.47 THEORY OF DEMAND AND SUPPLY 2.

47

UNIT – 2 : THEORY OF CONSUMER BEHAVIOUR

LEARNING OUTCOMES

At the end of this unit, you should be able to:

♦ Explain the meaning of utility.

♦ Describe how consumers try to maximize their satisfaction by spending on different

goods.

♦ Explain the law of diminishing marginal utility with examples.

♦ Describe the concept of consumer surplus with examples.

♦ Describe the meaning of indifference curve and the price line and show how these help in explaining
consumer equilibrium.

2.0 NATURE OF HUMAN WANTS

In economics, the term ‘want’ refers to a wish, desire or motive to own or/and use goods and services that give
satisfaction. Wants may arise due to physical, psychological or social factors. Since the resources are limited, we
need to make a choice between the urgent wants and the not so urgent wants.
1. All wants of human beings exhibit some characteristic features.
2. Wants are unlimited in number. All wants cannot be satisfied.
3. Wants differ in intensity. Some are urgent ,others are less intensely felt
4. Each want is satiable
5. Wants are competitive. They compete each other for satisfaction because resources are scarce in relation
to wants
6. Wants are complementary. Some wants can be satisfied only by using more than one good or group of
goods
7. A particular want may be satisfied in alternative ways
8. Wants are subjective and relative.
9. Wants vary with time, place, and person
10. Some wants recur again whereas others do not occur again and again
11. Wants may become habits and customs
12. Wants are affected by income, taste, fashion, advertisements and social norms and customs

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2.48 BUSINESS ECONOMICS

13. Wants arise from multiple causes such as physical and psychological instincts, social obligations and
individual’s economic and social status

2.1 CLASSIFICATION OF WANTS

In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries:
Necessaries are those which are essential for living. Necessaries are further sub-divided into necessaries for life or
existence, necessaries for efficiency and conventional necessaries. Necessaries for life are things necessary to meet
the minimum physiological needs for the maintenance of life such as minimum amount of food, clothing and shelter.
Man requires something more than the necessities of life to maintain longevity, energy and efficiency of work, such
as nourishing food, adequate clothing, clean water, comfortable dwelling, education, recreation etc. These are
necessaries for efficiency. Conventional necessaries arise either due to pressure of habit or due to compelling social
customs and conventions. They are not necessary either for existence or for efficiency.
Comforts:
While necessaries make life possible comforts make life comfortable and satisfying. Comforts are less urgent than
necessaries. Tasty and wholesome food, good house, clothes that suit different occasions, audio-visual and labour
saving equipments etc .make life more comfortable.
Luxuries:
Luxuries are those wants which are superfluous and expensive. They are not essential for living. Items such as
expensive clothing, exclusive vintage cars, classy furniture and goods used for vanity etc. fall under this category.
The above categorization is not rigid as a thing which is a comfort or luxury for one person or at one point of time
may become a necessity for another person or at another point of time. As all of us are aware, the things which were
considered luxuries in the past have become comforts and necessaries today.

2.2 WHAT IS UTILITY?

The concept of utility is used in neo classical Economics to explain the operation of the law of demand. Following
Jeremy Bentham, John Stuart Mill, and other nineteenth-century British economist-philosophers, economists apply
the term utility to "that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or
happiness”. Utility is thus the want satisfying power of a commodity. The utility of a consumer is a measure of the
satisfaction that the consumer expects to obtain from consumption of goods and services when he spends money on
a stock of commodity which has the capacity to satisfy his want. Utility is thus the anticipated satisfaction by the
consumer, and satisfaction is the tangible satisfaction derived.
A commodity has utility for a consumer even when it is not consumed. Utility is a subjective and relative entity and
varies from person to person. A commodity has different levels of utility for the same person at different places or at
different points of time. It should be noted that utility is not the same thing as usefulness. From the economic
standpoint, even harmful things like liquor may be said to have utility because people want them. Thus, in
Economics, the concept of utility is ethically neutral.

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.49 THEORY OF DEMAND AND SUPPLY 2.49

Utility hypothesis forms the basis of the theory of consumer behaviour. From time to time, different theories have
been advanced to explain consumer behaviour and thus to explain consumer’s demand for the product. Two
important theories are (i) Marginal Utility Analysis propounded by Alfred Marshall, and (ii) Indifference Curve Analysis
propounded by J.R. Hicks and R.G.D.Allen.

2.3 THE MARGINAL UTILITY ANALYSIS

The marginal utility theory, formulated by Alfred Marshall, a British economist, seeks to explain how a consumer
chooses to spend his income on different goods and services so as to maximize his utility. Marginal utility theory
treats consumers as striving to maximize utility which is a quantitative measure of the consumer’s well-being or
satisfaction. According to Marshall, utility is the numerical score in terms of’utils’ representing the satisfaction that a
consumer obtains from the consumption of a particular good. (Utils refer to the hypothetical measuring unit of utility).
This theory is based on certain assumptions. But before stating the assumptions, let us understand the meaning of
the terms total utility and marginal utility.
(a) Total utility: Assuming that utility is quantitatively measurable and additive, total utility may be defined as
the sum of utility derived from different units of a commodity consumed by a consumer. Total utility is the
sum of marginal utilities derived from the consumption of different units i.e.
TU= MU1+MU2+.....+MUn
WhereMU1, MU2,.....,MUn etc are marginal utilities of the successive units of a commodity.
(b) Marginal utility: The marginal utility of a good or service is the change in total utility generated by
consuming one additional unit of that good or service. In other words, it is the utility derived from the
marginal or one additional unit consumed or possessed by the individual.
Marginal utility = the addition made to the total utility by the addition of consumption of one more unit of a
commodity.
Symbolically,

MUn = TUn - TUn-1

Where,

MUn is the marginal utility of the nth unit,

TUn is the total utility of the nth unit, and

TUn-1 is the total utility of the (n-1)th unit.

2.3.1. Assumptions of Marginal Utility Analysis

The marginal utility analysis is stated with respect to certain conditions. It simply means that this law has certain
assumptions and without these, the law may not hold true.

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2.50 BUSINESS ECONOMICS

(1) Rationality: A consumer is rational and attempts to attain maximum satisfaction from his limited money
income.
(2) Cardinal Measurability of Utility: According to the neoclassical economists, utility is a cardinal concept
i.e., utility is a measurable and quantifiable entity. It implies that utility can be measured in cardinal numbers
and may be assigned a cardinal number like 1, 2, 3 etc. Marshall and some other economists used a
psychological unit of measurement of utility called utils.Thus, a person can say that he derives utility equal
to 10 utils from the consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of
commodity B. Since a consumer can quantitatively express his utility, he can easily compare different
commodities and express which commodity gives him greater utility and by how much. Utilities from
different units of the commodity can be added as well.
(3) According to this theory, money is the measuring rod of utility. The amount of money which a person is
prepared to pay for a unit of a good, rather than go without it, is a measure of the utility which he derives
from the good.
(4) The theory also assumes all the other factors ‘constant’ such as price of the commodity, tastes and
preferences, income, habits, temperament and fashion. If any of these changes, the marginal utility may not
decline and thus the law would not hold true.
(5) The theory assumes continuity in consumption and that there is no time gap or interval between
consumption of different units.
(6) The different units of the commodity consumed are assumed to be homogeneous or identical in nature. If
the units show variation or differ in taste, quality or any such similar aspects, then the law may not hold true.
If successive units are of superior quality, diminishing utility may not occur.
(7) The different units consumed should consist of standard units. For instance spoonfuls of juice or spoonfuls
of coffee are too small units and in such cases we could consider the normal units as a glass of juice or a
cup of coffee. Moreover, the commodity which is consumed by the consumer should be divisible in nature.
(8) The assumption of constancy of the marginal utility of money holds that the marginal utility of money
remains constant throughout when the individual is spending money on a good. This assumption, although
not realistic, has been made in order to facilitate the measurement of utility of commodities in terms of
money. If the marginal utility of money changes as income changes, the measuring-rod of utility becomes
unstable and therefore would be inappropriate for measurement.
(9) The hypothesis of independent utility implies that the total utility which a person gets from the whole
collection of goods purchased by him is simply the sum total of the separate utilities of the goods. The
theory ignores complementarity between goods.

2.3.2 The Law of Diminishing Marginal Utility

One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal Utility.
The law of diminishing marginal utility which states that each successive unit of a good or service consumed adds
less to total utility than the previous unit, is based on an important fact that while total wants of a person are virtually
unlimited, each single want is satiable i.e., each want is capable of being satisfied. Since each want is satiable, as a
consumer consumes more and more units of a good, the intensity of his want for the good goes on decreasing and a

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.51 THEORY OF DEMAND AND SUPPLY 2.51

point is reached where the consumer no longer wants it. Thus, the greater the amount of a good a consumer has, the
less an additional unit is worth to him or her.
Marshall, who was the exponent of the marginal utility analysis, stated the law as follows:
“The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every
increase in the stock that he already has.”In other words, ‘as a consumer increases the consumption of any one
commodity keeping constant the consumption of all other commodities, the marginal utility of the variable commodity
must eventually decline”.
This law describes a very fundamental tendency of human nature. In simple words, it says that as a consumer
consumes more units of a good, the extra satisfaction that he derives from an extra unit of a good goes on falling. It
is to be noted that it is the marginal utility and not the total utility which declines with the increase in the consumption
of a good.
We may illustrate the law with the help of an example. Consider Table 6, in which we have presented the total utility
and marginal utility derived by a person from chocolate bars consumed per day keeping constant all other factors
that affect utility.
Table 6 : Total and Marginal Utility Schedule

Quantity of chocolate bar

Total utility Marginal utility
consumed per day
1 20 20
2 34 14
3 45 11
4 50 5
5 50 0
6 46 -4

When one chocolate bar is consumed, the total utility derived by the person is 20 utils (unit of utility) and the marginal
utility derived is also 20 utils. With the consumption of 2nd chocolate bar, the total utility rises to 34 and the
corresponding marginal utility is14.With the second chocolate bar the consumer enjoys greater total utility: but the
extra utility derived from the second is smaller than that he derived from the first.
We see that till the consumption of chocolate bars increases to 4, the marginal utility from the additional chocolate
bars goes on diminishing (i.e., the total utility goes on increasing at a diminishing rate). The 5th chocolate bar adds
no utility and therefore, the total utility remains the same at 50. At this level of consumption, the consumer reaches
the ‘satiation’ point and gets no extra satisfaction or utility from consuming more of it. Once this point of satiation is
reached, the consumer would refuse any extra unit of chocolate even if it were free.
However, if the chocolate bars consumed increases to 6, instead of giving positive marginal utility, the sixth
chocolate bar gives negative marginal utility or disutility and it may cause him discomfort. We find that consuming the
6 th chocolate bar actually reduces the consumer’s total utility from 50 to 46.

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2.52 BUSINESS ECONOMICS

From table 6, we find that for every one-unit increment in chocolate consumption, the marginal utility is equal to the
change in total utility. Total utility increases every time the consumer consumes more units of chocolate bar till he
reaches the point of satiation, but the additional utility he derives from each successive chocolate bar gets smaller
and smaller as he consumes more. Putting it differently, the rate at which total utility increases gets smaller and
smaller as consumption increases.
From Table 6, we also find that there are some well defined relationships between total utility and marginal utility.
(1) Total utility rises as long as MU is positive, but at a diminishing rate because MU is diminishing
(2) Marginal utility diminishes throughout
(3) When marginal utility is zero, the total utility is maximum. It is the satiation point.
(4) When marginal utility is negative, total utility is diminishing
(5) MU is the rate of change of total utility or it is the slope of TU curve
(6) MU can be positive ,zero or negative
The information in Table 6 above can be graphically presented to show the relationship between total utility and
marginal utility (Fig. 13).

Fig. 13:Utility Derived from Chocolates Consumed Per Day

In Figure 13, we see that there is a close relationship between the graph of total utility in panel (a) and the
corresponding graph of marginal utility in panel (b). Diminishing marginal utility is seen in both panels of the figure
13; in panel (a), by the positive but decreasing slope (flattening out) of the total utility curve and in panel (b), by the
downward sloping marginal utility curve.

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.53 THEORY OF DEMAND AND SUPPLY 2.53

The marginal utility curve shows how marginal utility depends on the quantity of a good or serviceconsumed. As can
be seen from the figure, the marginal utility curve goes on declining throughout.
The principle of diminishing marginal utility is not always true. A few exceptions however, have been pointed out by
some economists. But it is true in large majority of cases, so that it serves as a foundation for the analysis of
consumer behaviour.

2.3.3 Limitations and Exceptions of the Law of Diminishing Marginal Utility

In the consumption of most goods and services, and for most people, the principle of diminishing marginal utility
holds true. However, the law of diminishing marginal utility has certain exceptions and is valid only under certain
conditions.
(1) The law of diminishing marginal utility is based on rigorous assumptions such as cardinal measurability of
utility, constancy of marginal utility of money, continuous consumption, homogeneity of units consumed.
The law would operate only when these unrealistic assumptions are met.
(2) Utility is not in fact independent. The shape of the utility curve may be affected by the presence or absence
of articles which are substitutes or complements. The utility obtained from tea may be seriously affected if
no sugar is available and the utility of bottled soft drinks will be affected by the availability of fresh juice.
(3) The law is not universal. There are many instances where the marginal utility does not fall or quite the
opposite may increase with increase in consumption or stock obtained. Such cases are considered as
exceptions to this law. For example, the law may not apply in the following situations
• The law may not apply in the case of prestigious goods and articles like gold, cash, diamonds etc.
where a greater quantity may increase the utility rather than diminish it.
• The law also may not hold well in the case of hobbies, rare collections etc where, with every
addition to the collection, the marginal utility will go on rising. Similarly, people who seek greater
knowledge and information will be more satisfied with every additional information secured by
them.
• The law may not be operating in cases such as creative art, painting, music, poetry etc as more of
these would generate greater satisfaction.
• The law does not hold good in the case of habit forming commodities like alcohol, cigarettes, and
computer games etc. because those who are habituated into these may experience increasing
utility with every additional intake.
• The law also fails in the case of people with miserly behaviour as accumulation of every additional
unit of money would give them greater levels of satisfaction.
However, we should keep in mind that in all the above mentioned cases, the fundamental assumptions necessary for
the law to operate are not met and as such they are not exceptions in the real sense.

2.3.4 Consumer Equilibrium in Single Commodity Case

The Law of diminishing marginal utility helps us to understand how a consumer reaches equilibrium .in case of a
single good. It states that as the quantity of a good with the consumer increases, marginal utility of the good
decreases. In other words, the marginal utility curve is downward sloping. A consumer will go on buying a good till

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2.54 BUSINESS ECONOMICS

the marginal utility of the good becomes equal to the market price. In other words, the consumer will be in equilibrium
(will be deriving maximum satisfaction) in respect of the quantity ofone good when marginal utility of that good is
equal to its price.

Fig:14 Consumer Equilibrium –Single Commodity Case

In figure 14 , the consumer is in equilibrium at point E with OQ quantity of commodity .We find that at point E, the
marginal utility of the good for the consumer is equal to its price.ie MUx= Px.
What happens when there is a change in the price of the good? The equality between marginal utility and price is
disturbed when the price of the good falls. The consumer will consume more of the good so as to restore the equality
between the marginal utility and price. The marginal utility from the good will fall when he consumes more of the
good. He will continue consuming more till the marginal utility becomes equal to the new lower price. On the other
hand, when price of the good increases, he will buy less so as to equate the marginal utility to the higher price. We
can say that the downward sloping demand curve is directly derived from the marginal utility curve.
Figure14 above illustrates this case. At price P the consumer is at equilibrium at E; MUX = P. When price falls to P1,
the consumer extend his consumption to reach E1 where his MUX = P1.
MUX
The marginal utility of money spent on X MU m = =1
PX
In reality, a consumer spends his income on more than one good. In such cases, consumer equilibrium is
explained with the law of Equi-Marginal utility. According to this law, the consumer will be in equilibrium when
he is spending his money on different goods and services in such a way that the marginal utility of each good is
proportional to its price and the last rupee spent on each commodity yields him equal marginal utility.
The law states that the consumer is said to be at equilibrium, when the following condition is met:
MUx MUy
= = MUM
Px Py

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.55 THEORY OF DEMAND AND SUPPLY 2.55

MUx P
Or = x = MUM pure paise khrch hone
MUy Py
chaiye
MUx Px
Or =
MUy Py

2.4 CONSUMER SURPLUS

The concept of consumer surplus was propounded by Alfred Marshall. Consumer surplus is a measure of welfare
that people gain from consuming goods and services. It measures the benefits buyers receive from participating in a
market. This concept occupies an important place not only in economic theory but also in economic policies of
government and in decision-making of business firms. eg more gst on good jiski satisfaction jada hai
The demand for a commodity depends on the utility of that commodity to a consumer. If a consumer gets more utility
from a commodity, he would be willing to pay a higher price and vice-versa. The willingness to payof each individual
consumer based on his utility determines the demand curve. When price is less than or equal to the willingness to
pay, the potential consumer purchases the good.
Itis common knowledge that consumers generally are ready to pay more for certain goods than what they actually
pay for them. This extra satisfaction which consumers get from their purchase of a good is referred to as consumer
surplus by Alfred Marshall. Consumer surplus is defined as the difference between the total amount that consumers
are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they
actually do pay (i.e. the market price).
Marshall defined the concept of consumer surplus as the “excess of the price which a consumer would be
willing to pay rather than go without a thing over that which he actually does pay”, is called consumers
surplus.”
Thus, consumer surplus = what a consumer is ready to pay - what he actually pays.
mtlb The concept of consumer surplus is derived from the law of diminishing marginal utility. As we know, according to the
price law of diminishing marginal utility, the more of a thing we have, the lesser the marginal utility it has. In other words,
change as we purchase more of a good, its marginal utility goes on diminishing. The consumer is in equilibrium when the
marginal utility of a good is equal to its price i.e., he purchases that many number of units of a good at which
nhi
marginal utility is equal to price (It is assumed that perfect competition prevails in the market). Since the price is the
hoga same for all units of the good he purchases, he gets extra utility for all units consumed by him except for the one at
perfect the margin. This extra utility or extra surplus for the consumer is called consumer surplus.
compet
Consider Table 7 in which we have illustrated the measurement of consumer surplus in case of commodity X. There
ition is only one price for a commodity in the market at a particular point of time. The price of X is assumed to be Rs. 20.
Table 7: Measurement of Consumer Surplus

Marginal Utility (worth

No. of units Price (`Rs) Consumer Surplus
Rs)
1 30 20 10
2 28 20 8

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2.56 BUSINESS ECONOMICS

3 26 20 6
4 24 20 4
5 22 20 2
6 20 20 0
7 18 20 –

We see from the above table that when the consumer’s consumption increases from 1 to 2 units,
his marginal utility falls from 30 to 28. His marginal utility goes on diminishing as he increases his consumption of
good X. Since marginal utility for a unit of good indicates the price the consumer is willing to pay for that unit, and
since market price is assumed to be at Rs.20, the consumer enjoys a surplus on every unit of purchase till the 6th
unit. Thus, when the consumer is purchasing 1 unit of X, the marginal utility is worth Rs30 and price fixed is Rs 20,
thus he is deriving a surplus of ` 10. Similarly, when he purchases 2 units of X, he enjoys a surplus of 8 [28 – 20].
This continues and he enjoys consumer surplus equal to 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he
buys 6 units, he is in equilibrium because his marginal utility is equal to the market price or he is willing to pay a sum
equal to the actual market price and therefore, he enjoys no surplus. Thus, given the price of Rs 20 per unit, the total
surplus which the consumer will get, is worth 10 + 8 + 6 + 4 + 2 + 0 = 30.
The concept of consumer surplus is closely related to the demand curve for a product. The demand curve reflects
buyer’s willingness to pay; we can also use it to measure consumer surplus. As we know, the height of the demand
curve measures the value buyers place on the good as measured by their willingness to pay for it. We have already
seen above that the difference between the willingness to pay and the market price is each buyer’s consumer
surplus. The difference between his willingness to pay and the price that he actually pays is the net gain to the con-
sumer, the individual consumer surplus.
The total consumer surplus in a market which is the sum of all individual consumer surpluses in a market, is equal to
the area below the market demand curve but above the price. The term consumer surplus is often used to refer to
both individual and total consumer surplus.
Thus, the total area below the demand curve and above the price is the sum of the consumer surplus of all buyers in
the market.
The concept of consumer surplus can be illustrated graphically. Consider figure 15. On the X-axis we measure the
amount of the commodity and on the Y-axis the marginal utility and the price of the commodity. MU is the marginal
utility curve which slopes downwards, indicating that as the consumer buys more units of the commodity, its marginal
utility falls. Marginal utility shows the price which a person is willing to pay for the different units rather than go
without them. If OP is the price that prevails in the market, then the consumer will be in equilibrium when he buys OQ
units of the commodity, since at OQ units, marginal utility is equal to the given price OP. The last unit, i.e., Qth unit
does not yield any consumer surplus because here price paid is equal to the marginal utility of the Qth unit. For all
units before the Qth unit, the marginal utility is greater than price and thus these units fetch consumer surplus to the
consumer.

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.57 THEORY OF DEMAND AND SUPPLY 2.57

actually
paid

Fig. 15: Marshall’s Measure of Consumer Surplus

In Figure 15, the total utility is equal to the area under the marginal utility curve up to point Q i.e. ODRQ. But, given
the price equal to OP, the consumer actually pays OPRQ. The consumer derives extra utility equal to DPR which is
nothing but consumer surplus.(The portion of demand curve RD1 is not relevant for our consumer as MUx is less
than Px in this part and therefore, the consumer will not buy any quantity beyond Q.)
The consumer welfare derived from a good is the benefit a consumer gets from consuming that good minus what the
consumer paid to buy the good. Consumer surplus is the buyer's net gain from purchasing a good. Graphically, it is
the triangular area below the demand curve and above the price line. The size of the consumer surplus triangle
depends on the price of the good. A rise in the price of a good reduces consumer surplus; a fall in the price increases
consumer surplus. Thus, a higher price results in a smaller consumer surplus and a lower price generates a larger
consumer surplus. The change in consumer surplus on account of a fall in price can be illustrated with the help of
figure 16.

c increase surplus for new

b is increse surplus for
old customer o q

Fig.16: Change in Consumer Surplus Due to a Fall In Price

A fall in price from P to P1 increases consumer surplus from APE to A P1F.The increase in consumer surplus has
two components.
(a) The increase in consumer surplus of existing buyers who were earlier paying price P (the rectangle marked
b).

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2.58 BUSINESS ECONOMICS

(b) The consumer surplus now available to the new buyers who started buying the commodity due to lower
prices (the triangle c)

2.4.1 Applications
The concept of consumer surplus has important practical applications. Few such applications are listed below:
(1) Consumer surplus is a measure of the welfare that people gain from consuming goods and services. It is
very important to a business firm to reflect on the amount of consumer surplus enjoyed by different
segments of their customers because consumers who perceive large surplus are more likely to repeat their
purchases.
(2) Understanding the nature and extent of surplus can help business managers make better decisions about
setting prices. If a business can identify groups of consumers with different elasticity of demand within their
market and the market segments which are willing and able to pay higher prices for the same products, then
firms can profitably use price discrimination.
(3) Large scale investment decisions involve cost benefit analysis which takes into account the extent of
consumer surplus which the projects may fetch.
(4) Knowledge of consumer surplus is also important when a firm considers raising its product prices
Customers who enjoyed only a small amount of surplus may no longer be willing to buy products at higher
prices. Firms making such decisions should expect to make fewer sales if they increase prices.
(5) Consumer surplus usually acts as a guide to finance ministers when they decide on the products on which
taxes have to be imposed and the extent to which a commodity tax has to be raised. It is always desirable
to impose taxes or increase the rates of taxes on commodities yielding high consumer surplus because the
loss of welfare to citizens will be minimal.

2.4.2 Limitations
It is often argued that this concept of consumer surplus is hypothetical and illusory. In real life, the surplus
satisfaction cannot be measured accurately.
(1) Consumer surplus cannot be measured precisely - because it is difficult to measure the marginal utilities of
different units of a commodity consumed by a person.
(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case the
consumer surplus is always infinite.
(3) The consumer surplus derived from a commodity is affected by the availability of substitutes.
(4) There is no simple rule for deriving the utility scale of articles which are used for their prestige value (e.g.,
diamonds).
(5) Consumer surplus cannot be measured in terms of money because the marginal utility of money changes
as purchases are made and the consumer’s stock of money diminishes. (Marshall assumed that the
marginal utility of money remains constant. But this assumption is unrealistic).
(6) The concept can be accepted only if it is assumed that utility can be measured in terms of money or
otherwise. Many modern economists believe that this cannot be done.

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2.5 INDIFFERENCE CURVE ANALYSIS

In the last section, we have discussed the marginal utility analysis of demand. A very popular alternative and a more
realistic method of explaining consumer demand is the ordinal utility approach. This approach uses a different tool
namely indifference curve to analyse consumer behaviour and is based on consumer preferences. The approach is
based on the belief that that human satisfaction, being a psychological phenomenon, cannot be measured
quantitatively in monetary terms as was attempted in Marshall’s utility analysis. Therefore, it is scientifically more
sound to order preferences than to measure them in terms of money. The consumer preference approach is,
therefore, an ordinal concept based on ordering of preferences compared with Marshall’s approach of cardinality.

2.5.0 Assumptions Underlying Indifference Curve Approach

(i) The foundation of consumer behaviour theory is the assumption that the consumer knows his own tastes
and preferences and possesses full information about all the relevant aspects of economic environment in
which he lives.
(ii) The consumer is rational and tends to take rational actions that result in a more preferred consumption
bundle over a less preferred bundle.
(ii) The indifference curve analysis assumes that utility is only ordinally expressible. The consumer is capable
of ranking all conceivable combinations of goods according to the satisfaction they yield. Thus, if he is given
various combinations say A, B, C, D and E, he can rank them as first preference, second preference and so
on. However, if a consumer happens to prefer A to B, he cannot tell quantitatively how much he prefers A to
B.
(iii) Consumer choices are assumed to be transitive. If the consumer prefers combination A to B, and B to C,
then he must prefer combination A to C. In other words, he has a consistent consumption pattern.
(iv) If combination A has more commodities than combination B, then A must be preferred
to B. This is sometimes referred to as the “more is better” assumption or the assumption of non-satiation.
monotonic prefernece
2.5.1 Indifference Curves
The ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is based on indifference
curve which represent the consumer’s preferences graphically. An indifference curve is a curve which represents all
those combinations of two goods which give same satisfaction to the consumer. Since all the combinations on an
indifference curve give equal satisfaction to the consumer, the consumer is completely indifferent among them. Or, it
represents the set of all bundles of goods that a consumer views as being equally desirable. In other words, since all
the combinations provide the same level of satisfaction the consumer prefers them equally and does not mind which
combination he gets. An Indifference curve is also called iso-utility curve or equal utility curve.
To understand indifference curves, let us consider the example of a consumer who has one unit of food and 12 units
of clothing. Now, we ask the consumer how many units of clothing he is prepared to give up to get an additional unit
of food, so that his level of satisfaction does not change. Suppose the consumer says that he is ready to give up 6
units of clothing to get an additional unit of food. We will have then two combinations of food and clothing giving
equal satisfaction to the consumer: Combination A which has 1 unit of food and 12 units of clothing, and combination
B which has 2 units of food and 6 units of clothing. Similarly, by asking the consumer further how much of clothing he

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2.60 BUSINESS ECONOMICS

will be prepared to forgo for successive increments in his stock of food so that his level of satisfaction remains
unaltered, we get various combinations as given in table 8:
Table 8 : Indifference Schedule

Combination Food Clothing MRS

A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1

Now, if we plot the above schedule, we will get the following figure.
In Figure 17, an indifference curve IC is drawn by plotting the various combinations given in the indifference
schedule. The quantity of food is measured on the X axis and the quantity of clothing on the Y axis. As in indifference
schedule, the combinations lying on an indifference curve will give the consumer the same level of satisfaction.

Fig. 17: A Consumer’s Indifference Curve

2.5.2 Indifference Curve Map

The entire utility function of an individual can be represented by an indifference curve map which is a collection of
indifference curves in which each curve corresponds to a different level of satisfaction. In short, a set of indifference
curves is called an indifference curve map. Each indifference curve is a set of points and each point shares a
common level of utility with the others. Combinations of goods lying on indifference curves which are farther from the
origin are preferred to those on indifference curves which are closer to the origin. Moving upward and to the right
from one indifference curve to the next represents an increase in utility, and moving down and to the left represents a
decrease. An indifference curve map thus depicts the complete picture of consumer tastes and preferences.
In Figure 18, an indifference curve map of a consumer is shown which consists of three indifference curves.
We have marked good X on X-axis and good Y on Y-axis. It should be noted that while the consumer is indifferent
among the combinations lying on the same indifference curve, he certainly prefers the combinations on the higher
indifference curve to the combinations lying on a lower indifference curve because a higher indifference curve

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.61 THEORY OF DEMAND AND SUPPLY 2.61

signifies a higher level of satisfaction. Thus, while all combinations of IC1 give him the same satisfaction, all
combinations lying on IC2 give him greater satisfaction than those lying on IC1.

satisfaction from 1 unit

gane equal to satisfaction
sacrifice sacrifice /gain or
deltla y by x
Fig. 18 : Indifference Map

2.5.3. Marginal Rate of Substitution

The Marginal Rate of Substitution (MRS) is the rate at which a consumer is prepared to exchange goods X and Y,
holding the level of satisfaction constant (i.e., moving along an indifference curve).
The marginal rate of substitution along any segment of an indifference curve refers to the maximum rate at which a
consumer would willingly exchange units of Y for units of X. The MRS at any point on the indifference curve is equal
to the (absolute value of) the slope of the curve at that point. When measured at a point, the MRS xy tells us the
maximum rate at which a consumer would willingly trade good Y for a infinitesimal bit more of good X.
Consider Table-8. In the beginning the consumer is consuming 1 unit of food and 12 units of clothing. Subsequently,
he gives up 6 units of clothing to get an extra unit of food, his level of satisfaction remaining the same. The MRS here
is 6. Likewise when he moves from B to C and from C to D in his indifference schedule, the MRS are 2 and 1
respectively. Thus, we can define MRS of X for Y as the amount of Y whose loss can just be compensated by a unit
gain of X in such a manner that the level of satisfaction remains the same.

Figure 19: Diminishing Marginal Rate of Substitution

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2.62 BUSINESS ECONOMICS

We notice that MRS is falling i.e., as the consumer has more and more units of food, the trade –off or rate of
substitution becomes smaller and smaller; i.e. he is prepared to give up less and less units of clothing.( Refer figure
19). When a consumer moves down his indifference curve, he gains utility from the consumption of additional units of
good X, but loses an equal amount of utility due to reduced consumption of Y. But at each step, the utility levels from
which the consumer begins is different. At point A in figure 19, the consumer consumes only a small quantity of food;
and therefore his marginal utility of food at that point is high. At A, then, an additional unit of food adds a lot to his
total utility. But at A he already consumes a large quantity of clothing; his marginal utility of clothing at that point is
low. This means that it takes a large reduction in the quantity of clothing consumed to counterbalance the increased
utility he gets from the extra unit of food.
On the contrary, consider point C. we find that the consumer consumes a much larger quantity of food and a much
smaller quantity of clothing than at point A. This means that an additional unit of food adds only lesser utility, and a
unit of clothing forgone costs more utility, than at point A. So the consumer is willing to give up less units of clothing
in return for another unit of food at C(he gives up only 2 units of clothing for 1unit of food, whereas he gives up 6
units of clothing at point A for one unit of food).
Moving down the indifference curve—reducing consumption of clothing and increasing food consumption—will
produce two opposing effects on the consumer’s total utility: reduction in total utility due to reduced consumption of
clothing, and increase in total utility due to higher food consumption. In order to keep the levels of satisfaction
constant, these two effects must exactly cancel out as the consumer moves down the indifference curve. The
principle of diminishing marginal rate of substitution thus states that the more of good Y a person consumes in
proportion to good X, the less Y he or she is willing to substitute for another unit of X.
There are two reasons for this.
1. The want for a particular good is satiable so that when a consumer has more of it, his intensity of want for it
decreases. Thus, in our example, when the consumer has more units of food, his intensity of desire for
additional units of food decreases.
2. Most goods are imperfect substitutes of one another. MRS would remain constant if they could substitute
one another perfectly.
We know that along the indifference curve:
(Change in total utility due to lower clothing consumption) = (Change in total utility due to higher food consumption)
Change in total utility due to a change in clothing consumption = MU c × ΔQ c
Change in total utility due to a change in food consumption = MUf × ΔQf
Therefore, along the indifference curve:−MUc × ΔQc = MUf × ΔQf
Note that the left-hand side of the equation has a minus sign as it represents the loss in total utility from decreased
clothing consumption. This must equal the gain in total utility from increased food consumption, represented by the
right-hand side of the equation. Along the indifference curve:
∆Qc – MUf
=
∆Qf MUc

or mrs = - muf /muc

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 mrs 1 perfect subsittube downward straight curve

.63 THEORY OF DEMAND AND SUPPLY 2.63

To generalize, the marginal rate of substitution of X for Y (MRSxy) is the slope of the indifference curve.
MUx
MRS xy =
MUy

As the number of units of Y the consumer is willing to sacrifice gets lesser and lesser, the marginal rate of
substitution gets smaller and smaller as we move down and to the right along an indifference curve. That is, the
indifference curve becomes flatter (less sloped) as we move down and to the right.

2.5.4 Properties of Indifference Curves

The following are the main characteristics or properties of indifference curves:
(i) Indifference curves slope downward to the right: This property implies that the two commodities can be
substituted for each other and when the amount of one good in the combination is increased, the amount of
the other good is reduced. This is essential if the level of satisfaction is to remain the same on an
indifference curve.
(ii) Indifference curves are always convex to the origin :It has been observed that as more and more of one
commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the
commodity being substituted (i.e. Y). This is called diminishing marginal rate of substitution. Thus, in our
example of food and clothing, as a consumer has more and more units of food, he is prepared to forego
less and less units of clothing. This happens mainly because the want for a particular good is satiable and
as a person has more and more of a good, his intensity of want for that good goes on diminishing. In other
words, the subjective value attached to the additional quantity of a commodity decreases fast in relation to
the other commodity whose total quantity is decreasing. This diminishing marginal rate of substitution gives
convex shape to the indifference curves.
However, there are two extreme situations.
(1) When two goods are perfect substitutes of each other, the consumer is completely indifferent as to
which to consume and is willing to exchange one unit of X for one unit of Y. His indifference curves
for these two goods are therefore straight, parallel lines with a constant slope along the curve, or
the indifference curve has a constant MRS.[Figure 20(A)].
(2) Goods are perfect complements when a consumer is interested in consuming these only in fixed
proportions. When two goods are perfect complementary goods (e.g. left shoe and right shoe), the
consumer consumes only bundles like A and B in figure 20(B) in which both X and Y in equal
proportions. With a bundle like A or B, he will not substitute X for Y because an extra piece of the
other good (here a single shoe) is worthless for him. The reason is that neither an additional left
shoe nor a right shoe without a paired one of each, adds to his total utility. In such a case, the
indifference curve will consist of two straight lines with a right angle bent which is convex to the
origin, or in other words, it will be L shaped. [Figure 20(B)] Avery interesting fact about this is that
in the case of perfect complements, the marginal rate of substitution is undefined because an
individual’s preferences do not allow any substitution between goods.

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2.64 BUSINESS ECONOMICS x y
1 1
2 1
3 1

one exra
cannot be
gain with
sacrifice

Fig. 20: Indifference Curve of Perfect Substitutes and perfect Complements

(iii) Indifference curves can never intersect each other: No two indifference curves will intersect each other
although it is not necessary that they are parallel to each other. In case of intersection the relationship
becomes logically absurd because it would show that higher and lower levels are equal, which is not
possible. This property will be clear from Figure 21.

Fig. 21 : Intersecting Indifference Curves

In figure21, IC1 and IC2 intersect at A. Since A and B lie on IC1, they give same satisfaction to the
consumer. Similarly since A and C lie on IC2, they give same satisfaction to the consumer. This implies that
combination B and C are equal in terms of satisfaction. But a glance will show that this is an absurd
conclusion because certainly combination C is better than combination B because it contains more units of
commodities X and Y. Thus we see that no two indifference curves can touch or cut each other.
(iv) A higher indifference curve represents a higher level of satisfaction than the lower indifference
curve: This is because combinations lying on a higher indifference curve contain more of either one or both
goods and more goods are preferred to less of them.
(v) Indifference curve will not touch either axes :Another characteristic feature of indifference curve is that it
will not touch the X axis or Y axis. This is born out of our assumption that the consumer is considering
different combination of two commodities. If an indifference curve touches the Y axis at a point P as shown
in the figure 22, it means that the consumer is satisfied with OP units of Y commodity and zero units of X
commodity. This is contrary to our assumption that the consumer wants both commodities although in
smaller or larger quantities. Therefore an indifference curve will not touch either the X axis or Y axis.

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.65 THEORY OF DEMAND AND SUPPLY 2.65

Fig. 22: Impossible Indifference Curve

2.5.5 The Budget Line

From the ordinal utility analysis discussed above, we have understood one part of a person’s consumption behavior
namely, consumer preference. A higher indifference curve shows a higher level of satisfaction than a lower one.
Therefore, a consumer, in his attempt to maximise satisfaction will try to reach the highest possible indifference
curve. But in his pursuit of buying more and more goods and thus obtaining more and more satisfaction, he has to
work under two constraints: first, he has to pay the prices for the goods and, second, he has a limited money income
with which to purchase the goods.
Consumers maximize their well-being subject to constraints. The most important constraint all of us face in deciding
what to consume is the budget constraint. In other words, consumers almost always have limited income, which
constrains how much they can consume. A consumer’s choices are limited by the budget available to him. As we
know, his total expenditure for goods and services can fall short of the budget constraint, but may not exceed it.
Algebraically, we can write the budget constraint for two goods X and Y as:
PXQX + PYQY ≤ B
Where
PX and PY are the prices of goods X and Y and QX and QY are the quantities of goods X and Y chosen and B is the
total money available to the consumer.
The requirement illustrated by the equation above that a consumer must choose a consumption bundle that costs no
more than his or her income is known as the consumer’s budget constraint.A consumer’s consumption possibilities
are the set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices.
We assume that the consumer in our analysis uses up his entire nominal money income to purchase the
commodities. So that his budget constraint is
in equilibrium PXQX + PYQY = B
The following table shows the combinations of Ice cream and chocolates a consumer can buy spending the entire
fixed money income of Rs.100, with the prices Rs 20 and Rs.10 respectively.

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2.66 BUSINESS ECONOMICS

Table: 9 Consumption Possibilities

Ice Cream Chocolate
A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0
The budget constraint can be explained by the budget line or price line. In simple words, a budget line
shows all those combinations of two goods which the consumer can buy spending his given money income
on the two goods at their given prices. All those combinations which are within the reach of the consumer
(assuming that he spends all his money income) will lie on the budget line. The consumer could, of course,
buy any bundle that cost less than Rs 100.(e.g. Point K )

Fig. 23: Price Line or the Budget Line

It should be noted that any point outside the given price line, say H, will be beyond the reach of the consumer and
any combination lying within the line, say K, shows under spending by the consumer.
The slope of the budget line is determined by the relative prices of the two goods. It is equal to ‘Price Ratio’ of two
goods. i.e. PX /PY i.e. It measures the rate at which the consumer can trade one good for the other .
The budget line will shift when there is: indiffrecence curve show willing to exchange
• A change in the prices of one or both products with the nominal income of the buyer (budget) remaining the
same.
• A change in the level of nominal income of the consumer with the relative prices of the two goods remaining
the same.
• A change in both income and relative prices

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.67 THEORY OF DEMAND AND SUPPLY 2.67

2.5.6 Consumer Equilibrium

Having explained indifference curves and budget line, we are in a position to explain how a consumer reaches
equilibrium position by choosing his optimal consumption bundle, given the constraints. A consumer is in equilibrium
when he is deriving maximum possible satisfaction from the goods and therefore is in no position to rearrange his
purchases of goods. We assume that:
(i) The consumer has a given indifference map which shows his scale of preferences for various combinations
of two goods X and Y.
(ii) He has a fixed money income which he has to spend wholly on goods X and Y.
(iii) Prices of goods X and Y are given and are fixed.
(iv) All goods are homogeneous and divisible, and
same and full unit
(v) The consumer acts ‘rationally’ and maximizes his satisfaction.

Fig. 24 : Consumer’s Equilibrium

To show which combination of two goods X and Y the consumer will buy to be in equilibrium we bring his indifference
map and budget line together.
We know by now, that the indifference map depicts the consumer’s preference scale between various combinations
of two goods and the budget line shows various combinations which he can afford to buy with his given money
income and prices of the two goods. Consider Figure 24, in which IC1, IC2, IC3, IC4 and IC5 are shown together
with budget line PL for good X and good Y. Every combination on the budget line PL costs the same. Thus
combinations R, S, Q, T and H cost the same to the consumer. The consumer’s aim is to maximise his satisfaction
and for this, he will try to reach the highest indifference curve.
Since there is a budget constraint, he will be forced to remain on the given budget line, that is he will have to choose
combinations from among only those which lie on the given price line. Which combination will our hypothetical
consumer choose? A consumer’s optimal choice should satisfy two criteria:
1. It will be a point on his budget line; and
2. It will lie on the highest indifference curve possible

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2.68 BUSINESS ECONOMICS

The consumer can arrive this choice moving down his budget line starting from point R .While doing this, he will pass
through a variety of indifference curves (To make the diagram simple, we have drawn only a few). Suppose he
chooses R. We see that R lies on a lower indifference curve IC1, when he can very well afford S, Q or T lying on
higher indifference curves. Similar is the case for other combinations on IC1, like H. Again, suppose he chooses
combination S (or T) lying on IC2. But here again we see that the consumer can still reach a higher level of
satisfaction remaining within his budget constraints i.e., he can afford to have combination Q lying on IC3 because it
lies on his budget line. Now, what if he chooses combination Q? We find that this is the best choice because this
combination lies not only on his budget line but also puts him on the highest possible indifference curve i.e., IC3. The
consumer can very well wish to reach IC4 or IC5, but these indifference curves are beyond his reach given his
money income. Thus, the consumer will be at equilibrium at point Q on IC3. What do we notice at point Q? We notice
that at this point, his budget line PL is tangent to the indifference curve IC3. In this equilibrium position (at Q), the
consumer will buy OM of X and ON of Y.
At the tangency point Q, the slopes of the price line PL and the indifference curve IC3 are equal. The slope of the
MUx
indifference curve shows the marginal rate of substitution of X for Y (MRSxy) which is equal to while the slope
MUy
Px
of the price line indicates the ratio between the prices of two goods i.e.,
Py

At equilibrium point Q,
MUx Px
MRS
= xy =
MUy Py

Thus, we can say that the consumer is in equilibrium position when the price line is tangent to the indifference curve
or when the marginal rate of substitution of goods X and Y is equal to the ratio between the prices of the two goods.
We have seen that the consumer attains equilibrium at the point where the budget line is tangent to the indifference
curve and
MUx MUy
=
Px Py

In fact the slope of the indifference curve points to the rate at which the consumer is willing to give up good Y for
good X. The slope of the budget line tells us the rate at which the consumer is actually able to trade good X and
good Y. When both these are equal, he will be maximizing his satisfaction given the constraints.
The indifference curve analysis is superior to utility analysis: (i) it dispenses with the assumption of measurability of
utility (ii) it studies more than one commodity at a time (iii) it does not assume constancy of marginal utility of money
(iv) it segregates income effect from substitution effect.

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.69 THEORY OF DEMAND AND SUPPLY 2.69

SUMMARY
• The existence of human wants is the basis for all economic activities in the society. All desires, tastes and
motives of human beings are called wants in Economics.
• In Economics, wants are classified in to necessaries, comforts and luxuries.
• Utility refers to the want satisfying power of goods and services. It is not absolute but relative. It is a
subjective concept and it depends upon the mental attitude of people.
• There are two important theories of utility, the cardinal utility analysis and ordinal utility analysis.
• The law of diminishing marginal utility states that as a consumer increases the consumption of a commodity,
every successive unit of the commodity gives lesser and lesser satisfaction to the consumer.
• Consumer surplus is the difference between what a consumer is willing to pay for a commodity and what he
actually pays for it.
• Consumer surplus is the buyer's net gain from purchasing a good. Graphically, it is the triangular area below
the demand curve and above the price line.
• A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus
• The indifference curve theory, which is an ordinal theory, shows the household’s preference between
alternative bundles of goods by means of indifference curves.
• Marginal rate of substitution is the rate at which the consumer is prepared to exchange goods X and Y.
• The important properties of an Indifference curve are: Indifference curve slopes downwards to the right, it is
always convex to the origin, two ICs never intersect each other, it will never touch the axes and higher the
indifference curve higher is the level of satisfaction.
• When two goods are perfect substitutes of each other, indifference curves for these two goods are straight,
parallel lines with a constant slope along the curve, or the indifference curve has a constant MRS
• Goods are perfect complements when a consumer is interested in consuming only in fixed proportions.. In
such a case, the indifference curve will consist of two straight lines with a right angle bent which is convex
to the origin, or in other words, it will be L shaped.
• Budget line or price line shows all those combinations of two goods which the consumer can buy spending
his given money income on the two goods at their given prices.
• The slope of the budget line is determined by the relative prices of the two goods. It is equal to ‘Price Ratio’
of two goods. i.e. PX /PY i.e. It measures the rate at which the consumer can trade one good for the other .
• The budget line will shift when there is: a change in the prices of one or both products with the nominal
income of the buyer (budget) remaining the same or when there is a change in the level of nominal income
of the consumer with the relative prices of the two goods remaining the same.
• A consumer is said to be in equilibrium when he is deriving maximum possible satisfaction from the goods
and is in no position to rearrange his purchase of goods.
The consumer attains equilibrium at the point where the budget line is tangent to the indifference curve and
MUx / Px =MUy /Py = MUz /Pz

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