ANALYSIS OF CONSUMER
DEMAND
The Concept of Utility
The concept of utility can be looked upon from two angles—from
the product angle and from the consumer’s angle.
From the product angle, utility is the want-satisfying property of
a commodity.
There is a subtle difference between the two concepts of utility.
From the ‘product angle’, the want-satisfying property of a
commodity is ‘absolute’ in the sense that this property is
ingrained in the commodity irrespective of whether one needs it
or not.
Another important attribute of the ‘absolute’ concept of utility
is that it is ‘ethically neutral’ because a commodity may satisfy a
Features of Utility
UTILITY IS SUBJECTIVE: It is subjective because
it deals with the mental satisfaction of a man.
UTILITY IS RELATIVE: Utility of a commodity
never remains the same. E.g. Cooler has utility in
the summer but not during winter.
UTILITY IS NOT ESSENTIALLY USEFUL:A
commodity having utility need not be useful.
Liquor and cigarette are not useful, but to satisfy
the want of an addict then they gave utility for
him.
UTILITY IS INDEPENDENT OF MORALITY:
Utility has nothing to do with morality.
Cardinal and Ordinal Approaches of Utility
The neo-classical economists (primarliy Marshal) propounded
the theory of consumption (consumer behavior theory) on the
assumption that utility is cardinal. For measuring utility, a term
‘util’ is coined which means units of utility.
Modern economists (primarily Hicks) rejected the cardinal utility
approach and introduced the concept of ordinal utility for the
analysis of consumer behavior.
According to them, it may not be possible to measure exact
utility, but it can be expressed in terms of less or more useful
good. For instance, a consumer consumes coconut oil and
mustard oil. In such a case, the consumer cannot say that
coconut oil gives 10 utils and mustard oil gives 20 utils.
Instead he/she can say that mustard oil gives more utility to
him/her than coconut oil. In such a case, mustard oil would be
given rank 1 and coconut oil would be given rank 2 by the
consumer. This assumption lays the foundation for the ordinal
Concepts of Utility
INTIAL UTILITY: The utility derived from the first unit
of a commodity is called initial utility. It is always
positive.
TOTAL UTILITY: It is the sum total of utility derived
from the consumption of all units of a commodity.
MARGINAL UTILITY: Marginal means change. It
refers to the additional utility obtained due to the
consumption of an additional unit of a commodity.
Marginal utility can be (i) positive (ii) zero (iii)
negative.
RELATION BETWEEN TOTAL UTILITY AND MARGINAL UTILITY
LAW OF DIMINISHING MARGINAL UTILITY: It
stated that as the consumer goes on consuming more
and more amount of commodity the marginal utility of
the commodity goes on declining becomes zero and
finally becomes negative.
Total utility is increasing at increasing rate so long as
marginal utility is positive.
Total utility becomes maximum when marginal utility
is zero.
Total utility starts declining when marginal utility is
negative.
EXAMPLE
UNTIS TOTAL MARGINAL
UTILITY UTILITY
1 8 8
2 14 6
3 18 4
4 20 2
5 20 0
6 18 -2
TU is maximum
Y
Saturation point
TU
0
X
Y
MU
MU +v
e
MU =
0
0 X
MU
(–)ve
Indifference Curve Analysis
Ordinal Utility Analysis:
The concept of Cardinal Utility was used by Marshal to define
Consumer's Equlibrium. Cardinal Utility means consumer could
measure the satisfaction derived by the consumption of any goods or
services in terms of number and unit of that measurment is Utils or
the Money. Where as Ordinal Utility means giving the rank to the
utility dervied by the consimption of goods and services. This Concept
was given by J.R. Hicks. This is more realstic and better than cardinal
utility. This is totally based onIntrospection.
• Indifference analysis is an alternative way of explaining consumer
choice that does not require an explicit discussion of utility.
• Indifferent: the consumer has no preference among the choices.
• Indifference curve: a curve showing all the combinations of two
goods (or classes of goods) that the consumer is indifferent among.
Assumptions
Completeness: Clearly able to rank different
product
Consistency: If a consumer prefer A to B in one
period then he will not prefer B to A in another
period.
Transitivity: If a consumer prefer A to B and B to
C, then he must prefer A to C.
Diminishing marginal rate of substitution: It is
assumed that as more and more units of X are
substituted for Y, the consumer will be willing to
give up fewer and fewer units of Y for each
additional unit of X,
Indeference curve
Indifference Map
Higher Indifference curve gives higher satisfaction or higher
utility whereas lower Indifference curve gives lower satisfaction
or lower utility.
The Marginal Rate of Substitution (MRS)
An indifference curve is formed by substituting one good for
another. The rate at which one good is substituted for another is
called Marginal Rate of Substitution (MRS).
The MRS refers to the rate at which one commodity can be
substituted for another, the level of satisfaction remaining the
same.
The MRS between two commodities X and Y, may be defined as
the quantity of Y required to replace one unit of X at different
combinations of the two goods so that the total utility remains
the same.
MRS is a Diminishing Rate:
• The basic postulate of ordinal utility theory is that if a
consumer goes on substituting one good for another, the
MRSy, x (or MRSx, y) goes on decreasing.
•It means that the quantity of a commodity that a
consumer is willing to sacrifice for an additional unit of
another commodity goes on decreasing when he goes on
substituting one commodity for another.
Why Does MRS Decrease?
• First, the want for a particular good is satiable so that as the
consumer has more and more of a good the intensity of his
want for that good goes on declining.
•The MRS decreases along the IC curve because, in most
cases, no two goods are perfect substitutes for one another.
• In case any two goods are perfect substitutes, the
indifference curve will be a straight line with a negative slope
showing constant MRS.
Properties of Indifference Curve
Indifference curves have the following four basic properties:
1. Indifference curves slope downward from left to right and have
a negative slope: Indifference curve being downward sloping
means that when the amount of one good in the combination is
increased, the amount of the other good is reduced. This must
be so if the level of satisfaction is to remain the same on an
indifference curve.
2. Indifference curves of imperfect substitutes are convex to the
origin;
3. Indifference curves do not intersect nor are they tangent to one
another;
Indifference Curves of Perfect Substitutes and Perfect
Complements
• The degree of convexity of an indifference curve depends upon the
rate of fall in the marginal rate of substitution of X for Y.
• When two goods are perfect substitutes of each other, the
indifference curve is a straight line on which marginal rate of
substitution remains constant.
• At the extreme, when two goods cannot at all be substituted for
each other, that is, when the two goods are perfect complementary
goods.
BUDGETARY CONSTRAINTS ON CONSUMER’S CHOICE: LIMITED
INCOME AND PRICES
The indifference map, a utility maximizing consumer would
like to reach the highest possible indifference curve on his
indifference map. But the consumer has two strong constraints:
(i) he has a limited income,
(ii) goods have a price and he has to pay the price for the goods.
Given the prices, the limitedness of income works as a
constraint on how high a consumer can reach on his
indifference map. This is known as budgetary constraint. In a
two-commodity model, the budgetary constraint may be
expressed through a budget equation as
CONSUMER’S EQUILIBRIUM: ORDINAL UTILITY
APPROACH
The basic theme of the theory of consumer demand, i.e., how
consumer determines the quantities of two goods to maximise
his total utility. In other words, the basic issue is how
consumer’s equilibrium is determined. A consumer attains his
equilibrium when he maximizes his total utility, given his
income and market prices of the goods and services that he
consumes. The ordinal utility approach specifies two conditions
for the consumer’s equilibrium:
(i) Necessary condition, known also as the first order condition,
and
(ii) Supplementary condition, known also as the second order
Thus budget line shows all those combinations of two goods which
the consumer can buy by spending his given money income on the
two goods at their given prices.
CONSUMER’S EQUILIBRIUM : MAXIMISING SATISFACTION
A consumer is said to be in equilibrium when he is buying such a combination of goods
as leaves him with no tendency to rearrange his purchases of goods. He is then in a
position of balance in regard to the allocation of his money expenditure among various
goods.
Condition for Consumer Equillibrium:
Budget line must be tangent to indifference curve = MRSxy = Px /Py
= MUx/MUy
CONSUMER NOT IN EQUILIBRIUM
• In cases of MUx increases or Px decreases or MUy decreases,
Py increases
MUx /Px > MUy /Py
It implies that satisfaction of the consumer derives from spending a
rupee on good X is greater than the satisfaction derived from
spending a rupee on Good Y. This the consumer will reallocate his
income by substituting Good X for Good Y.
• In cases of MUx decreasesor Px increases or MUy increases,
Py decreases
MUx /Px < MUy /Py
• It implies that satisfaction of the consumer derives from spending a
rupee on good Y is greater than the satisfaction derived from
Income Effect on Normal Goods
The change in consumption basket due to change in income is called
income effect. The income effect on consumption depends on
the nature of the goods—whether goods are normal or inferior.
‘Normal goods’ are the goods whose consumption changes in
the direction of change in income. That is, a normal good is one
whose consumption increases with increase in income and vice
versa.
The income-consumption curve may
be defined as the locus of points
representing various equilibrium
quantities of two commodities
consumed by a consumer at different
levels of income, all other factors
remaining constant.
Income Effect on Normal
Goods
Income-Effect on Inferior Goods
By definition, an inferior good is one whose consumption
decreases when income increases and vice versa. Panels (a) and
(b) of Figure present the case of inferior goods and the
negative income effect on their consumption.
In panel (a) of Figure, X is assumed to be an inferior good
and Y as a normal good. As shown in panel (a), the consumption
of inferior good X decreases when consumer’s income increases
as indicated by the leftward trend in the ICC curve.
Similarly, in panel (b) of Figure, Y is considered to be an
inferior commodity and X as normal good. Therefore,
consumption of Y decreases with increase in income. It means
that income effect on the consumption of inferior goods is
Income-Consumption Curve of Inferior
Goods
PRICE EFFECT: PRICE CONSUMPTION CURVE
Price consumption curve traces out the price effect. It shows how the changes in
price of good X will affect the consumer’s purchases of X, price of Y, his tastes
and money income remaining unaltered.
Effects of Change in Prices on
Consumption
The effects of change in price on consumer behaviour,
income remaining constant.
When price of a commodity changes, the slope of the
budget line changes, which changes the consumption basket
of goods and consumer’s equilibrium.
When price of goods changes, a rational consumer adjusts
his consumption basket with a view to maximizing his
satisfaction under the new price conditions. This change in
consumption basket is called price-effect.
Price-effect may be defined as the change in the quantity
consumed of a commodity due to change in its price.
What do you mean by marginal rate of substitution(MRS) ? Find out MRS YX from the
following information.
Combination Units of X Units of Y
A 30 1
B 26 2
C 23 3
D 21 4
E 20 5
(b) Bhubaneswar Dairy has observed that a 10% reduction in price has lead to 25%
increase in demand. Should the company be advised to reduce price(analyse based on its
revenue changes).
The Marginal Rate of Substitution (MRS) is the rate at which a
consumer is willing to substitute one good for another while keeping
their overall level of utility constant. It is calculated as the change in the
quantity of one good divided by the change in the quantity of the other
good, which represents the trade-off between the two goods.
A consumer has Rs.160 to spend on two goods X and Y. Given the price of good X at
Px= Rs.40 and price of good Y at Py= Rs.40.
[2]
(i) Draw a budget line and write the budget equation for the consumer.
(ii) Can the consumer buy (4, 1) and (3, 2) bundles of the two goods? Why?
The following Table shows Thomas Utility from consuming two different food- salad
and pastry. The price of a bowl of salad is Rs 3 and a price of a pastry is Rs 2.Fill up the
Table. QUANTITY TU MU MU/UNIT TU MU MU/UNIT
1 15 20
2 10 10
3 9 6
4 6 5
5 5 4
6 3.3 1
ii) If Thomas has Rs 10 to spend on salad and pastry, how many units of each good should he
purchase?
Thomas pocket money has increased from Rs 10 to Rs 18. If he spends only on these two goods,
what is optimal consumption bundle?
Find MRSXY.
X 4 6 8 10 12
Y 25 20 16 13 11
i) A person’s budget line in relation to good A and good B has intercept of
80 units of good A and 30 units of good B.If price of good A is 15,Find
out the income of that person, price of good B and slope of the budget
line.
i) A consumer consumes only two goods x and y. Her utility function
is U(x,y)=xy2, her income is₹9, and the prices of x and y are ₹2 and ₹3,
respectively. How many x and y will she consume?
b)What happens to the budget line if both the prices as well as the income
double? Draw the conclusion by giving a numerical example.
The utility function is given as U = xy, subject to the budget constraint 100
= 4x + 5y. Determine the utility maximization condition.
Q2(a) JMC, a company dealing in audio systems has been selling 500 audio systems per
month on average at a price of Rs 1000. Its main competitors, Kilachand Sounds, plans to
reduce price of its audio system from 1050 to 900. JMC has come to know of this move
and wants to know the impact of this change on its own sales. If the calculated cross
elasticity of demand between the two product is 0.7, calculate the impact on JMC based
on its revenue changes.
Indicate what happens to Total revenue (increase, decrease or remain constant) in the
following given table.
Price Quantity Price elasticity of Total
demanded demand Revenue
Increase Decrease More than one
Decrease Increase Less than one
Decrease Increase More than one
Increase Decrease one
Given Information:
•JMC, an audio systems company, sells 500 audio systems per month
at Rs. 1000.
•Kilachand Sounds, JMC's competitor, plans to reduce the price of its
audio system from Rs. 1050 to Rs. 900.
•The calculated cross-price elasticity of demand between the two
products is 0.7.
THANK YOU
