Theory of Consumer Behaviour
This chapter studies how individual consumers make choices about spending their income on different goods to maximize satisfaction. Two approaches are presented:
- Cardinal Utility Analysis - Measures utility in numerical terms
- Ordinal Utility Analysis - Ranks preferences without numerical measurement
2.1 Utility
Utility is the want-satisfying capacity of a commodity. It is subjective and varies between individuals and situations.
2.1.1 Cardinal Utility Analysis
Assumes utility can be measured numerically with two key measures:
Example:
| Units |
Total Utility |
Marginal Utility |
| 1 |
12 |
12 |
| 2 |
18 |
6 |
| 3 |
22 |
4 |
| 4 |
24 |
2 |
| 5 |
24 |
0 |
| 6 |
22 |
-2 |
Law of Diminishing Marginal Utility
As consumption of a good increases, the MU from each additional unit decreases, holding consumption of other goods constant.
Derivation of Demand Curve
The downward sloping demand curve can be explained by diminishing MU. Consumers are willing to pay less for additional units as MU decreases.
2.1.2 Ordinal Utility Analysis
Consumers rank bundles rather than measure utility numerically. Key concepts:
Indifference Curve
A curve showing all combinations of two goods that give equal satisfaction. Properties:
- Downward sloping (more of one good requires less of another for same utility)
- Higher curves represent greater satisfaction
- Never intersect
- Convex to origin due to diminishing Marginal Rate of Substitution (MRS)
Example of Diminishing MRS:
| Combination |
Bananas (Qx) |
Mangoes (Qy) |
MRS |
| A |
1 |
15 |
- |
| B |
2 |
12 |
3:1 |
| C |
3 |
10 |
2:1 |
| D |
4 |
9 |
1:1 |
Special Cases:
- Perfect Substitutes: Indifference curve is a straight line (constant MRS)
- Perfect Complements: Indifference curve is L-shaped (goods used in fixed proportions)
Monotonic Preferences
Consumers always prefer bundles with more of at least one good and no less of the other.
Indifference Map
A family of indifference curves representing different utility levels.
2.2 The Consumer's Budget
2.2.1 Budget Set and Budget Line
The budget line shows all combinations of goods that exhaust the consumer's income.
2.2.2 Changes in the Budget Set
- Income Change: Parallel shift of budget line (outward for increase, inward for decrease)
- Price Change: Pivot of budget line (steeper for price increase, flatter for price decrease)
2.3 Optimal Choice of the Consumer
The consumer's optimal bundle is where the budget line is tangent to an indifference curve.
This means the rate at which the consumer is willing to substitute equals the rate at which the market allows substitution.
2.4 Demand
2.4.1 Demand Curve and the Law of Demand
Law of Demand: There is an inverse relationship between price and quantity demanded, other things remaining constant.
2.4.2 Deriving Demand Curve
By changing price and observing new optimal points, we trace out the demand curve.
2.4.3 Normal and Inferior Goods
- Normal Goods: Demand increases with income
- Inferior Goods: Demand decreases with income
- Giffen Goods: A special case where demand increases with price (strong income effect)
2.4.4 Substitutes and Complements
- Substitutes: Goods that can replace each other (price of one affects demand for the other positively)
- Complements: Goods used together (price of one affects demand for the other negatively)
2.4.5 Shifts vs Movements along Demand Curve
- Movement along: Caused by price change of the good
- Shift: Caused by changes in other factors (income, prices of related goods, preferences)
2.5 Market Demand
Market demand is the horizontal summation of individual demand curves.
2.6 Elasticity of Demand
2.6.1 Elasticity along a Linear Demand Curve
Elasticity varies along a straight-line demand curve:
- Elastic (|eD| > 1) in upper portion
- Unit elastic (|eD| = 1) at midpoint
- Inelastic (|eD| < 1) in lower portion
2.6.2 Factors Determining Elasticity
- Nature of good (necessities tend to be inelastic, luxuries elastic)
- Availability of substitutes (more substitutes → more elastic)
- Time period (longer time → more elastic)
2.6.3 Elasticity and Expenditure
| Elasticity |
Price Increase |
Price Decrease |
| Elastic (|eD| > 1) |
Expenditure decreases |
Expenditure increases |
| Unit Elastic (|eD| = 1) |
Expenditure unchanged |
Expenditure unchanged |
| Inelastic (|eD| < 1) |
Expenditure increases |
Expenditure decreases |
Key Terms
- Utility
- Total Utility
- Marginal Utility
- Law of Diminishing MU
- Indifference Curve
- Marginal Rate of Substitution
- Budget Set
- Budget Line
- Consumer's Optimum
- Demand Curve
- Law of Demand
- Normal Goods
- Inferior Goods
- Substitutes
- Complements
- Price Elasticity of Demand
- Market Demand
Chapter Summary
- Consumers aim to maximize utility given budget constraints
- Cardinal utility measures satisfaction numerically; ordinal utility ranks preferences
- Indifference curves show equal satisfaction combinations with diminishing MRS
- Budget line shows affordable combinations based on prices and income
- Optimal consumption occurs where budget line is tangent to highest indifference curve
- Demand curves slope downward due to substitution and income effects
- Elasticity measures responsiveness of quantity demanded to price changes
- Market demand is the sum of individual demands
Review Questions
- What do you mean by the budget set of a consumer?
- What is budget line?
- Explain why the budget line is downward sloping.
- A consumer wants to consume two goods. The prices of the two goods are Rs 4 and Rs 5 respectively. The consumer's income is Rs 20.
- Write down the equation of the budget line.
- How much of good 1 can the consumer consume if she spends her entire income on that good?
- How much of good 2 can she consume if she spends her entire income on that good?
- What is the slope of the budget line?
- How does the budget line change if the consumer's income increases to Rs 40 but the prices remain unchanged?
- How does the budget line change if the price of good 2 decreases by a rupee but the price of good 1 and the consumer's income remain unchanged?
- What happens to the budget set if both the prices as well as the income double?
- Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2 if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8 respectively. How much is the consumer's income?
- Suppose a consumer wants to consume two goods which are available only in integer units. The two goods are equally priced at Rs 10 and the consumer's income is Rs 40.
- Write down all the bundles that are available to the consumer.
- Among the bundles that are available to the consumer, identify those which cost her exactly Rs 40.
- What do you mean by 'monotonic preferences'?
- If a consumer has monotonic preferences, can she be indifferent between the bundles (10, 8) and (8, 6)?
- Suppose a consumer's preferences are monotonic. What can you say about her preference ranking over the bundles (10, 10), (10, 9) and (9, 9)?
- Suppose your friend is indifferent to the bundles (5, 6) and (6, 6). Are the preferences of your friend monotonic?