Chapter 2. Theory of Consumer Behaviour

Consumer’s Equilibrium
• A consumer is one who buys goods and services for satisfaction of wants.
• Any combination of amount of two goods will be known as a consumption bundle.
• objective of a consumer is to get maximum satisfaction from spending his income on various goods and services, given prices.

Utility
• Utility of a commodity is its want-satisfying capacity.
• Utility is subjective. Different individuals can get different levels of utility from same unit of commodity.
• Utility that one individual gets from commodity can change with change in place and time.
• There are two types of utility measures: [i] Cardinal utility measures and [ii] Ordinal utility measures.

Cardinal Utility Analysis
• It assumes that level of utility can be expressed in numbers.
• Ordinal measurement of utility means that utility can only be ranked. It can not be expressed in terms of units.

Measures of Utility Total Utility [TU]: This is total satisfaction derived from consuming given amount of all units of commodity x.
• More of commodity x provides more satisfaction to consumer.
• TU depends on quantity of commodity consumed.
• Therefore, TUn refers to total utility derived from consuming n units of a commodity x. TU = ∑MU Or TU n = MU1 + MU2 + MU3 + .. + MUn

Marginal Utility [MU]:
This is change in total utility due to consumption of one additional unit of a commodity. MUn = TUn – TUn – 1

Law of Diminishing Marginal Utility
• It states that marginal utility from consuming each additional unit of a commodity declines as its consumption increases, while keeping consumption of other commodities constant.
• Law of Diminishing Marginal Utility is a psychological law arrived at by introspection and by empirical evidence.
• MU becomes zero at a level when TU remains constant.

Relation between TU and MU
• TU rises in proportion to increase in commodity consumption as long as MU is positive.
• When MU from each succeeding unit starts to decrease, TU grows/increases at a slower rate.
• When TU reaches its maximum value, MU becomes zero. At this moment, TU stops expanding, which is called point of Saturation. When consumption exceeds point of satisfaction, MU becomes negative, and TU begins to decline.

Marginal Rate of Substitution [MRS]
• MRS is simply rate at which consumer will substitute one product for another, so their total utility remains constant.
• Law of Diminishing MRS causes an indifference curve to be convex to origin.

Indifference Curve
• An indifference curve joins all points representing bundles which are considered indifferent by consumer.
• An indifference curve shows different combinations of two goods that yield same level of utility or satisfaction to consumer.

Features of Indifference Curve
• Indifference curve slopes downwards from left to right.
• Higher indifference curve gives greater level of utility.
(1) As long as MU of a commodity is positive, an individual will always prefer more of that commodity, as more of commodity will increase level of satisfaction.
• Two indifference curves never intersect each other: Two indifference curves intersecting each other will lead to conflicting results. consumer’s preferences over all bundles can be represented by a family of indifference curves It is known as an indifference map of consumer.

Monotonic Preferences
• preferences of consumer are called monotonic preferences. It is where one bundle has more of one good than other and not less of other good in between two bundles. This offers a high level of satisfaction.

Budget Set, Budget Line and Budget Constant:
• set of bundles available to consumer is known as budget set. budget set is thus collection of all bundles that consumer can buy with her income at prevailing market prices
• budget constraint is boundary of opportunity set of all possible combinations of consumption that someone can afford given prices of goods and individual’s income.

Equality of Marginal Rate of Substitution and Ratio of Prices:
• optimum bundle of consumer is located at point where budget line is tangent to one of indifference curves.
• If budget line is tangent to an indifference curve at a point, absolute value of slope of indifference curve [MRS] and that of budget line [price ratio] are same at that point.
• optimum point would be located on budget line. A point below budget line cannot be optimum.

Demand
• quantity of a commodity that a consumer is willing to buy and is able to afford, given prices of goods and income of consumer, is known as demand for that commodity.
• Law of Demand: Law of Demand states that other things being equal, there is a negative relationship between demand for a commodity and its price. In other words, when price of commodity increases, demand for it falls and when price of commodity decreases, demand for it rises, other factors remaining same.

Demand Curve
graphical representation of demand function is known as a demand curve.
• amount of a good that a consumer would optimally choose is likely to increase when price of good falls and it is likely to decrease with a rise in price of good.
• negative slope of demand curve can be explained in terms of two effects namely, substitution effect and income effect that come into play when price of a commodity changes.

Types of Goods
• quantity of a good that consumer demands can increase or decrease with rise in income depending on nature of good. For most goods, quantity that a consumer chooses, increases as consumer’s income increases and decreases as consumer’s income decreases. Such goods are known as ‘normal goods’.
• There are some goods demand for which moves in opposite direction of income of consumer. Such goods are known as inferior goods.
• A Giffen good is a low income, non-luxury product that defies standard economic and consumer demand theory. Demand for Giffen goods rises when price rises and falls when price falls.
• quantity of a good that consumer chooses can increase or decrease with rise in price of a related good depending on whether two goods are substitutes or complementary to each other. Goods which are consumed together are known as complementary goods. Examples of goods which complement each other include tea and sugar, shoes & socks, pen & ink.

Shifts in Demand Curve
• For normal goods, demand curve shifts rightward and for inferior goods, demand curve shifts leftward.
• If there is an increase in price of a substitute good, demand curve shifts rightward. On other hand, if there is an increase in price of a complementary good, demand curve shifts leftward.
• demand curve can shift due to a change in tastes and preferences of consumer. If consumer’s preferences change in favour of a good, demand curve for such a good shifts rightward. On other hand, demand curve shifts leftward due to an unfavourable change in preferences of consumer.

Market Demand
• market demand for a good at a particular price is total demand of all consumers taken together. market demand for a good can be derived from individual demand curves.

Elasticity of Demand
• Price elasticity of demand is defined as a percentage change in quantity demanded of a good to a percentage change in its price.
• Price elasticity of demand is a measure of responsiveness of demand for a good to changes in its price. Price elasticity of demand for a good is defined as percentage change in demand for good divided by percentage change in its price. Price elasticity of demand for a good. eD = Percentage change in demand for good Percentage change in price of good elasticity of demand at different points on a straight line demand curve can be derived by this method.
• Elasticity is zero at point where demand curve meets horizontal axis and it is infinity at point where demand curve meets vertical axis. At midpoint of demand curve, elasticity is one, at any point to left of midpoint, it is greater than 1 and at any point to right, it is less than 1.

Factors Determining Price Elasticity of Demand for a Good:
• price elasticity of demand for a good depends on nature of good and availability of close substitutes of good.
• If income level of consumers is high, elasticity of demand is less.
• demand for a good is likely to be elastic if close substitutes are easily available.
• On other hand, if close substitutes are not available easily, demand for a good is likely to be inelastic.
• price elasticity of demand is likely to be low for necessities and high luxuries.

Elasticity and Expenditure
• expenditure on a good is equal to demand for good times its price.
• price of a good and demand for good are inversely related to each other.
• expenditure on good would change in opposite direction as price change if and only if percentage change in quantity is greater than percentage change in price, i.e., if good is priceelastic.
• expenditure on good would change in same direction as price change if and only if percentage change in quantity is less than percentage change in price, i.e., if good is price inelastic.
• expenditure on good would remain unchanged if and only if percentage change in quantity is equal to percentage change in price, i.e., if good is unit-elastic.

Relationship between Total Expenditure and Price of Elasticity of Demand:
• Ed=1: When total spending [price X quantity] remains constant despite a rise or reduction in price of a good.
• Ed>1: When prices fall, total expenditure rises; when prices rise, total expenditure falls.
• Ed<1: When total expenditure falls as a result of a price decrease and total expenditure rises as a result of a price increase.