THEORY OF CONSUMER BEHAVIOUR

CONCEPTSDemand arise due to utility

Measurement of Utility:Cardinal Utility: Utility is objectively measurableOrdinal Utility: Consumers can rank their preferences

TOTAL UTILITY(TU)Sum total of all the utilities derived from the total number of all units consumed

Sum of Marginal Utility (MU) of different units of the commodityTUn = MU1 + MU2 + ..+ MUn = MU

MARGINAL UTILITY (MU)Change in TU resulting from a one unit change in consumption of goodMUn = TUn TUn-1

RELATION B/W TU & MU

No of unitsTUMU1101021883246428453026300728-2824-4

RELATION B/W TU & MU

CARDINAL APPROACH TO CONSUMER EQUILIBRIUM- MARGINAL UTILITY ANALYSIS

ASSUMPTIONS OF MU ANALYSISCardinal measurement of UtilityHypothesis of Independent utilityConstancy of marginal Utility of MoneyRationalityLimited Money Income

LAW OF DIMINISHING MUUtility derived by consumer from the consumption of each additional unit of a commodity keeps on decreasing with every increase in the stock of the commodity which he/she already has.NOTE: TU continues to increase though at a decreasing rate

EXAMPLE

Cups of tea consumed per dayTUMU11212222103308436654046411739-2834-5

APLICATION OF CONCEPT OF DIMINISHING MARGINAL UTILITYDiamond Water Paradox: Water which is so essential & useful to life has such a low price while diamonds which are quite unnecessary have such a high price.????

Water.available in abundancerelatively low MU

LAW OF EQUI MARGINAL UTILITYConsumer will redistribute his money income b/w goods in such a way that utility derived from last rupee spent on each good is equal

Consumer is in equilibrium when MU of money expenditure on each good is the same

NOTE: does not mean spending of equal amount of money on each commodity

LAW OF EQUI MARGINAL UTILITYConsumer will spend his money income between goods in such a way that MU of each good is proportional to its price

If there are 2 goods x and ythen MUx/Px = MUy/Py

LAW OF EQUI MARGINAL UTILITYIf MUx/Px MUy/Py then consumer will substitute good x for good y

Reasoning: As a result of increase in the quantity of good x MUx will fall and because of a decrease in the quantity of y MUy will increaseConsumer will continue substitution till MUx/Px becomes equal to MUy/Py

EXAMPLE ON CONSUMER EQUILIBRIUM Given: Px = Re ; PY = Rs 2; Money Income= Rs 19

UnitsMUxMUyMUx/PxMUy/Py12024108218219731618864141575512963610351

CRITICAL EVALUATION OF MU ANALYSISUnrealistic assumption of Cardinal measurability of utilityWrong hypothesis of independent utilityInvalid assumption of Constant Marginal utility of moneyFailed to explain the giffen paradoxFailed to explain the splitting of price effect into income effect and substitution effect

ORDINAL UTILITY APPROACH TO CONSUMER EQUILIBRIUM- INDIFFERENCE CURVE ANALYSIS

ASSUMPTIONSPerfect KnowledgeRationalityOrdinal UtilityTransitivityConsistencyNon satiety (MIB)Diminishing Marginal Rate of Substitution

MORE IS BETTERBundles that have at least as much of every good & more of some good are preferred to other bundlesBundle B is preferred to A- B contains at least as much of good Y & strictly more of good X.Bundle B is preferred to C- B contains at least as much of good X & strictly more of good Y.More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI.I.II.III.Good YGood XACB

INDIFFERENCE CURVE (IC)Locus of points among which consumer is indifferent

Each point on an IC yields the same TU as any other point on the same IC

Consumer is indifferent among all points on IC

It does not indicate exactly how much satisfaction is derived from these combinations

INDIFFERENCE SCHEDULEICGood YGood X

COMBINATIONUNITS OF GOOD XUNITS OF GOOD YA321B415C511D68E76

INDIFFERENCE MAPSet of ICs corresponding to different levels of satisfaction

Higher IC represent greater satisfactionGood X

MARGINAL RATE OF SUBSTITUTION (MRS)MRS of X for Y (MRSXY) measures the number of units of Y that must be sacrificed per unit of X gained so as to maintain a constant level of satisfaction.Units of YMRSXY = (-1) Y/ X

EXAMPLE

COMBINATIONGOOD XGOOD YMRSxyA112B284C353D432E521

DIMINISHING MARGINAL RATE OF SUBSTITUTIONThe Convexity of an IC implies that MRS diminishes as X is substituted for Y along an IC.

MRS at Q = Y1Y2 / X1X2MRS at R = Y2Y3 / X2X3Units of Y

NOTE The rate at which a consumer is willing to trade good Y for good X is equal to the ratio of MU X to MU Y

MRSXY = -Y/ X = MU X / MU Y

CHARACTERSTICS OF ICnegative slope (Slope downwards from left to right)convex to the origin (diminishing MRS)higher IC represents a higher level of satisfactioncan not intersect each other

IMPOSSIBLE INDIFFERENCE CURVES Units of Y HorizontalUnits of X

IMPOSSIBLE INDIFFERENCE CURVES Units of Y VerticalUnits of X

IMPOSSIBLE INDIFFERENCE CURVES

IMPOSSIBLE INDIFFERENCE CURVESIntersection abeUnits of XUnits of YIC 1IC 2

EXCEPTIONAL SHAPES OF ICPERFECT SUBSTITUTES . MRS between two goods is constant and therefore the IC is linear.PERFECT COMPLEMENTS: no possibility of substitution so MRS will be 0. Satisfaction can not be increased by increasing the units of one commodity at the expense of the other so MRS will be infinity.

BUDGET LINE/ PRICE LINE/ CONSUMPTION POSSIBILITY LINESet of commodity bundles that can be purchased if the entire money income is spent, given the prices of the two commoditiesI = xpx + ypy

y = 1/py . I px/ py .x

BUDGET CONSTRAINTOpportunity setL1 (Pz = Re 1, PB = Rs 2, M= Rs 50) 201010030abcd50 = M / PzGood X25 = M / PBGood Y

SHIFTS IN THE BUDGET LINEINCREASE IN MONEY INCOME : Budget line shift outwards to the rightUnits of YUnits of X0

SHIFTS IN THE BUDGET LINEDECREASE IN THE MONEY INCOME : Budget line shift inwards to left

Units of Y Budget line pivots from AB to AC i.e. it will shift only at its end touching the X axis.INCREASE IN THE PRICE OF GOOD X

Budget line pivots from AB to AC i.e. it will shift only at its end touching the Y axis.INCREASE IN THE PRICE OF GOOD Y

SLOPE OF THE BUDGET LINESlope of the Budget Line is equal to the ratio of prices of two goods.Slope of Budget line = OA/OB = (I/Py) / (I/Px) = Px/Py

CONSUMER EQUILIBRIUMConsumer is said to be in equilibrium where he maximizes his satisfaction subject to his budget constraint.

CONDITIONS FOR CONSUMER EQUILIBRIUMFIRST ORDER CONDITION (NECESSARY)Slope of budget line should be equal to the slope of ICMRSXY = PX/ PY SECOND ORDER CONDITION (SUFFICIENT)At the point of equilibrium, IC must be convex to the origin.

Units of X

DECOMPOSITION OF PRICE EFFECT INTO INCOME AND SUBSTITUTION EFFECTPRICE EFFECT: total change in quantity demanded caused by a change in the price

SUBSTITUTION EFFECT: change in quantity demanded resulting from a change in price when the change is restricted to a movement along the original IC, thus holding real income constant

INCOME EFFECT: change in quantity demanded resulting exclusively from a change in real income, all other prices and money income held constant

INCOME EFFECTPositive I.E. With an increase in the income the consumer consumes more units of the good.Negative I.E. With an increase in income the consumption of the good falls (inferior goods)

INCOME CONSUMPTION CURVE & INCOME EFFECT (1) ICCUNITS OF GOOD XUNITS OF GOOD Y+VE I.E. for Good X & Good Y

INCOME CONSUMPTION CURVE & INCOME EFFECT (2) ICCUNITS OF GOOD XUNITS OF GOOD Y-VE I.E. for Good X (inferior good)

INCOME CONSUMPTION CURVE & INCOME EFFECT (3) ICCUNITS OF GOOD XUNITS OF GOOD Y-VE I.E. for Good Y (inferior good)

INCOME CONSUMPTION CURVE & INCOME EFFECT (4) UNITS OF GOOD XUNITS OF GOOD YGood Y inferiorGood X inferior

SUBSTITUTION EFFECT UNITS OF GOOD XUNITS OF GOOD YIC

HICKSIAN APPROACH: NORMAL GOODSRQPx3x2x1PE = SE(x1 x2) + IE (x2 x3)Units of XUnits of YFor a decline in price of good x

HICKSIAN APPROACH: INFERIOR GOODSRQPx3x2x1Units of XUnits of YPE = SE(x1 x2) + IE (-x2 x3)SE >Negative IE

HICKSIAN APPROACH: GIFFEN GOODSRQPx3x2x1Units of XUnits of YPE = SE(x1 x2) + IE (-x2 x3)Negative IE > SE

POSSIBLE COMBINATIONS OF INCOME EFFECT AND SUBSTITUTION EFFECT OF A DECLINE IN THE PRICE OF GOOD X

CaseSubstitution EffectIncome EffectTotal EffectNature of the commodityA-ve+veNormalB-ve-ve but smaller than SEInferiorC-ve-ve but larger than SEGiffen

SIMILARITY B/W MARSHALLIAN APPROACH & INDIFFERENCE CURVE APPROACHAssume that consumers are rationalAssumption of diminishing MU in some sense or the other

SUPERIORITY OF IC ANALYSISOrdinal measurement of utilityAnalysis of demand without assuming constant MU of moneyHypothesis of interdependent utilityGreater insight into price effectLess restrictive & fewer assumptions

CRITIQUE OF IC ANALYSISIncludes most ridiculous combinationsSuitable for two good case onlyLimited empirical nature.

EXERCISE: Textbook Page # 106Consider a world in which there are only 2 goods. An individual has an income of Rs 30,000. Price of deodorant is Rs 30 per can & price of mouthwash is Rs 40 per bottle.

Expressing deo as dependent variable, write eq for budget constraint.

What is the slope of budget constraint?

If P of mouthwash increases to Rs 50., write new eq for budget constraint.

*Px = Rs 2 per unitPy = Rs 3 per unitIncome = Rs 19

*