Consumer Behaviour

The study of the economic behaviour of the individual consumer is a prequel to the study
of demand for goods and services in the product (commodities) market. This is utility theory
which goes back to first principles. The theories provide the foundation for the law of demand,
indicating how and why consumers respond in particular ways to the structure of incentives and
various other factors (prices, income, tastes) in the market. An understanding of consumer
behaviour and how consumers optimize within budget constraints is useful, particularly to sellers
in their quest for market advantage and greater competitiveness.

Consumer preferences and choice refer to the decisions individuals make when
selecting goods and services that best satisfy their needs and wants, based on their tastes, income,
and available options. Preferences reflect a consumer's ranking of different combinations of
products according to the satisfaction (or utility) they provide. These choices are influenced by
factors such as price, income levels, cultural and social norms, and personal habits. Economists
assume that consumers act rationally to maximize their satisfaction within their budget
constraints. Understanding consumer preferences is essential for businesses and policymakers, as
it helps in predicting demand, designing products, and setting appropriate pricing strategies.

Utility

Consumer theory has its genesis in the theory of utility maximization. The concept of
utility or satisfaction is central to the study of the consumer behaviour in the market. The utility
of a consumer is a measure of the satisfaction the consumer derives from consumption of
goods and services. Utility is want-satisfying power.

-“Utility” and “usefulness” are not synonymous. Paintings by Picasso may offer great utility to
art specialists but are useless functionally.

- Utility is subjective. The utility of a specific product may vary widely from person to person.
Eyeglasses have tremendous utility to someone who has poor eyesight but no utility to a person
with good vision.

- Utility is difficult to quantify. But for purposes of illustration we assume that people can
measure satisfaction with units called utils. A util is a unit of utility. For example, a particular
consumer may get 100 utils of satisfaction from an ice cream, 10 utils ofsatisfaction from a
candy bar. These imaginary units of satisfaction are convenient for quantifying consumer
behavior for explanatory purposes. (Mcconnell)

An individual’s utility depends on everything that individual consumes. The set of all the
goods and services an individual consumes is known as the individual’s consumption
bundle. The relationship between an individual’s consumption bundle and the total amount
of utility it generates for that individual is known as the utility function.(Krugman)

Cardinal Utility and Ordinal Utility

(Maddala)
The Law of Diminishing Marginal Utility

The basic idea behind the principle of diminishing marginal utility is that the
additional satisfaction a consumer gets from one more unit of a good or service declines as
the amount of that good or service consumed rises. That is, as the amount of good consumed
increases, the marginal utility of that good tends to decline Or, to put it slightly differently, the
more of a good or service you consume, the closer you are to being satiated—reaching a point at
which an additional unit of the good adds nothing to your satisfaction. According to Marshall,
“The additional benefit a person derives from a given increase of his stock of a thing diminishes
with every increase in the stock that he already has”. To understand this law further, important
distinction is must be made between total utility and marginal utility.
 TU is the sum of MUs

TUn= MU1+ MU2+………+MUn

Diminishing MU
Note the following points

a. MU curve slops downwards illustrating the law of diminishing MU

b. TU curve starts at the origin. Zero consumption yields zero utility
c. TU is rising, but at a diminishing rate. It shows decrease in MU
d. TU is maximum when MU is zero. This is the saturation point. From then on
additional consumption yields disutility
e. MU is the slope of TU curve.
Theories of Consumer Behaviour

In general, there are considered to be two major approaches to the theory of utility
maximization: The Cardinal theory and the Ordinal theory. A third approach, the Revealed
Preference theory, is usually viewed as an addition or upgrade to the Ordinal theory but may be
considered a theory in its own right. The Ordinal theory is buoyed by the Revealed Preference
theory.

As the study proceeds, it may be observed that all three approaches lead to the same
conclusion or testable hypothesis: that, normally, as the price of a good falls, the quantity
demanded increases. This becomes known as the Law of Demand

The Cardinal utility theory

The Cardinal utility theory is considered to be the oldest version of utility theory. Central
to the Cardinal theory is the concept of measurable utility. The assumption is that utility or
satisfaction is measurable on a cardinal scale (i.e. a scale with zero as the origin). It was believed
that this measurement could be done in money, or in the older vintages, in subjective units called
Utils. The concept of measurable utility is attributed mainly to the nineteenth-century
economists, including Gossen (1854), Jevons (1871) and Walras (1874). Another economist,
Marshall (1890), is often included with this group because of his assumption of additive and
independent utilities which would imply measurability of utility.
Assumptions of the Cardinal utility theory

The principal assumptions of the Cardinal theory may be set out as follows:

1. Rational behavior. This implies that the consumer aims at the maximization of utility given
income and prices.

2. Cardinal Utility. Utility is measured by the monetary units the consumer is willing to pay for
another unit of a commodity.

3. Constant marginal utility of money. This assumption is necessary if money is to be used as a

measuring rod. It means that a unit of money (e.g. one dollar) has the same utility to the holder
no matter how much money the holder possesses.

4. Diminishing marginal utility for a commodity.

5. Additivity. The total utility of a basket of goods depends on the quantities of the individual
commodities. For a basket comprising two goods x and y, the total utility (U) for the consumer is
the sum of the utilities gained from the two goods. This may be expressed as: U = Ux +Uy

Theories based on Cardinal Utility Approach

There are two important laws to explain consumer’s behavior based on the cardinal utility
approach. They are the following:

I. The Law of Diminishing Marginal Utility(Alfred Marshall) or Gossen's First Law

II. The Law of Equi-Marginal Utility or Gossen’s Second Law

I. The Law of Diminishing Marginal Utility

Maximisation of Utility- Consumer equilibrium (one commodity case)

Consider a single commodity (x), the price of which is given. The consumer seeks to maximize
the utility from consuming the commodity. The condition of equilibrium is,

MUx = Px

If MUx > Px, the consumer can increase welfare by purchasing more of x commodities
If MUx < Px, the consumer can increase his total satisfaction by cutting down his purchase of x
commodities

If MUx = Px, the consumer will be in equilibrium

Derivation of Demand Curve from MU curve (from law of diminishing marginal utility)
The law of equi-marginal utility (Consumer equilibrium in two-commodity case)

(law of substitution or the law of maximum satisfaction)

Law of diminishing marginal utility is applicable only to a single want with one
commodity in use. But, in reality there may be a number of wants to be satisfied at a time, and,
these various wants are to be satisfied with several goods. To analyse, such a situation, one has
to extend the law of diminishing marginal utility and such an extended form is called the law of
equi-marginal utility. Equi-marginal utility has been formulated by Marshall.

`The law of equi-marginal utility states that, other things being equal, a consumer
gets maximum total utility from spending his given income, when he allocates his
expenditure to the purchase of different goods in such a way that the marginal utilities
derived from the last unit of money spent on each item of expenditure tends to be equal . To
maximize satisfaction, the consumer should allocate his or her money income so that the last
dollar spent on each product yields the same amount of extra (marginal) utility. We call this the
utility-maximizing rule . When the consumer has “balanced his or her margins” using this rule,
he or she has achieved consumer equilibrium and has no incentive to alter his or her expenditure
pattern.

So long as the ratios of marginal utility of money are not equalised, the consumer will go
on redistributing his expenditure from one commodity to another, buying less of one, and more
of another, that is substituting one for the other, till these ratios become equal. In symbolic
terms, that proportionality rule may be stated as follows:
The law of equi-marginal utility may be explained with the help of an imaginary example which
is as follows: Let us assume that a consumer has a given income of Rs. 24. He wishes to spend
his entire income on three different goods a, b, and c. The prices of these goods are Rs.2 per unit
of ‘a’, Rs. 3 per unit of ‘b’ and Rs.5 per unit ‘c’.The consumer has a definite scale of preference
as revealed by the marginal utility schedule given below. Consumer is rational and seeks to
maximize his satisfaction.Now the question is how this consumer would spend his Rs.24 so that
he derives maximum satisfaction.

Computation of the ratios of the law of equi-marginal utility

Units Mua Mub Muc Mua/Pa Mub/Pb Muc/Pc

1 30 24 15 15 8 3
2 20 15 10 10 5 2
3 16 9 8 8 3 1.6
4 8 6 5 4 2 1
5 6 3 1 3 1 0.2
6 4 1 0 2 0.3 0

Consumer maximises his satisfaction when he purchases 5 units of commodity a, 3 units of

commodity b and 1 unit of commodity c.

Evidently, the consumer’s optimum allocation of expenditure:

Rs.10 on commodity ‘a’ thus purchasing 5 units (5 x2= 10)

Rs. 9 on commodity ‘b’ thus purchasing 3 units (3 x 3 = 9)

Rs. 5 on commodity ‘c’ thus purchasing 1 unit (5 x 1 = 5)

The operation of the law of equi-marginal utility can be explained with the help of a graph.
 In the diagram money expenditure of a given income is denoted on the ‘x’ axis and ‘y’
axis represents marginal utility. Mua, Mub, Muc are the marginal utility curves for the three
assumed goods, a, b, c respectively. It can be seen that these curves are drawn in such a way that
they show the relative order of preference of the given goods a, b, and c. In graphical terms, now
the consumer will allocate his given income in such a way that he will purchase OA goods of
unit ‘a’, OB units of good ’b’, OC units of good ‘c’. It is easy to see that by spending his income
the consumer equalizes the marginal utilities of each commodity purchased, thus maximizing his
total satisfaction.

Limitations of the law

1. In practice its difficult for the consumers to know the MU of different goods.
2. Its difficult to find goods which give consumers greater satisfaction and others which
give lesser satisfaction
3. When consumers acquire certain habits and customs, they ignore MU from other goods
which could be more
4. Goods are sometimes purchased out of impulse. Consumers may not always behave in a
rational way.
5. Commodities are not always divisible to the extent necessary for the equalization of marginal
utilities.

Importance of the law

1. It guides the consumers in spending their limited income judiciously.

2. The producer can have optimal combination of factors of production, when the last unit of
investment expenditure brings equal productivity to all the factors of production employed.

3. Modern states are welfare states and consider the maximization of social benefits in their
revenue and expenditure activities. The principle of ‘maximum social advantage’ involves the
law of substitution when it proposes that revenues must be distributed in such a way that the last
unit of expenditure brings equal welfare and satisfaction to all classes of people.
Paradox of Value

When a household has maximized its total utility, it has allocated its income in the way
that makes the marginal utility per dollar equal for all goods. That is, the marginal utility from a
good divided by the price of the good is equal for all goods. This equality of marginal utilities
per dollar holds true for diamonds and water: Diamonds have a high price and a high marginal
utility. Water has a low price and a low marginal utility. When the high marginal utility from
diamonds is divided by the high price of a diamond, the result is a number that equals the low
marginal utility from water divided by the low price of water. The marginal utility per dollar is
the same for diamonds and water.
 Value and Consumer Surplus

Another way to think about the paradox of value and illustrate how it is resolved uses
consumer surplus. Figure explains the paradox of value by using this idea. The supply of water in
part (a) is perfectly elastic at price PW, so the quantity of water consumed is QW and the large
green area shows the consumer surplus from water. The supply of diamonds in part (b) is
perfectly inelastic at the quantity QD, so the price of a diamond is PD and the small green area
shows the consumer surplus from diamonds. Water is cheap, but brings a large consumer
surplus; diamonds are expensive, but bring a small consumer surplus.
 Consumer Surplus

The benefit surplus received by a consumer or consumers in a market is called consumer

surplus. It is defined as the difference between the maximum price a consumer is (or consumers
are) willing to pay for a product and the actual price. In nearly all markets, consumers
individually and collectively gain greater total utility in money terms (total satisfaction) from
their purchases than the amount of their expenditures ( product price x quantity). This utility
surplus arises because all consumers pay the equilibrium price even though many would be
willing to pay more than that price to obtain the product.

Consider the figure, where the demand curve shows the buyers’ maximum willingness to
pay for each unit of the product and we assume that the equilibrium price, P1 , of oranges is $8
per bag. The portion of the demand curve D lying above the $8 equilibrium price shows that
many consumers of oranges would be willing to pay more than $8 per bag rather than go without
oranges.

See table, for example, where column 2 reveals that Bob is willing to pay a maximum of
$13 for a bag of oranges; Barb, $12; Bill, $11; Bart, $10; and Brent, $9. Betty, in contrast, is
willing to pay only the $8 equilibrium price. Because all six buyers listed obtain the oranges for
the $8 equilibrium price (column 3), five of them obtain a consumer surplus. Column 4 shows
that Bob receives a consumer surplus of $5 ( $13 $8); Barb, $4 ( $12 $8); Bill, $3 ( $11 $8); Bart,
$2 ( $10 $8); and Brent, $1 ( $9 $8). Only Betty receives no consumer surplus because her
maximum willingness to pay $8 matches the $8 equilibrium price.
 Obviously, most markets have more than six people. Suppose there are many other
consumers besides Bob, Barb, Bill, Bart, Brent, and Betty in the market represented by Figure
6.5. It is reasonable to assume that many of these additional people are willing to pay more than
$8 for a bag of oranges. By adding together the individual consumer surpluses obtained by our
named and unnamed buyers, we obtain the collective consumer surplus in this specific market.
To obtain the Q1 bags of oranges represented, consumers collectively are willing to pay the total
amount shown by the sum of the green triangle and tan rectangle under the demand curve and to
the left of Q1. But consumers need pay only the amount represented by the tan rectangle ( P1
Q1). So the green triangle is the consumer surplus in this market. It is the sum of the vertical
distances between the demand curve and the $8 equilibrium price at each quantity up to Q1.
Alternatively, it is the sum of the gaps between maximum willingness to pay and actual price,

Consumer surplus and price are inversely (negatively) related. Given the demand curve,
higher prices reduce consumer surplus; lower prices increase it. To test this generalization, draw
in an equilibrium price above $8 in Figure 6.5 and observe the reduced size of the triangle
representing consumer surplus. When price goes up, the gap narrows between the maximum
willingness to pay and the actual price. Next, draw in an equilibrium price below $8 and see that
consumer surplus increases. When price declines, the gap widens between maximum willingness
to pay and actual price.
 Applications of Consumer Surplus

1. This concept is useful in Public Finance for judging the relative merits of different types
of taxation. A tax raises the price and reduces consumer surplus. Agaisnt the
disadvantage can be set off the advantage accruing to the government in the form of
revenue. If the gain to the society is less than losss of consumer surplus, the tax is a bad
tax.
2. The concept is useful in determining monopoly prices. A monopolist can charge different
prices from different consumers according to the consumer surplus earned by them.

Limitations of Consumer Surplus

1. Consumer’s surplus cannot be measured precisely – because it is difficult to measure the price
each consumer will be ready to pay.
2. In the case of necessaries, the marginal utilities of the earlier units are infinitely large i.e.
consumer can pay a very high amount for such initial unit of necessary commodity. In such case
the consumer’s surplus is always infinite.
3. The consumer’s surplus derived from a commodity is affected by the availability of substitutes.
4. There is no simple rule for deriving the utility scale of articles which are used for their prestige
value (e.g., diamonds).
5. Consumer’s surplus cannot be measured in terms of money because the marginal utility of
money changes as purchases are made and the consumer’s stock of money diminishes. (Marshall
assumed that the marginal utility of money remains constant. But this assumption is unrealistic).
6. The concept can be accepted only if it is assumed that utility can be measured in terms of money
or otherwise. Many modern economists believe that this cannot be done.