feels hungry again, the marginal
utility, in this case, will increase.
 It is crucial that each unit of a product is standardized. This implies that the size, quality, and
volume of each unit should be the same. In case of a deviation, the marginal utility may change.
In the pizza example, if the second slice is smaller than the first one, then it is possible that Mr. A
would get the same level of satisfaction as from the first.
 One can easily measure utility. Also, a consumer can tell their satisfaction level in absolute value,
such as 1, 2, 3, etc.
 A consumer must consume the product in a reasonable quantity. For example, if a thirsty person
drinks water with a spoon, then every additional spoon will increase the satisfaction level.
 The marginal utility of money remains constant. Usually, after spending money on the first unit,
consumers are left with less money. The remaining money is generally dearer to the consumer.
This will increase the MU for money for the consumer. But the law assumes there is no change in
the MU for the money.
 The income of the consumer and the price of the commodity don’t change.
 There is no change in the taste and fashion of the consumer.
Exceptions
It is important to note that the law of diminishing marginal utility does not always hold. There are a few
scenarios when this law doesn’t hold, and these are:
 In the case of Addictions/Hobbies, this law doesn’t hold. For example, a person who loves to
paint may not witness a drop in marginal utility after a new painting. Similarly, for an alcoholic,
an extra glass of alcohol may not decrease the marginal utility.
 Items that are rare or valuable are also an exception to this law. For example, if someone loves to
collect a limited-edition watch, then they could continue collecting such items indefinitely
without any drop in the marginal utility.
Apart from these two exceptions, there is criticism against this law as well. And this criticism is that the
assumptions of the law of diminishing marginal utility may not always hold. For instance, a consumer
may not always make a rational decision. And there can also be cases when there is a usual gap between
the consumption of two units of a commodity.
Despite the exceptions and criticism, the law of diminishing marginal utility is a very popular economics
concept. Economists and exporters widely use this law to explain why consumers get less satisfaction
with every additional unit. Moreover, companies also use this concept to increase the marginal utility of
their products and services for consumers. This, in turn, help companies to increase their sales.

Why Must Marginal Utility be Equal to Price?

Marginal Utility is the extra or additional utility or satisfaction that a user gets after consuming one more
unit of a commodity. The concept of MU is very useful in understanding consumers’ buying decisions,
given their limited income. Also, in economics books, you would have read that it is important for
consumers to keep consuming until the marginal utility equals the price of the goods or services. But why
must marginal utility be equal to price?

In a nutshell, we can say that to reach optimal consumption; the marginal utility must be equal to the
price. But exactly how equating marginal utility and price gives optimal consumption is something we
will be answering in this article.
Explanation: Why Must Marginal Utility Equal to Price?
Marginal utility (MU) isn’t constant; in fact, it keeps on diminishing as we consume more units of the
same commodity. The MU is generally highest for the first unit and drops as a user consumes more units
of the same commodity. We call this the law of diminishing marginal utility.
Depending on the number of units that one consumes, the marginal utility can be positive, zero, or even
negative.
Suppose you are thirsty and you like an energy drink, then the first unit will give you maximum
satisfaction. Now, if you still want to drink another unit, then the MU of the energy drink will be positive.
MU will be zero if consuming another energy drink won’t bring any satisfaction or joy to you. And MU
will be negative if you don’t feel like drinking any more energy drinks or consuming more will get you
sick.
One can easily relate this diminishing MU concept with the concept of diminishing prices as well. If you
continue to consume more of a commodity, its MU will drop. Along with the drop in MU, the price that
you could be willing to pay for that extra unit will drop as well.
Taking the above energy drink example, you could be willing to pay a higher price for the first unit of
energy drink because you are thirsty. After the first unit, you don’t feel that thirsty, so you may not be
willing to pay the same price that you could have paid for the first unit. So, we can say that the optimum
level of consumption is to consume a product or service until the point where the MU equals the price.
Suppose we measure utility in terms of dollars spent, i.e., the money that a user will be willing to spend to
buy an additional unit. Now it would be illogical to pay the price for that commodity if the satisfaction
you get is less than that.

Example
Taking the energy drink example above, suppose the price of one energy drink is $10. If you are very
thirsty, then you could be willing to pay extra to get the energy drink, say $20. The MU for the first
energy drink ($20) is more than its price.
Now, you are not that thirsty, but you still feel the urge to drink another energy drink. You are ready to
pay $15 for it. For the second energy drink also, the MU ($15) is more than the price.
Now, you are not thirsty, but you can still drink another energy drink. But now you are ready to pay $10
for it. In this case, the MU of the third energy drink is equal to its price. So, this will be optimum
consumption.
In real life also, there are a lot of examples that use such a concept. Ticket pricing by Airlines does reflect
the marginal utility concept. The prices go up as the journey date approaches. Since the marginal utility
for a passenger will be more due to any medical emergency, unplanned trip, etc., they would be willing to
pay a higher price if they book the ticket close to the journey date.

Law of Equi Marginal Utility – Meaning, Assumptions, and Importance

Law of Equi Marginal Utility helps to explain consumer behavior in the case of more than one good or
service. There is no limit to human wants, but the income to satisfy those wants is limited. So, the law of
equi marginal utility explains how a consumer allots their limited income to various goods and services to
attain maximum satisfaction.
Australian economist H. H. Gossen was the first to come up with this law. Thus, we also call this law
Gossen’s second law, the law of maximum satisfaction, or the law of substitution. We can also call it
the principle of proportionality between prices and marginal utility (MU).
We can also call the law of equi marginal utility an extension of the law of diminishing marginal utility.
This is because a buyer can achieve maximum satisfaction by spending on different products in such a
way that the last dollar spent on each product offers equal MU.
Explanation: Law of Equi Marginal Utility
To get maximum satisfaction, a consumer needs to compare the satisfaction they get from each dollar
spent on different goods. Or, the consumer needs to spend the income in a way that the marginal utility of
all the things is equal. Suppose the dollar spent on one product gives the buyer more satisfaction than the
same dollar spent on another product. In that case, the buyer will continue to spend on the former product
until the satisfaction from the last dollar spent on the two products is equal.
Or, the buyer will substitute a few units of a product that gives him more satisfaction for some units of the
product that gives him less satisfaction. Now because of consuming more of one product, its MU will
drop, while the MU of the other will go up. Such a process will continue until the MU’s of two are equal.
This is the law of law of equi marginal utility.
Assumptions of Law of Equi Marginal Utility
Following are the assumptions of the law of equi marginal utility:
  Prices of the products don’t change.
 The income of the consumer doesn’t change.
 MU of the money remains constant.
 The buyer has complete information on the utility they get from the product or services.
 The buyer acts rationally to maximize satisfaction.
 The consumer is able to express or measure utility in cardinal terms.
 Products have substitutes, and the consumer has many wants.
 The Law of diminishing marginal utility forms the basis of this law.
Example
Assume Mr. A has two products of his choice – chocolates, and ice-creams, and has $7.

Suppose Mr. A spends $3 on ice-creams and $4 on chocolates. In this case, the marginal utility of the
3rd ice cream is 6, while of 4th chocolate is 2. Since the MU of ice cream is more than the chocolate, Mr.
A will continue to buy more ice-creams and fewer chocolates.
Now, Mr. A buys one more ice cream and one less chocolate, or four ice-creams and three chocolate.
Now, the MUs of both are the same at 4. So four ice creams and three chocolates give Mr. A the
maximum satisfaction.
We can calculate the total utility (TU) for this combination. TU for 4 ice-creams is 28 (10 + 8 + 6 + 4),
while for three chocolates is 18 (8 + 6 + 4). So, TU for the combination is 46. The total utility from no
other combination (with $7) will be more than the TU of the above combination (four ice creams and
three chocolates).
So, Mr. A was able to maximize satisfaction by equalizing the MUs by substituting the product that gives
more utility with the one less useful.
 Importance of Law of Equi Marginal Utility
The following points will help to bring out the importance of the law of equi marginal utility:
 It helps a rational consumer to maximize satisfaction using their limited resources. To maximize
the satisfaction level, the consumer makes an effort to equalize the weighted marginal utility of
all products.
 This law helps producers with production. Producers have limited resources to buy
various factors of production. So, the producer makes an effort to equalize the MU of all factors
to achieve the maximum output and profit.
 This law also forms the basis of the distribution of income among factors of production. An
entrepreneur would pay each factor as per the marginal productivity, which is measurable in
monetary terms. Also, the entrepreneur can substitute one factor with another until the marginal
productivity of the factors is the same on the basis of the money they get for their services.
 It assists during the exchange of goods and services also. Usually, people exchange a product that
has low utility with a product that gives them higher utility. So, in a way, this law helps in the
exchange wealth, trade, import, and export.
  Government can use this concept in public finance to attain the maximum social advantage. For
this, the MU of every dollar spent on one segment must equal the MU of a dollar spent on all
other segments.
 One can use this law to efficiently allocate time between work and rest. To decide between the
work and rest hours, one needs to compare the MU work with the MU of rest.
 One can also use this law to decide between saving and spending. For this, the consumer needs to
decide between the present and future needs. If the consumer believes that a dollar saved has
more utility than the dollar spent, then the consumer will save more. The consumer will continue
to save until the MU of the money spent and saved are equal.
 It helps with pricing as well. The prices of product go up if it is scarce. So, this law says that one
should go for the substitute, which is less scarce. Such an action would help to push down the
price of the primary product.
Exceptions to Law of Equi Marginal Utility
Though the law of equi marginal utility has many applications, it is not without exceptions. Following are
situations or scenarios when this law won’t work (we can also call these the limitations of this law):
 This law isn’t applicable in the case of knowledge. For instance, reading more and varieties of
books gives more satisfaction to a scholar.
 Also, this law doesn’t apply to indivisible goods. This is because consumers cannot divide the
product to adjust the utility.
 In the case of fashion and customs also, this law doesn’t hold. This is because people generally
tend to spend money on birthdays, marriages, and deaths.
 This law won’t work if a consumer’s income is very low, as maximizing utility isn’t possible due
to low income.
 Calculating MU for durable products isn’t possible. So, this law doesn’t work for durable goods
as well.
 If the goods of a consumer’s choice are unavailable, then this law won’t work. It is because the
consumer, in this case, will go for the product that gives him some satisfaction than products that
hold no utility at all.
 Some consumers don’t care for maximizing utility, or they are lazy consumers. Such buyers will
continue to consume products disregarding utility.
 This law won’t work when the products face frequent price changes. Price changes make it harder
to calculate the utility of products.
 When there is no limit on resources, there is no need to divert resources from one product to
another. So, the law won’t hold. Gifts of nature, such as water, are an excellent example of this.

Consumer Equilibrium – Meaning, Example, and Graph

What is Consumer Equilibrium?
Equilibrium in economics refers to a point or position that offers maximum benefits in a given situation.
Similarly, a consumer is said to be in equilibrium when they don’t want to change the current level of
consumption. Or, we can say consumer equilibrium is a point at which a consumer gets maximum
satisfaction from the commodities, given their income and prices of commodities remain unchanged.
Consumer Equilibrium is a very popular economics concept. This is because it helps to explain how
consumers maximize their utility by consuming one or more commodities. Moreover, it also assists
consumers in ranking the combination of two or more commodities on the basis of their taste and
preference.
Understanding Consumer Equilibrium
In simple words, a consumer is in equilibrium if he believes that he won’t be able to change his situation
either by making more money or increasing the expenditure, or altering the quantity of commodities that
he buys.
A rational consumer will buy a commodity to the point where the price of the commodity equals
the marginal utility (MU) from it. Until such a condition is met, the consumer will buy more or less of the
commodity.
In case the consumer buys more, the marginal utility will drop. And it would lead to a situation when a
consumer pays a higher price than the MU. The consumer will have to lower consumption to overcome
such a situation (negative utility or dissatisfaction). This will lead to a rise in MU. The consumer will
continue to reduce consumption until the price equals the marginal utility.
If the MU is more, it would mean that the consumer got additional satisfaction from the unit he consumed
earlier. Thus, the consumer would have to consume more of the commodity until the MU reduces and
equals the price.
So, we can say that by adjusting the purchase of a commodity, a consumer will be able to reach
equilibrium. Adjusting the purchase will get consumers to a point where the consumer’s total utility is
maximum, and the price equals the MU.
We can further explain equilibrium under two different situations. These are when a consumer spends all
income on a single commodity and when a consumer spends all income on two commodities.

Consumer Equilibrium: When Consumer Spend all Income on a Single Commodity

To explain this concept, we need to make the following assumptions:
 Consumer buys only one commodity.
 The price of the commodity is fixed. And the consumer only needs to decide the quantity they
need to buy at that price.
 Consumer acts rationally to maximize the total level of satisfaction.
  The consumer has enough money to purchase as many units as he wants of the commodity at the
given price.

Law of Diminishing Marginal Utility

We can use the law of diminishing marginal utility to explain the equilibrium in the case of a single
commodity. This law states that as a consumer consumes more quantity of a commodity, the marginal
utility from each additional quantity reduces.
In this case, the consumer uses two factors to determine the quantity that he would buy. These two factors
are the price of each unit of the commodity and the utility that a consumer gets. This means when
deciding on buying a unit of a commodity, a consumer compares the commodity’s price with the utility.
In this case, the consumer will be at equilibrium when the MU (in money terms) is equal to the price of
the commodity. If the commodity is ‘X,’ then the equilibrium will be MUx = Px. Px here is the price of
the commodity.
When the MUx is more than the price, the consumer will go on purchasing the commodity. This is
because the consumer is paying less for the additional satisfaction. As a consumer purchases more units,
it would lead to a drop in MU. The consumer will continue to buy more units until he reaches a state of
equilibrium, where MUx = Px.
In a scenario where the MUx is less than the price, the consumer will need to reduce consumption so as to
increase the satisfaction level. The reduction in consumption will continue until MUx equals the price.

Example of Single Commodity

Let’s take an example to understand the concept better.
Suppose Mr. A wants to buy a commodity that has a price of $10. To make it simple, we are assuming
that one MU equals $1.
When the quantity consumed is 1 and MUx is 20, then MUx in money terms will be $20 (20 * $1). The
difference, in this case, will be $10, or we can say MUx is more than the price (the price, in this case, is
$10 as there is only one unit).
So, to reach equilibrium, the consumer will increase their consumption. When the consumption rises to 2
units, the difference reduces to 6. And, when the consumption is 3 units, the difference is zero. So, at 3
units, MUx equals the price, which is the equilibrium point.
Now, suppose Mr. A continues to increase consumption beyond three units. This will result in a drop in
MUx. To reach equilibrium, Mr. A will now have to reduce consumption.

Consumer Equilibrium: When Consumer Spend all Income on Two or More Commodities
The law of diminishing marginal utility doesn’t hold when there are two or more commodities. Instead,
we use the law of equi-marginal utility to find out how a consumer allocates the income optimally. As per
this law, the consumer should use his income to buy commodities in such a way that the last dollar spent
on each commodity gives the consumer equal marginal utility so as to get maximum satisfaction.
Further, as per this law, a consumer is at equilibrium when the ratio of MU and the price of one
commodity is the same as the ratio of MU and the price of other commodities.
For instance, if there are two commodities (a and b), then the equilibrium will be: (MUa/Pa) = (MUb/Pb).
A point to note is that MU/P is basically the Utility in monetary terms, or the MU of the last dollar spent.
Example of Two or More Commodities
Let’s take an example to get a better understanding:
Mr. A has an income of $5 that he needs to use to buy two commodities X and Y. The price of both
commodities is $1 each. It means, Mr. A can buy a maximum of five units of each commodity. The table
below shows the marginal utility for Mr. A after consuming various units of both commodities.

From the above table, we can get that Mr. A will first buy one unit of X as it will give 20 utility. Then he
will buy one unit of Y as it gives him 16 utility.
In this case, the equilibrium will be when Mr. A consumes 3 units of X and 2 units of Y.
MUx/Px at 3 units is 12, while MUy/Py at 2 units is 12.
With this combination, Mr. A will be able to use all his income (With $5, Mr. A can buy 3 units of X and
2 units of Y).
So, now we can say that consumer equilibrium is a point at which a consumer gets maximum satisfaction
from consuming certain units of one or more commodities. This economic concept is simple to
understand. Thus, economists and educational institutions use it widely to explain how a consumer makes
choices.
 Ordinal Utility – Meaning and Assumptions
The utility is an important term in economics as it refers to satisfaction. Measuring utility has always been
a topic of debate. Many economists view utility as a qualitative thing that isn’t measurable. On the other
hand, many economists believe utility is measurable. Thus, there are two main theories for utility – one
that says the utility is measurable in absolute terms and the other that says the utility isn’t measurable, but
it is possible to rank it. The former approach is called Cardinal Utility, while the latter one is called
Ordinal Utility.
Modern economists are the proponents of the Ordinal Utility approach, unlike the neo-classical
economists, who believe it is possible to express utility in cardinal numbers. In 1930, John Hicks and R.J.
Allen made an argument in favor of using Ordinal Utility to explain consumer behavior.
What is Ordinal Utility?
As per Ordinal Utility, it isn’t possible to measure utility in numbers. However, it is possible for
consumers to rank their preferences. This approach believes that utility is a psychological thing,
something similar to happiness. Also, as per this approach, utility is a subjective thing and varies from
person to person.
So, in simple words, we can say that ordinal utility asserts that it is easier to ask a consumer how good a
product is in comparison to others instead of how good any product is. For example, it is easy for anyone
to tell if they love pizza or burgers, but now how much he loves pizza or burgers.
We can use an indifference curve (IC) to graphically show the preferences of consumers. In fact, the
concept of IC is based on the Ordinal Utility approach. Each IC (on an IC map) depicts combinations of
two goods that hold equal utility for a consumer. So, if there is more than one IC, then the curve that is
distant from the origin offers a higher utility level. Another name for Ordinal Utility theory is indifference
curve analysis because IC is the primary analytical tool of this theory.
Thus, as per this approach, one can measure the utility in relative terms, like if a product is less than or
equal to or more than the other product. Or, we can say that this approach explains consumer behavior
through preferences or rankings. In the pizza and burger example, if a person likes pizza more, then pizza
would have a higher rank than the burger.
So, in this approach, ordering or ranking of the satisfaction level is more important.
 Ordinal Utility Assumptions
Following are the assumptions of the Ordinal Utility approach:
1) Rationality: The basic assumption is that consumer is a rational being, i.e., he prefers more to less and
tries to maximise his satisfaction.
2) Indifference curve analysis assumes that utility is only ordinally expressible i.e. utility derived from
two goods can be compared, as more, less, or equal, but not how much more or less.
3) Transitivity: Consumer choices are assumed to be transitive. Transitivity of choices means that if a
consumer prefers A to B and B to C, then he prefers A to C, or if she treats A>B and B>C, then she also
treats A>C.
4) Consistency: Consistency of choice means that if a person prefers A over B in one period, he/she will
not prefer B over A in another period.
5) Non satiety: This assumption means that a consumer prefers a larger quantity of all the goods over
smaller quantities of the same.
6) Diminishing Marginal Rate of Substitution (MRS): MRS is that rate at which a consumer is willing to
substitute one commodity (say X) for another (say Y) while maintaining the same utility or level of
satisfaction to the consumer.
The ordinal utility approach states that satisfaction or utility isn’t measurable in numbers. But it is
possible for a consumer to rank the satisfaction that they get from different combinations of commodities.
This approach is a psychological thing. And the focus is on ranking one combination against another and
not by how much a consumer prefers one combination over another.
Indifference Curve – Meaning, Features, Example, and Graph
J.R Hicks used the concept of Indifference curve to analyse consumer behaviour. A consumer facing
choice between large number of bundles of two goods tries to maximise his satisfaction by choosing a
combination which gives him maximum utility. In the course of decision making, consumer finds out that
goods can be substituted for each other and identifies various combinations of commodities that give him
equal level of satisfaction. When all these combinations are plotted graphically, it produces a curve called
Indifference curve.
Indifference Curve (or IC) is an economic phenomenon that helps understand customer preference. It is
basically a graphical representation showing different combinations of two commodities that give a
similar level of satisfaction to a customer; hence, the customer is indifferent between them. At every point
on the curve, the customer is indifferent as they get the same level of utility at those points.
Each point on the indifference curve shows different consumption bundles or combinations of two
commodities. We can say that this economic concept analyses the commodity combinations, budget
constraints, as well as preferences of customers.
British economist Francis Ysidro Edgeworth was the first to propose the IC. Another name for this
curve is the iso-utility curve.
Indifference Schedule
An indifference schedule is a table which represents various combinations of two goods, which yield
equal satisfaction to consumer. Since all the combinations give equal level of satisfaction, consumer
is indifferent between them.

In above table, five different combinations of Tea and Biscuits are depicted. All these combinations
give equal level of satisfaction i.e. K. The consumer is indifferent whether he buys 1 cup of tea and
12 biscuits or 2 cups of tea and 8 biscuits. Different schedules can be formed showing different levels
of satisfaction
Indifference Curve
The graphical presentation of Indifference schedule is known as Indifference curve. The indifference
curve is locus of all the combinations of two commodities which give same level of satisfaction to the
consumer.

Fig. 5.1 is graphical representation of Table 5.1. It shows all the combinations of good X and good Y i.e.
A, B, C, D and E which yield equal level of satisfaction to the consumer. The curve is downward sloping,
convex to the point of origin.

Indifference Map
The combinations of two commodities X and Y given in the Indifference schedule are not the only
possible combinations for these commodities. The consumer may make any other combinations with less
of one or both of the goods, each yielding the same level of satisfaction but less than the one shown in
schedule. IC curve of this schedule will be above IC1. Similarly, the consumer may make other
combinations with more of one or both of the goods, each combination yielding the same satisfaction but
greater than the satisfaction indicated. A diagram showing different indifference curves
corresponding to different indifference schedules of the consumer is indifference map. In other
words, a set or family of indifference curves is an indifference map.
Fig. 5.2 shows four indifference curves: IC1, IC2, IC3 and IC4. All the points on IC2 will yield higher
satisfaction than the points on IC1 and all the points on IC3 will yield lesser satisfaction than the points
on IC4.

Law of Diminishing Marginal Rate of Substitution

What is Marginal Rate of Substitution?
Marginal rate of substitution may be defined as the rate at which a consumer will exchange successive
units of a commodity for another. In other words, Marginal rate of substitution is the rate at which, in
order to get the additional units of a commodity, the consumer is willing to sacrifice or give up to get one
additional unit of another commodity. The Marginal Rate of Substitution can symbolically be represented
as under:
MRSxy= ΔY/ΔX
Where
MRSxy= Marginal rate of substitution of X for Y
ΔY= Change in ‘Y’ commodity
ΔX= Change in ‘X’ commodity.

Diminishing Marginal rate of Substitution

One of the basic postulates of ordinal utility theory is that Marginal rate of substitution (MRSxy or
MRSyx) decreases. It means that the quantity of a commodity that a consumer is willing to sacrifice for
an additional unit of another commodity goes on decreasing. Law of diminishing Marginal rate of
substitution is an extensive form of the law of diminishing Marginal Utility. As discussed in previous
section, Law of diminishing marginal Utility states that as a consumer increases the consumption of a
good, his marginal utility goes on diminishing. Similarly as consumer gets more and more unit of good X,
he is willing to sacrifice less and less units of good Y for each extra unit of X. The significance of good X
in terms of good Y goes on diminishing with each addition of good X. The law can be understood with
the help of following Table 5.2.

To have the second combination and yet to be at the same level of satisfaction, the consumer is ready to
forgo 3 units of Y for obtaining an extra unit of X. The marginal rate of substitution of X for Y is 3:1. The
rate of substitution is units of Y for which one unit of X is a substitute. As the consumer desires to have
additional unit of X, he is willing to give away less and less units of Y so that the marginal rate of
substitution falls from 3:1 to 1:1 in the fourth combination. In Fig. 5.3 given below at point M on the
Indifference curve I, the consumer is willing to give up 3 units of Y to get an additional unit of X. Hence,
MRSxy =3. As he moves along the curve from M to N, MRSxy, = 2. When the consumer moves
downwards along the indifference curve, he acquires more of X and less of Y. The amount of Y he is
prepared to give up to get additional units of X becomes smaller and smaller.

The marginal rate of substitution of X for Y (MRSxy) is, in fact, the slope of the curve at a point on the
indifference curve, such as points M, N or P in Fig. 5.3.
Thus MRSxy = ∆Y/∆X.

Features of Indifference Curve

Properties of Indifference Curve
1) Indifference curve slopes downwards from left to right: It implies that Indifference curve has a
negative slope. This attribute is based on the assumption that if a consumer uses more quantity of one
good, he has to reduce the consumption of the other good in order to stay at the same level of satisfaction.
2) Indifference curves are generally convex to the origin ‘O’: This property is based on the principle of
Diminishing Marginal Rate of Substitution. It means that as the units of ‘X’ are increased by equal
amounts, the ‘Y’ diminishes by smaller and smaller amounts. This happens because as a consumer gets
more and more units of ‘X’ good, he is willing to give up less and less units of good Y for each extra unit
of X.
3) Indifference curves cannot intersect each other: This is because of the fact that each indifference
curve represents different level of satisfaction. If two indifference curves intersect, it will lead to self-
contradictory result. In Fig. 5.4, two Indifference curve IC1 and IC2 are shown intersecting each other at
point C. But this is not possible.
Point ‘A’ and point ‘C’ on Indifference curve IC1 represents combination yielding equal satisfaction.
That is satisfaction from A combination = the satisfaction from C combination, therefore,
i) Pt. A = Pt. C ( Because both lie on same IC curve IC1)
ii) ii) Pt. B = Pt. C ( Because both lie on same IC curve IC2)
Thus Pt. B = Pt. A in terms of satisfaction. But this is impossible because at combination ‘B’ quantities of
both X and Y are more than in combination ‘A’, hence this is self-contradictory.

Thus, two Indifference curves cannot intersect with each other. The Indifference curves cannot be
tangent to each other.
4) Higher Indifference curve represents higher level of satisfaction: In Fig. 5.5, the indifference
curve IC2 lies above and to the right of the IC1. Point C on IC2 represents more units of ‘x’ than
point A on IC1. Similarly, Point B on IC2 represents more units of ‘y’ than point A on IC1. It is thus
evident that higher the indifference curve, the higher the satisfaction it represents because our
consumer prefers more of a good to less of it. Also note that all the points between B and C on IC2
show larger amounts of both X and Y compared to point A on IC1.
5) Indifference curves do not touch either of the axes X or Y . This is because of the assumption
that the consumer purchases combination of different commodities. In case, an indifference curve
touches either axis, it means the consumer wants only one commodity and his demand for the second
commodity is zero. Purchasing one commodity means monomania, i.e. consumer’s lack of interest in
the other commodity. This is against the assumption of Indifference curve which is a two good model.

6) No Indifference curve cuts either of axes: If it were to happen, the consumer will be consuming
negative quantity of that commodity which makes no sense.
 SOME EXCEPTIONAL SHAPES OF INDIFFERENCE CURVE

Indifference curve may take a different shape in case of perfect substitutes and perfect complements.
Some exceptional shapes of Indifference curve are discussed as follows:

Perfect Substitutes Two goods are perfect substitutes if the utility consumers get from one good is the
same as another. When two goods are perfect substitutes of each other, their indifference curve will be a
straight diagonal line sloping downwards from left to right. It is because of the fact that MRS in such
cases is constant i.e. 1. For example: Suppose good A and good B are perfect substitutes, consumer will
be indifferent between them and will be ready to sacrifice equal quantity of good A to achieve good B.
But, even here, the ICs will not cross the axes.

Perfect Complements
Two goods may be perfect complementary to each other. Just as left and right shoes, cups and saucers of
a tea set etc. In such case, the indifference curve will be parallel to each other and bent at 90 degree angle
or L shaped. Perfect complementary goods are those goods which are used in fixed ratio i.e. 1:1or 2:2.
They cannot be substituted for each other, thus putting MRS as zero. This case is shown in Fig. 5.7. It is
clear that IC1 and IC2 are right angled curves, meaning thereby that the consumer buys piece of each
right shoe. This will be useless. The consumer will be no better off and he will remain at point ‘A’ on
IC1. In case, he buys 2 pieces of left shoe and only one piece of right shoe, it will be useless, the
consumer will be no better off and he will remain at point C of IC1. It means that having one more pair of
shoe will not add to his satisfaction. But if he buys one more shoe, his satisfaction will immensely
increase and he will move to point B on higher Indifference curve IC2.
 BUDGET LINE
As discussed above, a rational consumer always acts according to his budget constraint and tries to
maximise his level of satisfaction. Thus, the knowledge of the concept of budget line or what is also
called budget constraint is essential for understanding the theory of consumer’s equilibrium.
A consumer in his attempt to maximize his satisfaction will try to reach the highest possible indifference
curve. But in his pursuit of maximizing satisfaction by buying more and more goods, he has to consider
two constraints:
first, he has to pay the prices for the goods and,
secondly, he has a limited money income to purchase the goods.

Thus, how much a person is capable to buy depends upon the prices of the goods and the money income
which he has at his disposal. Price line or budget line represents all possible combinations of two goods
that a consumer can purchase with his given income and the given prices of two goods. Let us try to
understand the concept with the help of an example:
Suppose a consumer has an income of Rs. 100 to spend on Oranges and Apples which cost Rs. 10 each.
He can either spend his limited income only on one good or both the goods. All the possible alternative
combinations of two goods are presented in Table 5.3.
It can be observed from the above table that if the consumer spends his total income of Rs. 100 on
Apples, he is able to buy 10 Apples. On the other hand, if he buys Oranges alone, he can get 10 Oranges
by spending his total income. Further, a consumer can also buy both the goods in different combinations.
The budget line can be written algebraically as follows: Algebraic Expression for Budget Set: The
consumer can buy any bundle (A, B), such that: M ≥ (PX * QX) + (PY * QY) Where PX and PY denote
prices of goods X and Y respectively and M stands for money income We can rewrite the budget line as:
PYQY = M – PXQX dividing both sides by PY yields: QY =  Åç − Å ç Q This is the budget line
plotted in Fig. 5.8.
SLOPE OF BUDGET LINE
As we know that the slope of a curve is calculated as a change in variable on the Y-axis divided by
change in variable on the X-axis, slope of the budget line in given example will be number of units of
Oranges, that the consumer is willing to sacrifice for an additional unit of Apple.

Slope of Budget Line = Units of Oranges (Y) willing to Sacrifice/ Units of Apples (X) willing to Gain
= ∆Y/∆X

In above example, 1 Apple need to be sacrificed each time to gain 1 Orange. So, Slope of Budget Line =
–1/1 = –1
This slope of budget line is equal to ‘Price Ratio’ of two goods.
Price Ratio = Price of X (PX)/Price of Y (PY)
= –PX /PY
Budget line is presented in Fig. 5.8.
SHIFT IN BUDGET LINE
Budget line is drawn on the basis of assumption of constant prices of the goods and constant income of
the consumer. Thus, if there is any change in either of the two variables, budget line shifts. Thus, there are
two variables that cause shift in Budget Line:
1) Change in Income of the consumer
2) Change in equal proportion of Prices of both the goods.

Change in Income of the consumer

If income changes while the prices of goods remain the same, Budget line will shift rightwards or
leftwards. Since the prices of two goods are constant, slope of budget line will remain constant. The effect
of changes in income on the budget line is shown in Fig. 5.9. If consumer’s income increases while prices
of both goods X and Y remain unaltered, the price line shifts upward and is parallel to the original budget
line.
This is because with the increased income the consumer is able to purchase proportionately larger
quantity of both goods than before. On the other hand, if income of the consumer decreases, prices of
both goods X and Y remaining unchanged, the budget line shifts downward but remains parallel to the
original price line. This is because a lower income will leave the consumer in a position to buy
proportionately smaller quantities of both goods.
Changes in Price of either of the two goods:
Budget Line also shifts when there is change in price of either of the two goods. Increase in price of any
commodity reduces the purchasing power of the consumer, in turn reducing the quantity demanded.
Shift of Budget line due to change in prices of either good x or good y is presented below:

Changes in Budget Line as a Result of Changes in Price of Good X

Suppose, price of good X rises, the price of good Y and income remaining unaltered. With higher price of
good X, the consumer can purchase smaller quantity of X. In Fig. 5.10, original price line is AB. With
increase in Price of good X, budget line will shift to AB2 i.e. consumer will be able to buy less quantity of
good X, quantity of good Y remaining same. Similarly when there is fall in price of good X, keeping prices
of good Y constant, budget line shifts from AB to AB1 i.e. consumer will be able to buy more quantity of
good X, quantity of good Y remaining same.

Change in Price of good Y

Fig. 5.11 shows the changes in the budget line when price of good Y falls or rises, with the price of X and
income remaining the same. It can be observed from Fig. 5.11 that the initial budget line is AB. With fall
in price of good Y, other things remaining unchanged, the consumer could buy more of Y with the given
money income and therefore budget line will shift above to EB. Similarly, with the rise in price of Y,
other things being constant, and the budget line will shift below to DB.
 CONSUMER EQUILIBRIUM THROUGH
INDIFFERENCE CURVE ANALYSIS
Assumptions
As discussed above, consumer equilibrium is a point of maximum satisfaction for the consumer. It is a
state of rest for the consumer. Study of Consumer equilibrium requires some assumptions to be made
about the consumer behavior. These are:
i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and
prices.
ii) Consumer has an indifference map, showing his scale of preference for various combinations of good x
and y.
iii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction
of each combination of goods.
iv) Consistency of choice: It is also assumed that the consumer is consistent in the choice of combination
of goods.
v) Consumer has a given and fixed amount of money income to spend on the goods. Thus, consumer has
to choose to spend his income on either of the two goods or a combination thereof.
vi) All the units of the goods are homogeneous.
vii) The goods are divisible i.e. they can be divided into small units.
viii) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

Conditions of Consumer’s Equilibrium

There are two fundamental conditions of consumer’s equilibrium through Indifference curve approach:
1) The price line should be tangent to the Indifference curve. It means that at the point of equilibrium
the slope of the indifference curve and of the price line should be same. The slope of Indifference curve
indicates MRSxy i.e. –ΔY/ΔX. The slope of the price line indicates the ratio between price of two goods
X and Y i.e. Px/Py.
2) Indifference curve should be convex to the point of origin: Marginal rate of substitution of X for Y
(MRSxy i.e. Δy/Δx) is equal to the slope of the price line that indicates the ratio between prices of two
goods.

Condition 1: MRSXY = Ratio of prices or PX/PY

Let the two goods be X and Y. The first condition for consumer’s equilibrium is that
MRSxy = Px/Py
• If MRSxy> Px/Py, it means that the consumer is willing to pay more for X than the price prevailing in
the market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the
ratio of prices and the equilibrium is established.
• If MRSxy< Px/Py, it means that the consumer is willing to pay less for X than the price prevailing in the
market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes
equal to the ratio of prices and the equilibrium is established.

Condition 2: MRS continuously falls

The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of
equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless
MRS continuously falls, the equilibrium cannot be established. Thus, both the conditions need to be
fulfilled for a consumer to be in equilibrium.
Let us now understand this with the help of a diagram:

In Fig. 5.12, IC1, IC2 and IC3 are the three indifference curves and MM is the budget line. With the
constraint of budget line, the highest indifference curve, which a consumer can reach, is IC2. The budget
line is tangent to indifference curve IC2 at point ‘P’. This is the point of consumer equilibrium.

All other points on the budget line to the left or right of point ‘P’ will lie on lower indifference curves and
thus indicate a lower level of satisfaction. As budget line can be tangent to one and only one indifference
curve, consumer maximises his satisfaction at point P, when both the conditions of consumer’s
equilibrium are satisfied:

i) MRS = Ratio of prices or PX/PY:

At tangency point P, the absolute value of the slope of the indifference curve (MRS between X and Y)
and that of the budget line (price ratio) are same. Equilibrium cannot be established at any other point
such as MRSXY> PX/PY at all points to the left of point P or MRSXY< PX/PY at all points to the right
of point P. So, equilibrium is established at point P, when MRSXY = PX/PY.

ii) MRS continuously falls:

The second condition is also satisfied at point P as MRS is diminishing at point P, i.e. IC2 is convex to
the origin at point P.

Criticism of Indifference Curve

Like many other economic concepts, most criticism against IC is because of its oversimplifying or
unrealistic assumptions. Also, many economists argue that the preferences of a user may change between
two time periods. Some economists believe that having a concave or even a circular curve is possible. If
we leave out these criticisms, then the indifference curve is the most popular and one of the best
explanations of customer preferences.

How Indifference Curve Analysis is Superior over Utility Analysis?

1. It Dispenses with Cardinal Measurement of Utility:

The entire utility analysis assumes that utility is a cardinally measurable quantity which can be assigned
weights called ‘Utils’.

If the utility of an apple in 10 utils of a banana it is 20 utils, and of a cherry 40 utils, then the utility of a
banana is twice that of an apple and of cherry four times that of apple and twice that of banana. This is not
measurability but transitivity.

In fact, the utility which a commodity possesses for a consumer is something subjective and
psychological and therefore cannot be measured quantitatively. The indifference approach is superior to
the utility analysis because it measures utility ordinarily.

2. It studies Combination of Two Goods Instead of One Good:

The utility approach a single commodity analysis in which the utility of one commodity is regarded
independent of the other. Marshall avoided the discussion of substitutes and complementary goods by
grouping them together as one commodity.

While the Indifference Curve technique is a two-commodity model which discusses consumer behaviour
in the case of substitutes complementary and unrelated goods. It is thus superior to the utility analysis.

3. It Provides a better Classification of Goods into Substitutes and Complements:

Early days economists explained substitutes and complements in terms of cross elasticity of demand.
Prof. Hicks considers this inadequate and explains them after making compensating variations in income.
He thus overcomes the ambiguity to be found in the traditional classification of substitutes and
complements.

4. It Explains the Law of Diminishing Marginal Utility without the Unrealistic Assumptions of the
Utility Analysis:

The utility analysis postulates the Law of Diminishing Marginal Utility which is applicable to all types of
goods including money. But this law is based on the cardinal measurement, it possesses all the defects
inherent in the latter.
Prof. Hicks says that it is a positive change and it is scientific and at the same time, free from the
psychological quantitative measurement of the utility analysis. The application of this principle in the
fields of consumption, production and distribution has made economics more realistic.

5. It is free from the Assumption of Constant Marginal Utility of Money:

The Utility analysis assumes constant marginal utility of money. Marshall justifies it on the plea that an
individual consumer spends only a small part of his whole expenditure on any one thing at a time. This
assumption makes the utility theory unrealistic in more than one way. On the other-hand, the Indifference
Curve technique analyses the income effect when the income of the consumer changes.

6. It Explains the Dual Effects of the Price Effect:

Utility analysis fails to analyse the income and substitution effects of a price change. In the indifference
curve technique when the price of a good falls, the real income of the consumer increases. This is the
income effect.

Further, when the price falls, the goods become cheaper. This Indifference Curve technique is definitely
superior to the utility analysis because it discusses the income effect when the consumer’s income
changes, the price effect when the price of a particular goods changes and its dual effect in the form of the
income and substitution effect.

7. It Explains the Proportionality Rule in a Better Way:

The Indifference Curve technique explains consumer’s equilibrium in a similar but in a better way than
the Marshallian proportionality rule. The consumer is in equilibrium at a point where his budget line is
tangent to the Indifference Curve. At this point the slope of the Indifference Curve equals the budget line.

8. It Explains the Law of Demand more Realistically:

The Indifference Curve technique explains the Law of Demand in a more realistic manner. It explains the
effect of the fall in the price of an inferior goods on consumer’s demand. Giffen goods which remained a
paradox for Marshall through-out, have been ably explained with the help of this technique.

Indifference Curve and Utility Approach: Similarities

Similarity # 1. Assumption of Rationality:

Both the approaches assume that their consumers behave rationally. They behave rationally so as to
maximize their utility or satisfaction. Marshall used the term utility. But Hicks and Allen preferred the
term ‘satisfaction’ instead of ‘utility’. What is important to us is that what is ‘utility’ with Marshall
is ‘satisfaction’ with Hicks.

Similarity # 2. Equilibrium Condition:

So far as the equilibrium condition of consumer is concerned, both the approaches believe in the
proportionality rule. In Marshall’s analysis, a consumer reaches equilibrium when the ratios of the
marginal utilities of various commodities, say X and Y, are equal to their price ratio of two goods.
Symbolically,

MUX/MUY = PX/PY
In the indifference curve analysis, a consumer reaches equilibrium when the slope of the indifference
curve, MRSXY, is equal to the slope of the budget line, PX/PY. Symbolically,

MRSXY = PX/PY

It is worth noting here that there is a relationship between marginal rate of substitution (MRS) and
marginal utility (MU). As a consumer moves along an indifference curve his consumption of one good,
say Y, decreases, while that of another good, say X, rises.

When the consumer sacrifices Y, his marginal utility for Y becomes -∆Y × MU of Y. But as consumption
of X increases his MU for X becomes ∆X × MU of X. Since, on an indifference curve, satisfaction
remains unchanged, decline in utility must be compensated by an increase in utility. That is,

– ∆Y.MUY = ∆X.MUX

Or- ∆Y/∆X = MUX/MUY

– ∆Y /∆X is the slope of the indifference curve which is nothing but MRSXY.

So, one can write

MRSXY = MUX/MUY

It is thus clear that the equilibrium condition for both the approaches is the same:

MRSXY (=MUX/MUY) = PX/PY

In the indifference curve analysis, MUX/MUY has been substituted for MRSXY.

Similarity # 3. Introspective Approach:

Both the approaches employ the method of introspection. Utility approach is labeled as “introspective
cardinalisim” while indifference analysis is labeled as “introspective ordinalism”. Utility analysis is
based on introspection. Like the utility analysis, indifference approach is also rooted in the introspectively
derived ordinal utility functions of the consumers.

To this extent, this approach is also subjective. In view of this, Tapas Majumdar said:

“…the basic methodological approach of Hicks-Allen is the same as in the Marshallian marginal utility
hypothesis; it is, that is to say, mainly introspective…”.

Similarity # 4. Diminishing MU:

Both the approaches implicitly or explicitly assume diminishing marginal utility derived from a com-
modity. However, diminishing marginal utility is explicitly recognized in utility analysis. The concept of
diminishing marginal utility is implicit in the Hicks- Allen analysis. In this analysis, an indifference curve
becomes convex to the origin because of diminishing MRS. And MRS is equivalent to MU X/MUY.

Law of diminishing MU and the law of diminishing MRS are the two sides of the same coin.

Thus, what is clear from the above discussion is that there are striking similarities—rather than striking
differences —between the two approaches.
Indifference curve analysis has simply substituted new concepts and equations in place of psychological
or subjective concept of utility. It has simply changed the garb without altering the basic premise. In view
of this, Robertson thinks that the indifference curve technique is just an ‘old wine in a new bottle’.