Lecture iv

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CONSUMER BEHAVIOUR

• Consumer is a king -- buying power, preferences & price signals

• Preference & choice• Objectives• To derive maximum utility• To pay lowest possible price

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UTILITY ANALYSIS

• Utility – capacity of commodity to satisfy human want

• Cardinal approach -- measurability of utility

• Ordinal approach – Ranking of utility

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UTILITY ANALYSIS

Good Cardinal Ordinal

A1 20 2

A2 22 1

A3 18 3

A4 15 4

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RELATION BETWEEN TOTAL & MARGINAL UTILITY• Marginal utility is addition to total

utility • Total utility increases with every

addition at diminishing rate• Marginal utility diminishes with every

additional unit consumed• When total utility is maximum

Marginal utility is zero• Total utility diminishes when Marginal

utility is less than zero

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THE LAW OF DIMINISHING MARGINAL UTILITY

• Dr. Marshall states “ the additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has”

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“ceteris paribus marginal utility from every successive unit consumed goes on declining”

• Homogeneous units• Time period of consumption• Consumption up to the point where

MU=PRICE

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ASSUMPTIONS OF THE LAW OF DMU• Cardinal measurement of utility• Consumer is rational• Limited income• Constant prices• MUM is constant

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THE LAW OF EQUI-MARGINAL UTILITY• The consumer will distribute his

given amount of money on different goods in such a way that the marginal utility of last rupee spent on each good is made equal

• Ratios of MU to P for all goods are equal

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CONSUMER’S EQUILIBRIUM• Maximum satisfaction by allocating

income over different goods in such a way that MU of all goods will be in proportion to their respective prices

• MU of exp. or MU last rupee spent on each good will be made equal

• MUa/Pa= MUb/Pb=MUc/Pc = ----MUn/Pn

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DIMINISHING MU & THE LAW OF DEMAND • Demand curve slopes downward

as MU declines with every additional unit consumed

• Consumer demands the good till MU = price

• So lower quantity is demanded at high price & vice versa

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D

MU

Q Q1

Q2

Q Q1 Q2

A

BCP2

P1

P

P

P1P2

QD

MU&P

0

0

PUtility

MU & DD CURVE

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LIMITATIONS OF CARDINAL ANALYSIS• Measurability of utility questioned• Utility is not independent• Mum is not constant• No distinction between income &

substitution effects• Unable to explain Giffen paradox • Neglects cross effects of related

goods • Unrealistic

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INDIFFERENCE CURVE (IC) ANALYSIS Scale of preference the base of IC

technique • Based of Ordinal measurement

of utility • Ranking of goods as per

satisfaction derived • Two goods consumed• Independent of Prices & income

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ASSUMPTIONS OF IC ANALYSIS • Rational consumer • two goods• Income, taste, habits, & prices of

goods remain same• Comparison and ranking of alternative

commodities in order of preference• Transitivity• Continuity

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IC SCHEDULE• List of combinations of two goods X&Y

giving same utility

Combinations

Com. X Com. Y

A 1 14

B 2 10

C 3 7

D 4 5

E 5 4

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Techniques of (IC) ANALYSISIndifference curve• A graphical representation of I

schedule• It is a locus of various combinations

of goods giving EQUAL satisfaction

Indifference map • It is a family/set of ICs

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INDIFFERENCE CURVE

0Com. X

Com. Y

IC

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INDIFFERENCE MAP

1

23

0X

Y

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MARGINAL RATE Of SUBSTITUTION

• MRS is the amount of commodity Y given up to obtain additional unit of commodity XCombn

Com. X

Com. Y

MRSxy

∂y/∂x

A 1 14 -- --

B 2 10 4:1 4/1

C 3 7 3:1 3/1

D 4 5 2:1 2/1

E 5 4 1:1 1/1

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MARGINAL RATE OF SUBSTITUTION• MRS diminishes for normal goods

• To obtain one more unit of X less & less of Y would be given up

• So IC takes negative shape

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IC FOR NORMAL GOODS• DMRS so IC takes convex shape

0 X

Y

1

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IC FOR SUBSTITUTES

• Constant MRS so IC is straight line

Y

X0

a

b

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IC FOR COMPLEMETS

IC1

IC2

IC3

IC4

0X

YConsumption in fixed proportion

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PROPERTIES OF IC

• All ICs slope downwards from left to right

• No two ICs intersect • IC is convex to origin (reasons)• Higher IC represents higher level of

satisfaction• IC can not touch either axis• ICs need not be parallel to each other

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BUDGET OR PRICE LINE• PL shows various quantities of goods

can be purchased with given income

0 Com. X

Com. y

A

B

X

Y M= Pxqx + Pyqy

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CONSUMER’S EQUILIBRIUM• Transformation of scale of preferences into reality by buying certain units of x & y to maximize satisfaction

• No tendency to rearrange his purchases

• Constraints faced by Consumer prices of goods Consumer’s income

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ASSUMPTIONS

• IC map for X&Y is given • Constant prices of X&Y• Price ratio remains constant• Entire income is spent• X & Y are divisible• Rational consumer

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EQUILIBRIUM CONDITIONS • The tangency of price line (PL) & IC is

necessary condition for equilibrium i.e. slope of PL = slope of IC

• IC has to be convex at the point of tangency

• MRSxy=PX/PY = MUx/Px = MUy/Py

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CONSUMER’S EQUILIBRIUMCOM.Y

12

3

4E

A

B0

C

D

Y

COM.X

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INCOME EFFECT--IE

• Change in real income changes the position of consumer equilibrium

• Consumer is better/worse off • Real income increases or declines• Incase of normal goods IE is positive• Income consumption curve rises

upward

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INCOME EFFECT--IECOM.Y

ICC

12

3

A

B B1

B20COM.X

E E1

E2

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INCOME EFFECT--IE

• In case of normal goods IE is Positive

• If commodity x is inferior IE is negative ICC rises up and bends backward

• If commodity y is inferior IE is negativeICC rises up and turns downward

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SUBSTITUTION EFFECT--SE• Change in price influences the

position of consumer equilibrium• Adjustment in money income to

maintain real income constant

• Price effect= Income effect+ substitution effect

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SUBSTITUTION EFFECT-- SE

E

E1

1

A

COM.X

COM.Y

0 B B2 B1

A1

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PRICE EFFECT--PE• Change in price influences the position

of consumer equilibrium• Consumer is better/worse off • Real income increases or declines• Incase of normal goods PE is positive• PE is negative for inferior/Giffen

goods• Price effect= income effect+

substitution effect

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PRICE EFFECT--PE

PCC

12

3

A

B B1

B20

COM.Y

COM.X

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DERIVATION OF DEMAND CURVE FROM PRICE CONSUMPTIONCURVE

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SUPERIORITY OF IC ANALYSIS• Ordinal utility• Consideration of Diminishing MUM• Separating price effect into income &

substitution effects• Explains Giffen's paradox• Better way of classifying substitutes

& complementary goods• Wider application

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Consumer’s surplus

• Dr. Marshall defines consumer’s surplus as “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 the economic measure of this surplus satisfaction– it may be called consumer’s surplus”

• Consumer’s surplus= ΣMU - ΣP