Theory of Consumer ChBeahpatieas

LearningObjectives
consumer behaviour - Cardinal utility analysis Utility -Total utit
Approaches to utility - Law of diminishing marginal utility - Consumer equilibrim
and marginal
law of DMU - Law of equi-marginal utility - Consumer surnke
according to
The study of microeconomics begins by examining the economic behaviolr of a
consumer. The consumer is the basic economic unit. He or she decides, which
consumer behavi
commodities should be purchased and in what quantities. Theory of
analyses the guiding force behind consumer decisions. The study of consumer behaviouy
is the first step in derivation of the market demand curve. It explains the fundamentil
issue in economics, ie., howa consumer with limited income decides which goods and
services to buy and in what quantity.
1.Approaches to Consumer Behaviour
There aretwobasic approaches in economics that determines consumer equilibrium- cardinal
utility and ordinal utility analysis. The cardinal utility school ofthoughtassumed that utility s
measurable in quantifiable terms. However, ordinal utility school of thought argued that utlty
is a psychological concept. Therefore, it cannot be quantified in cardinal number. It is ony
possible to rank or compare utility.
2. Cardinal Utility Analysis
Cardinal utility school of thought was pioneered by economists like Stanley Jevons, Leon
Walras and H.H.Gossen. Howeyer, it was Prof. Alfred Marshall who gave scientific
treatment to cardinal utility approach(The cardinal utility analysis is based on the.assumptio,
a

that utility is measurable in

quantifiable
money a consumer is willing to pay terms. According to Prof, Marshall the forthat
amountof
for acommodity utility
particular product. Therefore, Marshall considered priceindicates his or her
is an indirect of utility.
34 measure
 Theory of Consumer Behaviour

3.Utility
Uúlity is the power of acommodity or service to satisfy human wants.)Goods are desired
because of their ability to satisfy human wants. In economics, concept of utility is ethically
neutral. The terms utility and usefulness are different in meaning, A product may not be
useful to the consumer. Stillit may have utility. For instance, cigaret smoking is harmful and
iniurious to health but consumer of a cigarette obtains some utility fiom snmoking cigarettes.
The meaningof utility is also different from satisfaction. Satisfaction is the outcome of
consumption ofa product. However, utilityis the cause for consumption of aproduct. Utility
exists even before consumption take place; whercas, satisfaction.comes.only after-the
Consumption ofa product, Prof. Marshall maintained that utility is measurable in terms of the
price a consumer iswiling to pay for a commodity or service.
TU
4. Total Utility and Marginal Utility
The amount of utility consumer obtains from the consumption of different units vary from
each other. Total utility is the sum of these individual utilities that consumer derives from the
consumption of all such units of a commodity. In other words, total utility is the aggregate
utility derived from all units ofa commodity consumed. Marginal utilityindicates the additiona
utility derivedfrom an additional unit of commodity
consumed.
MU, =TU, - TU,

s]Law of Diminishing Marginal Utility fmo

It was Economist H.H. Gossen who first postulated the law of diminishing marginal utility.
Therefore, it is known as Gossen's first law of consumption.However, it was Prof. Marshall
who gave a scientific treatment to this law. The law of diminishing marginal utility can be
stated as. "The additional utility which a consumer derives from a given increase of stock
diminishes with every increase in stock that he or she already has."

5.1. Illustration of the law

To explain the law of diminishing marginal utility, let us take the following hypothetical utility
schedule. The Table 3.1 shows, as units of commodity - Xconsumedincrease, the marginal
utilityderived from each successive units, tends to diminish.
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 Orrdmu - Ve. u gtanta

whe
Mu
Managerial Economics

The consumption the

ese
Table 3.1 Total utility and Marginal utility of
goods -X, per period of first unit
Units ofX Total Utility Marginal Utility
0
the consumer a total
utils. Total
iuttiilmitye ofgives
utility 10
2
3
10
16
20
10
6
4
consumption of increases
additional with
goods - Xuntil the fifth units of
unit is the unit. Fifth
4 22
22
2
saturation
However, the consumption point,
6 20 -2 of the
sixth unit brings disutility and decline
in total utility. The third
coluun
the table presents marginal utility resulting from the consumption of each additional mn of
goods -X. Marginal utility is positive initially, but decline until the fifth unit, for which maroinsl
utility is zero. Thereafter, marginal utility becomes negative.

TUx

22
X
of 20
utility
16
Toal TUY

4 6

Quantity of X
MU,
Marginal
utility
of

Quantity ofX MUY

Fig 3.1: Total and Marginal Utility Curves
In the top panel, utility (TU) increase by smaller and smaller
amounts (shaded areas) and so the
marginal utility (M) in the bottom panel declines. TUremains unchanged with the consumption of the
5th unit, and so MU is zero. After the fifth unit,
TUdeclines and MU is negative.
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 NU
Theory of Consumer Behaviour

The above table is represented in Fig. 3.1 to derive marginal utility curve. On the X-axis we
measure the units of goods - X, consumed. On the Y- axis we measure total utility and
marginal utility. TU and MU are plotted for every unit consumed. Joining these plots, we
arrive at total utility curve on the top pancl of the diagram and marginal utility curve on the
bottom panel. Note that marginal utility curve is downward sloping from left to right indicating
the operation of the law of diminishing marginal utility. Marginal utility from the consumption
of successive units of the same goods diminishes. We observe the following relationship
between total utility and marginal utility.
Total utility keeps increasing as long as marginal utilityis positive.
Total utility is maximum, when marginal utility reaches zero.
Total utility tends to diminish, when marginal utility is negative.
Marginal utility from successive units diminishes, and ultimately marginal utility becomes
negative.
5.2. Assumptions of the Law
1, Homogeneity: The law holds good only if all successive units of the commodity taken
in the process of consumption are homogenous in nature. The quality, size, taste, and
colour of the successive units consumed should be identical. If there is any difference
in the nature of various units of goods, marginal utility may increase rather than diminish.
2. Continuity: The consumption process should take place continuously at a given point
of time.Units are taken one after another successively, without any time interval.
3. Reasonability: The consumption should take place in jdeal size, of normal standard
unit. If tea is consumed in spoon, instead of glass, the law will not operate.
4 Rationality: Consumer is assumed to be rational. Given the income and price of the
commodity, consumer spends his income to obtain maximum possible satisfaction or utility.
and
5 Constancy: The law presumes that there is no change in income, taste, habits
substitutes
preference of the consumer. Similarly, price of the goods consumed and its
remain constant.
assumed
6. Constancy of marginal utility of money: Throughout the consumption, it is
that marginal utility of money remains constant.
measurenent of
7. Cardinal measurement of utility: The law is based on the cardinal
utility. It is assumed that utility can be numerically measured by the consumer.
by adding the
8 Additive: It is assumed that utility is additive. Total utility is obtained
utilities derived from various units consumed.
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(aceos o] MU mie ho
Suglsalifalion
9. Goods are assumed to be of ordinary nature: Commodities like jewcls,
and artifacts do not follow the law of diminishing marginal utility.
5.3. Consumer EquilibriumAccording to Law of DMU
diamonds,
From the above analysis, we come to understand that when consumer spends
income continuously on various units of the same commodity, marginal
his limited
Iutility derived from
the successive units tends to diminish. In such a situation, consumer attain
the price paid for equilibrium
a unit of when
urpes goods is
equal to the marginal utility derived
loone from that particular unit of goods.
Price Consumer equilibrium is explained
E in Fig.3.2.
Let us assume that m¡rket price
MU of the commodity remains constant
at point P in the diagram,
Downward sloping MU curve
indicates that marginal utility is
diminishing. The consumer attains
Marginal Utility equilibrium ae point E, where his
Fig 3.2. Consumer equilibrium according to law of
marginal utility (QE) is equal to the
diminishing marginal utility. price (OP). 00 is the equilibrium
amount of consumption. Note that to the right ofpoint E, the marginal utility is less than the
price. On the contrary, to the left ofE, the price is less than marginal utility. Consumer
obtains maximun utility at point E, where the total utility is maximum. Thus, necessary
condition required for consumer equilibriumis-that marginalutility-derived-from- the- unit
consumed should be equal to its price. In other words, at point E, MU, = P,

5.4. Importance of the Law

The law of diminishing marginal utlity is the basis of thelaw of demand. Consumers
are willing to buy more units of acommodity only when its price falls, This is due to the
operation of thelaw of diminishing marginal utility. When more units are purchased of
consumed, consumner's marginal utility diminishes. Therefore, the price should aslo fall
in order to induce the cunsumer to buy more units ofa commodity. The law of diminishing
marginal utility establishes the operation of the law of demand.

38
 lu maty
Tane budey
1, a
as in vome progrenea hoyonive le
Theory of Consumer Behaviour

2, The law of diminishing utility justifies the policy ofprogressive tax in fiscal policy. In
progressive tax system, higher tax rates are imposcd at higher income groups. This is
based on the assumption, that marginal burden of the tax is comparatively less in high
income group of the socicty than low income group.
3. The law ofdiminishing marginal utility explains the theory ofvalue. The law ofdiminíshing
marginal utility resolves the water diamond paradox, Scarcity creates value. Scarce
commodities, like diamond, command greater value, whereas abundant commodities
like water and air command no value in exchange. This is because marginal utility
diminishes with increase in stock.
The law of diminishing marginal utility explains the reason for variety in production.
When same products are supplied continuously, its marginal utility to consumer tends to
diminish. Therefore, producers bring differentiated products into the market to prevent
the operation of diminishing marginal utility.
t s The law of diminishing marginal utility is the basis of equal,distribution of wealth.
The theory of consumer surplus is based on the law odshng TaTgy