Unit II: Consumer Theory

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Topics

• Ordinal Utility theory: (Indifference curve approach)

• Consumer’s preferences;
• Interference curves;
• Budget line;
• Consumer’s equilibrium;
• Income and substitution effect;
• Price consumption curve
• derivation of demand curve for a commodity;
• Criticisms of the law of demand

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Meaning of
Consumer Behaviour & Utility
• Consumer Behaviour refers to the phenomenon of consumer’s reaction
reflected in the market through the instrumentality of price by way of
preferences and likings.

• The consumer buys a commodity because it gives him satisfaction. In technical

term, a consumer purchases a commodity because it has utility for him.

• Utility of a good is its expected capacity to satisfy a human want. To a

consumer, the utility of a good is the satisfaction which he expects from its
consumption. It is the extent to which it is expected to satisfy his want(s).

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Utility Analysis
• The cardinal approach or utility analysis is the neo-classical theory built up by
Marshell, Pigou and others.

• Utility means the want satisfying power of a commodity or service.

• Following are the features of utility.

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Features of Utility
1) Utility and satisfaction are 2. Actual satisfaction may be 3. Utility is neutral – It does
different – Utility is the more or less than then utility – not comment or criticize
satisfaction level which a Utility is the expected level of the consumption of any
consumer expects to get from a satisfaction which can be more commodity (for example,
commodity while satisfaction or less than the actual alcohol, cigarette, etc). It
here means actual satisfaction satisfaction level. has nothing to relate with
derived by a consumer. usefulness.

4. Utility is a subjective concept 5. It is dependent upon 6. Measurability of utility –

– It can differ from person to qualities of commodities, Marshell states that utility
person or even for a same mental level of consumer, time can be measured in
person, from time to time. period. numerical terms. Prof
Boulding provided the unit
of measuring utility –
“utils”.

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Approaches to Consumer Behavior

Cardinal Utility Analysis Ordinal Analysis – Indifference Curve

(Alfred Marshell) (Hicks and Allen)

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Cardinal Measurement of Utility
• Cardinal utility approach assumes that utility can be measured in cardinal numbers such as
1, 3, 10, 15, etc.

Total, Marginal & Average Utility

• Total Utility means the sum of utility derived by consuming all the units of a commodity.
• Marginal Utility means the additional utility derived from every successive unit of
consumption of any commodity. It can be defined as the increase in total utility derived
every next unit of consumption.
• Average Utility means per unit Total Utility derived by the consumer.

Formulae
TU = MU

MU(n) = TU(n) – TU(n-1) OR TU / Q

AU = TUn / N
BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics
 Law of Diminishing Marginal Utility

The law of diminishing Marginal Utility states that the additional utility (satisfaction)
derived by every successive unit of consumption of a standard units of a commodity
decreases.

As per Prof. Boulding, “As a consumer increases the consumption of one

commodity, keeping constant the consumption of all the other commodities, the
marginal utility of the variable commodity must eventually decline.”

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Tabular Presentation of utilities
X Units TU MU AU
1 10 10 10
2 18 8 9
3 24 6 8
4 28 4 7
5 30 2 6
6 30 0 5
7 28 -2 4
BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics
 Diagrammatic Presentation of
Utilities

35
TU
Maximum
30

25

20

TU
15 MU
AU

10

0
1 2 3 4 5 6 7

MU Zero
-5
BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics
 Relation between MU and TU

When MU is positive TU increases

When MU is zero TU is maximum
When MU is negative TU decreases

Following points are noteworthy in this regard-

 As long as MU decreases but remains positive, The TU increases
 When MU becomes zero, TU reaches its maximum.
 When MU becomes negative, TU starts declining.

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Consumer Equilibrium under
Cardinal Approach
• Consumer equilibrium is achieved when a consumer maximizes their utility given
their income and the prices of goods.
• According to the Marginal Utility Theory, a consumer maximizes utility by
allocating their income in such a way that the marginal utility per unit of rupee
spent on each good is equal. This is expressed as:
MUA ​ = ​ MUB​
PA PB
• It is also represented as the equality of the ratio between the marginal utilities
and prices of the respective products.
MUA ​ = ​PA​
MUB PB

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics

 Limitations of Law of
Diminishing Marginal Utility
The Law of diminishing marginal utility has some drawbacks. This law might not be applicable
in certain circumstances. In the case of exceptional cases, MU might increase for some time,
whereas cardinal utility might work. Six important exceptional cases to the law are:
1) Change of Taste and Preferences
• In case of a change in consumer tastes and preferences, he can like a commodity more, so the
MU of any commodity price rises.
• For example, a person initially might not have any interest in eating pizza. But after eating one
pizza, he may get a better taste for pizza and may get better satisfaction from the 2nd or the
3rd one.
2) Inadequate Initial Consumption
• If the initial quantity of a commodity is minimal, a person might not get satisfaction. In this
case, a person will have a high level of satisfaction in 2nd or 3rd consumption.
• For example, a glass of water might not fully fill the person's thirst, but the 2nd or 3rd glass
will do.
BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics
 3) Emotional or Fancy Buying
• The Law of marginal utility is not applicable when a consumer is buying something
fancy or things to which they are emotionally attached.
• An example is the artwork of a known painter or a rare book of a dead author.

4) Miser’s Collections or Hobby Collections

• A miser (a person who likes collecting money) will get more and more satisfaction
from the additional money. Similarly, a person who likes collecting things, e.g.,
stamps, coins, works of art, etc. will also get more and more satisfaction with
additional units as hobby-collections satisfaction increases gradually.

5) Consumption at Different Time Periods

• If the consumption of a particular commodity of different units and at different
times, MU from additional units is not likely to decrease. For example, consumption
of the same food in three other meals of the day, MU may not diminish.

BBA/B.Com/BA-LLB I SEMESTER Principles of Microeconomics