CA Foundation Course Elite Gurukul

Chapter – 2
THEORY OF CONSUMER BEHAVIOUR
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.
 All wants of human beings exhibit some characteristic features.
 Wants are unlimited in number. All wants cannot be satisfied.
 Wants differ in intensity. Some are urgent, others are less intensely felt
 “Utility” depends on intensity of wants.
 In general, Utility is satisfaction. But in economic sense, Utility is a
want satisfying power of a commodity.
 Each want is satiable
 Wants are competitive. They compete each other for satisfaction
because resources are scarce in relation to wants
 Wants are complementary. Some wants can be satisfied only by using
more than one good or group of goods
 A particular want may be satisfied in alternative ways
 Wants are subjective and relative. And hence, utility is also subjective or
relative concept.
 Wants vary with time, place, and person and hence utility.
 Some wants recur again whereas others do not occur again and again
 Wants may become habits and customs
 Wants are affected by income, taste, fashion, advertisements and social
norms and customs
 Wants arise from multiple causes such as physical and psychological
instincts, social obligations and individual’s economic and social status

CLASSIFICATION OF WANTS
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.
Comforts:
While necessaries make life possible comforts make life comfortable and
satisfying. Comforts are less urgent than necessaries.
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.

Total Utility and Marginal Utility

The two important concepts of utility are Total Utility (TU) and Marginal
Utility (MU) which are useful in theories of consumer behaviour.

TU refers to the sum total of utilities derived from the consumption of

all the units of a commodity consumed by a consumer at a given time.

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In other words, it is a sum of marginal utilities up to the units consumed by a

consumer. TU = ∑ MU

MU is the additional utility derived from the consumption of an additional unit

of the commodity. MU = TUn – TUn-1 Or MU = ∆TU /∆N

RELATIONSHIP BETWEEN TU & MU

Total and Marginal Utility Schedule
UNITS Total Utility (TU) Marginal Utility (MU)
0 0 -
1 10 10
2 18 8
3 23 5
4 25 2
5 25 0
6 23 -2

 Both TU and MU are interrelated. TU = ∑ MU & MU = TUn – TUn-1

 At first unit, TU = MU.
 Initially, when TU is increasing at decreasing rate, MU is decreasing but
remains positive.
 When TU is maximum and constant, MU = 0 (zero).
 When TU starts decreasing, MU becomes negative.

LAW OF DIMINISHING MARGINAL UTILITY

In simple words it says that as a consumer takes more units of a good, the extra
satisfaction that he derives from an extra unit of a good goes on falling.

Total and Marginal Utility Schedule

Quantity of tea Total Utility Marginal Utility

consumed (cups per day)
1 30 30
2 50 20
3 65 15
4 75 10
5 83 8
6 89 6
7 93 4
8 96 3
9 98 2
10 99 1
11 95 -4

The law of diminishing marginal utility is applicable only under certain

assumptions:
i. The different units consumed should be identical in all respects. The
habit, taste, treatment and income of the consumer also remain
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unchanged.
ii. The different units consumed should consist of standard units. If a
thirsty man is given water by successive spoonful, the utility of second
spoonful may conceivably be greater than the utility of the first.
iii. There should be no time gap or interval between the consumption of one
unit and another unit i.e. there should be continuous consumption.
iv. The law may not apply to articles like gold, cash where a greater quantity
may increase the lust for it.
v. The shape of the utility curve may be affected by the presence or absence
of articles which are substitutes or complements.

CONSUMER SURPLUS
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.

Measurement of Consumer Surplus

No. of units Marginal Utility Price (₹) Consumer
(worth ₹) Surplus
1 30 20 10
2 28 20 8
3 26 20 6
4 24 20 4
5 22 20 2
6 20 20 0
7 18 20 –

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

INDIFFERENCE CURVE ANALYSIS

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
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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.

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.
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.
Indifference Schedule
Combination Food Clothing MRS
A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1

An indifference curve IC is drawn by plotting the various combinations given in

the indifference schedule.

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.
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.

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Properties of Indifference Curves

i. Indifference curves slope downward to the right:

ii. Indifference curves are always convex to the origin:

 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.

 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),

iii. Indifference curves can never

intersect each other:

iv. A higher indifference curve represents a higher level of satisfaction than the
lower indifference curve:

v. Indifference curve will not touch

either axes:

The Budget Line

From the ordinal utility analysis discus
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.
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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

Consumer Equilibrium
The consumer has a given indifference map which shows his scale of
preferences for various combinations of two goods X and Y.
He has a fixed money income which he has to spend wholly on goods X and Y.
Prices of goods X and Y are given and are fixed.
All goods are homogeneous and divisible, and
The consumer acts ‘rationally’ and maximizes his satisfaction.

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