Consumer Behaviour (Utility Analysis)

Introduction

In economic theory, consumer behavior addresses the concepts of consumer preference

and consumer surplus. Consumer surplus is the extra amount a consumer is willing to
pay for a good, but he actually paid less for the good. A consumers' surplus can exist
only within the context of the concept of diminishing marginal utility. This concept
holds that, at some point, consumption of additional incremental quantities of a good
will yield successively smaller increases in utility. Thus, it is assumed that an
individual will be willing to pay more for the first unit of consumption than for a unit
consumed at some point further along.
Cardinal and Ordinal Utility

Utility is an economic term referring to the total satisfaction received from consuming
a good or service. For example, satisfaction you get by consuming a cup of tea is the
utility of that cup of tea. If this measure is given, one may think of increasing or
decreasing utility, and thereby explain economic behavior in terms of attempts to
increase one’s utility. Changes in utility are sometimes expressed in fictional units
called utils. There are mainly two kinds of measurement of utility implemented by
economists: cardinal utility and ordinal utility.
Utility was originally viewed as a measurable quantity, so that it would be possible to
measure the utility of each individual in the society with respect to each good available
in the society, and to add these together to yield the total utility of all people with
respect to all goods in the society. Society could then aim to maximise the total utility of
all people in society, or equivalently the average utility per person. This conception of
utility as a measurable quantity that could be aggregated (summed up) across
individuals is called cardinal utility.
Cardinal utility quantitatively measures the preference of an individual towards a
certain commodity. Numbers assigned to different goods or services can be compared.

Example: For a coffee addict, a utility of 100 utils towards a cup of cappuccino is
twice as desirable as a cup of tea with a utility level of 50 utils.
The concept of cardinal utility suffers from the absence of an objective measure of
utility. For example, the utility gained from consumption of a particular good by ‘A’
will be different than ‘B’.
Ordinal utility represents the utility, or satisfaction derived from the consumption of
goods and services, based on a relative ranking of the goods and services consumed.
With ordinal utility, goods are only ranked only in terms of more or less preferred,
there is no attempt to determine how much more one good is preferred to another.

Example: You may prefer to consume or buy more apples than bananas while your
friend may prefer to consume or buy more bananas than apple.
The modern economists have discarded the concept of cardinal utility and have instead
employed the concept of ordinal utility for analysing consumer behaviour. The
concept of ordinal utility is based on the fact that it may not be possible for consumers
 to express the utility of a commodity in absolute terms but it is always possible for a
consumer to tell introspectively whether a commodity is more or less or equally
useful as compared to another.
Example: A consumer may not be able to tell that an ice cream gives 5 utils and a
chocolate gives 2 utils. But he or she can always tell whether chocolate gives more or
less utility than ice cream.
This assumption forms the basis of the ordinal theory of consumer behaviour.
Ordinal utility is the underlying assumption used in the analysis of indifference
curves.
Marginal Utility Analysis

Marginal utility is an additional utility obtained from the consumption or use of an

additional unit of a good. It can be put in other words as the change in total utility
divided by the change in quantity. Marginal utility indicates an extra satisfaction from
consuming an extra unit. Marginal utility needs to be contrasted with the related term
total utility. Marginal utility is the additional amount of satisfaction obtained from
consuming one additional unit of a good. Total utility is the overall amount of
satisfaction obtained from consuming several units of a good. While the maximization
of total utility represents the ultimate goal of consumption, the analysis of consumer
behaviour gives greater emphasis on the marginal utility.
As consumer proceeds with his consumption total utility increases as more of a good is
consumed, but the marginal utility decreases with the consumption of each additional
unit. The decrease in marginal utility with an increase in the consumption of a good
reflects law of diminishing marginal utility.

The Law of Diminishing Marginal Utility: Marshillian Approach

Marginal utility refers to the change in satisfaction which results when a little more or
little less of that good is consumed.
The law of diminishing marginal utility says that with the increase in the consumption
of a good there is a decrease in the marginal utility that person derives from consuming
each additional unit of that product.
Assumptions

The basic propositions of this traditional approach are

1. Cardinal measure of utility: Utility is a measurable and quantifiable
concept. A person can specify that he gets five units of utility by
consuming one unit of good A etc. Utility is an imaginary unit of
measuring utility.
2. Independent utilities: Utility is additive; the utilities derived from
different independent goods can be added to get the measure of total
utility.
3. Constant marginal utility of money: The marginal utility of money remains
 constant for a particular consumer when he spends money on various
goods. All other commodities except money are subject to the law of
diminishing marginal utility.
The "Law of Diminishing Marginal Utility" can be put in other way as total utility
increases more and more slowly as the quantity consumed increases. With every
additional increase in the consumption the total utility increases but at decreasing rate. It
is happens due to the underlying decrease of marginal utility. The value of total utility
also declines and it starts declining when the value of marginal utility gets negative. Let
us explain it with an example.
Example: When a thirsty person takes five bottles of cold drink continuously, the
consumption of first bottle gives him utility, second bottle gives him lesser utility than
first but his total utility increases. Third bottle gives him still less utility but increases total
utility. The utility from fourth bottle may be zero as he is no more thirsty. But the fifth bottle
may cause uneasiness and thus give negative utility, i.e., the total utility may now
actually go down.

According to the law of diminishing marginal utility when a person consumes more and more
units of a good his total utility increases while the extra utility derived from consuming
successive units of the good diminishes. The total utility reaches a maximum value when
marginal utility approaches zero and then total utility starts declining.
Law of Equi-marginal Utility

The Law of Equi-Marginal Utility is an extension to the law of diminishing marginal

utility. The principle of equi-marginal utility explains the behavior of a consumer in
distributing his limited income among various goods and services. This law states that
how a consumer allocates his money income between various goods so as to obtain
maximum satisfaction.

Assumptions
The principle of equi-marginal utility is based on the following assumptions:
1. The wants of a consumer remain unchanged.
2. He has a fixed income.
3. The prices of all goods are given and known to a
consumer.
4. He is one of the many buyers in the sense that he is
powerless to alter the market price.
5. He can spend his income in small amounts.
6. He acts rationally in the sense that he want maximum
satisfaction.
7. Utility is measured cardinally. This means that utility,
or use of a good, can be expressed in terms of "units"
or "utils". This utility is not only comparable but also
quantifiable.

Principle

Suppose there are two goods 'x' and 'y' on which the consumer has to spend his given
income. The consumer's behavior is based on two factors:
1. Marginal Utilities of goods 'x' and 'y'
2. The prices of goods 'x' and 'y'
The consumer is in equilibrium position when marginal utility of money expenditure
on each good is the same.
Mathematically, the law can be explained by the help of the following
formula: MU of good A/ Price of A = MU of good B/ Price of B
In any case when the Marginal Utilities of the goods A and B are unequal, the consumer
will purchase a combination that will give him highest Marginal Utility per dollar
value of each good, in such a way that the entire budget amount is spent.
Example: A firm has a total capital of 100 million which it has the option of
spending on three projects, A, B, and C. Each of these projects requires a unit
expenditure of 10 million. Suppose also that the marginal productivity schedule of
each unit of expenditure on the three projects is given as shown in the following table.

Going by the equi-marginal principle, the firm will allocate its total resource ( 100
million) among the projects A, B and C in such a way that marginal product of each
project is the same i.e., MPA = MPB = MPC.
It can be seen from the above table that going, by this rule, the firm will spend 1st,
2nd, 7th, and 10th unit of finance on project A, 3rd, 5th, and 8th unit on Project B, and
4th, 6th, and 9th unit on project C. In all, it puts 4 units of its finances in project A, 3
units each in projects n and C. In other words, of the total finances of 100 million, a
profit maximization firm would invest 40 million in project A, 30 million each in
projects B and C.