Theory of Consumer Behaviour

 Utility analysis is the main pillar of knowledge for the study of

demand

 What is Utility?
It is a pleasure, happiness or satisfaction derived while consuming
goods and services.

 Choices of the consumer are based on maximizing expected

utility/satisfaction
For this the consumer must be able to measure compare the utility of
various bundles of goods

 Measurement of Utility – Cardinal (money/utils) vs Ordinal (ranks)

 The Cardinalists and the theory of Demand
LAW OF DIMINISHING MARGINAL UTILITY:
As we go on consuming additional units of a commodity, the
marginal utility i.e., the pleasure derived from consumption of
the subsequent units diminishes.
CONSUMER EQUILIBRIUM:
When the marginal utility of the commodity is equal to its price.

Symbolically, MU x  Px
where, MU x is Marginal utility of commodity x
Px is price of commodity x.

If, MU x  Px - the consumer will increase quantity consumption of X till its MU is equal
to the price and vice versa.
 Assumptions of the Cardinal Utility Theory
1. Rationality:
The consumer is assumed to be rational that he aims at maximizing his utility subject to his
income constraint.

2. Cardinal measurability of utility

Utility is a cardinal concept and therefore is measurable. The most convenient measurement
of utility is money.

3. Constant marginal utility of money

If the value of money changes, it cannot be used as a measuring rod for utility.

4. Diminishing marginal utility

The marginal utility of a commodity diminishes as the consumer acquires more of it.
 Indifference Curves Analysis

Indifference curves are derived from the ordinal

concept of utility analysis.
Indifference curves are devices to represent
preferences and are used in choice theory.
Developed by F. Y. Edgeworth and V. Pareto and
others in the first part of the 20th century.
An indifference curve is a graph showing
combination of goods for which a consumer is
indifferent, i.e, he derives the same satisfaction
from each of the given combinations.

i.e., a  b  c
 Properties of Indifference Curve
1. Downward slopping
2. Convex to the origin
3. Cannot intersect or meet each other
4. A higher indifference curve represent a higher level of satisfaction
 Drawing Consumer’s Budget Line

Budget Schedule of a Consumer

with a given income (Rs. 1000) and Consumer's Budget-line
prices of goods 25
Bundle Good X Good Y
(@ Re 100) (@Re 50) 20
A 10 0
B 5 10 15

Good Y
C 4 12 10

D 3 14 5

E 2 16
0
F 0 20 0 2 4 6 8 10 12

Good X
Utility Maximization/Consumer’s Equilibrium
 Using Calculus to show
Indifference curves are downward sloping and convex to the origin

U  f ( x, y ) or U ( x, y )

Taking total derivatives

dU dU
dU  d x dy
dx dy
Since, the consumer remains on the same indifference curve, i.e. utility remains same.

So, d U  0
dU dU
Or, d x d y0
dx dy

dy dU dU
 /
dx dx dy

dy f
  1 (ratio of marginal utilities of x and y), it shows the slope of the indifference curve
dx f2
Example:
Linear Utility
 Consumer’s Equilibrium using Calculus

Maximise U = U (X, Y)
Subject to I = Px (X) + Py (Y)

Where, U is Utility, X is quantity of good x, Y is quantity of good y, I is income

or budget of the consumer,
Px is price of good x and Py is price of good y.
 
Since, it is problematic to maximize the utility function using calculus as we have an equality
constraint.

Langrangian function is a tool often used to optimization problems with an equality

constraint.

In general, the Langrangian function is the sum of the original objective function and a term
that involves functional constraint and a Langrangian multiplier ƛ.

The Lagrangian function given as:

Z = U(X, Y) + ƛ [I – Px (X) – Py (Y)] …………………………..(1)
Z = U(X, Y) + ƛ [I – Px (X) – Py (Y)] …………………………..(1)
 
To maximize Z, we find the partial derivatives of Z with respect to X, Y, and ƛ and set them
equal to zero.
 
That is,
∂Z/∂X = ∂U/∂X – ƛPx = 0
∂Z/∂Y = ∂U/∂Y – ƛPy = 0
∂Z/∂ƛ = I – Px (X) – Py (Y) = 0
 
Or, MUx - ƛPx = 0
MUy – ƛPy = 0

Solving for ƛ, MUx/Px = MUy/Py = ƛ

MUx / Px = MUy / Py …………………………(2)

That is, the consumer should buy each good (or X and Y) to the extent that the marginal utilities
of rupee spent on the last unit of each good (X & Y) are equal. This is called the principle of
equi-marginal utility.
Numeric Examples
Maximise utility function given as:
1) U = xy;
Subject to, I = x + y = 10 (where, both the prices of x and y is equal to 1)

2) U = 3x + xy + y
Subject to, I = 4x +2y = 70
Linear Indifference Curve (Perfect Substitutes)
 Right-angled indifference curves (Perfect Complements )

Perfect complements are goods that

are always consumed in fixed
proportions.

A nice example is that of a right shoe

and a left shoe. The consumer likes
shoes, but always wears right and left
shoes together. One extra right or left
shoe does not do him/her any good.
 Meaning of Demand

1. Desire for a commodity

2. Ability to pay, and

3. Willingness to pay for it

 Determinants of Demand

Price of the product Climate

Income of the consumer  Socio-cultural factors

 State of economic development

 Tastes and preferences
 Awareness about the product
 Prices of related
commodities and uses
 Demand function and the law of demand

The law of demand states that buyers of a good will purchase more of the good if its price is lower
and vice versa, other things remaining the same.
D x  f ( Px , Y , Py , C , T )

Where, Dx is demand for commodity X,

Px is price of commodity X,
Y is income of the consumer,
Py is the price of its related commodity,
C is climate,
T is tastes and preferences of the consumer,
f stands for functional relationship.

D x  f ( Px )
 Individual Demand

Individual Demand Schedule

Price of Strawberries Demand for Strawberries

(in Rupees per K.G.) (in K.G.)

20 3
18 5
15 8
12 12
10 15
 Market Demand

Market demand is an aggregate of all individuals’ demand in the market.

Price of Quantity Demand of consumer (in K.G.) Market
Strawberries Demand Market Demand Curve
(In Rupees per A B C
K.G.)
25
20 3 2 5 10 20
18 5 4 7 16
15
15 8 7 9 24

Price
10
12 12 10 15 37
10 15 13 18 46 5
Individual Demand Curve of A I n d i v i d u a l o f D e ma n d o f B Ind iv id ua l D e ma nd c urve o f C
0
25 25
25 0 10 20 30 40 50
20 20
20
Demand
15 15 15

10 10
10

5
5
5
0
0
0 5 10 15 0
0 5 10 15 20
0 5 10 15 20
D e ma n d
De mand De ma nd
 Change in quantity demand and change in demand

Change in quantity demand Change in demand (Shift in the demand curve)

(Movement along the same demand curve)
Consumer Surplus

Shows the difference between the price

consumers pay for a unit and the price they
are willing to pay.

The concept helped to resolve the so called

water-diamond paradox, which plagued
classical economists until 1870.

Water-Diamond Paradox: Why is water, which

is essential for life, so cheap, while diamonds,
which are not essential, so expensive?
Why does the Law of Demand Operate or the Demand Curve Slopes
Downward to the right?  

There can be any or all of the following three reason(s) responsible:

1. Price effect
2. Income effect
3. Substitution effect  

The fourth reason that may also be attributed to the downward sloping of the
demand curve is the application of the law of diminishing marginal utility.
 Exceptions of the law of demand

1. Giffen Paradox
Normal good, Inferior good and Giffen good
Giffen goods are those inferior goods for which income effect is stronger than
the substitution effect, and the law of demand does not operate.

Price effect = Income effect + Substitution effect

  For a price fall
Income effect Substitution effect Resultant Price effect Demand curve

Normal good +3 +3 +6 Downward sloping

Inferior good (case 1) -2 +3 +1 Downward sloping

Inferior good (Case 2) -3 +2 -1 Upward sloping

   
For a price rise
Income effect Substitution effect Resultant Price effect Demand curve

Normal good -3 -3 -6 Downward sloping

Inferior good (case 1) +2 -3 -1 Downward sloping

Inferior good (Case 2) +3 -2 +1 Upward sloping

 Hypothetical Example of a Giffen Good

Income = Rs. 1000/ a month Price Rise: The price of potatoes increased to Rs. 60.
(to be spent on Potato & Meat)
Consumption of potatoes: Rs 60 x 14 kg = Rs. 840 for 25 days.
Potato is an inferior commodity while
meat is superior one.
The remaining income, i.e., Rs. 160 is insufficient for consuming
The prices of potatoes and meat are meat for the rest of the month (i.e., 5 days).
given as Rs. 50 and Rs. 150
respectively.
Therefore, he ends up buying more potatoes (the cheaper
Consumption of potatoes: Rs. 50 commodity) of the following quantity to meet his requirement for
x 14 kgs = Rs. 700 for 25 days. the remaining 5 days and forgoes the consumption of meat.
Consumption of meat: Rs. 150x 2 More potatoes: Rs 60 x 2 kg = Rs.120 for 5 days.
kgs. = Rs. 300 for the rest of 5 days.
The total demand for potatoes at old price (Rs. 50) was 14 kilograms
Total expenditure= Rs. 1000 in 30 whereas at an increased price (Rs. 60) is16 kilograms.  
days
 
Thus, higher is demanded at a higher price and violated the law of
demand.
Exceptions (cont.)

2. Precious and prestigious goods (Veblen goods)

3. Speculation of prices

4. Habitual goods