Consumer Behaviour

Utility

The theory of consumer behaviour aims to explain how a rational consumer allocates their limited income to purchase different goods and services to maximise their satisfaction. The foundation of this theory lies in the concept of utility.

Utility is the want-satisfying power of a commodity. It is the subjective satisfaction that a consumer derives from consuming a good or service. It's important to note that utility is a subjective concept; the utility derived from a cup of coffee may be very high for one person and zero for another.

There are two main approaches to analysing utility and consumer behaviour: Cardinal Utility Analysis and Ordinal Utility Analysis.

Cardinal Utility Analysis

Propounded by neoclassical economists like Alfred Marshall, this approach assumes that utility can be measured in cardinal numbers (like 1, 2, 3, etc.). The hypothetical unit of measurement for utility is called a 'util'.

Total Utility and Marginal Utility

• Total Utility (TU): It is the total satisfaction derived from consuming all the units of a commodity.
• Marginal Utility (MU): It is the additional utility derived from the consumption of one more unit of a commodity.

  $ MU_{\text{n}} = TU_{\text{n}} - TU_{\text{n-1}} $

  Alternatively, $ MU = \frac{\Delta TU}{\Delta Q} $, where $ \Delta TU $ is the change in total utility and $ \Delta Q $ is the change in quantity consumed (usually 1 unit).

Derivation Of Demand Curve In The Case Of A Single Commodity (Law Of Diminishing Marginal Utility)

The Law of Diminishing Marginal Utility (DMU) states that as a consumer consumes more and more units of a commodity, the marginal utility derived from each successive unit goes on diminishing. This is a fundamental law of consumption.

Derivation of Demand Curve: A rational consumer will purchase a commodity up to the point where the marginal utility they derive from the last unit is equal to the price they have to pay for it. Assuming the marginal utility of money ($MU_m$) is constant and equal to 1, the consumer's equilibrium condition is:

$ MU_x = P_x $

From the table above, if the price of X ($P_x$) is ₹4, the consumer will buy 4 units because at the 4th unit, $MU_x=4$. If the price falls to ₹2, the consumer will now buy 5 units to equate the new, lower price with the lower marginal utility. Thus, as price falls, quantity demanded rises. The MU curve, which shows the relationship between quantity and the marginal utility (which the consumer equates with price), effectively becomes the individual's demand curve.

Ordinal Utility Analysis

Modern economists like J.R. Hicks and R.G.D. Allen criticised the cardinal approach, arguing that utility is a psychological phenomenon and cannot be measured quantitatively. They proposed the ordinal utility analysis, which states that a consumer can only rank their preferences for different combinations of goods (e.g., they can say they prefer bundle A over bundle B, but not by 'how much'). This approach uses the tool of Indifference Curves.

Indifference Curve

An Indifference Curve (IC) is a curve that represents all the combinations of two goods that provide the same level of satisfaction to the consumer. Since all points on the curve yield the same utility, the consumer is 'indifferent' between any of these combinations.

Shape Of An Indifference Curve

An indifference curve is typically downward sloping and convex to the origin. This shape is due to the Marginal Rate of Substitution (MRS). The MRS is the rate at which a consumer is willing to sacrifice some amount of one good (say, Good Y) to obtain one more unit of another good (Good X), while maintaining the same level of utility.

$ MRS_{xy} = |\frac{\Delta Y}{\Delta X}| $

The MRS is diminishing because as the consumer has more of Good X, its marginal utility falls. As they have less of Good Y, its marginal utility rises. Therefore, they are willing to give up less and less of Good Y to get each additional unit of Good X. This Diminishing Marginal Rate of Substitution gives the IC its convex shape.

Indifference Map

An Indifference Map is a set or family of indifference curves, each representing a different level of satisfaction. A higher indifference curve represents a higher level of satisfaction because it involves combinations with more of at least one good.

Features Of Indifference Curve

1. Indifference curves slope downwards to the right: This is because to consume more of one good, the consumer must consume less of the other to keep the satisfaction level constant.
2. Higher indifference curves represent higher levels of satisfaction: This follows from the assumption of 'more is better'.
3. Indifference curves are convex to the origin: This is due to the diminishing marginal rate of substitution.
4. Indifference curves can never intersect each other: If they did, it would violate the assumption of transitivity and consistency in preferences. A single point cannot represent two different levels of satisfaction.

The Consumer’s Budget

A consumer's choice is not just based on their preferences (shown by indifference curves) but also on what they can afford. This is determined by their income and the prices of the goods.

Budget Set And Budget Line

A Budget Set is the collection of all possible combinations (bundles) of two goods that a consumer can afford to buy with their given income and the prevailing market prices.

The Budget Constraint can be expressed as: $ P_x X + P_y Y \le M $

where $P_x$ and $P_y$ are the prices of Good X and Good Y, and M is the consumer's income.

The Budget Line represents all the bundles that the consumer can purchase by spending their entire income. Its equation is:

$ P_x X + P_y Y = M $

Price Ratio And The Slope Of The Budget Line

The slope of the budget line measures the rate at which a consumer can substitute one good for another in the market.

Derivation of Slope:

Start with the budget line equation: $ P_x X + P_y Y = M $

Rearrange to express Y in terms of X: $ P_y Y = M - P_x X $

$ Y = \frac{M}{P_y} - \frac{P_x}{P_y} X $

This is in the form of a straight line equation $y = c + mx$. The slope of the line is the coefficient of X.

Slope of Budget Line = $ -\frac{P_x}{P_y} $

The slope is the negative of the price ratio. It tells us how many units of Good Y must be given up to get one more unit of Good X in the market.

Changes In The Budget Set

• Change in Income: If income (M) increases, the budget line shifts outwards, parallel to the original line. If income decreases, it shifts inwards.
• Change in Price: If the price of Good X ($P_x$) falls, the budget line pivots outwards from the Y-intercept. If $P_x$ rises, it pivots inwards. The Y-intercept remains unchanged. A similar pivot occurs from the X-intercept for a change in the price of Good Y.

Optimal Choice Of The Consumer

The consumer's optimal choice, or consumer's equilibrium, is the point where they achieve the maximum possible satisfaction, given their budget constraint. This occurs at the point where the budget line is tangent to the highest attainable indifference curve.

Equality Of The Marginal Rate Of Substitution And The Ratio Of The Prices

At the point of tangency, the slope of the indifference curve is equal to the slope of the budget line.

Slope of Indifference Curve = $ MRS_{xy} $

Slope of Budget Line = $ \frac{P_x}{P_y} $ (ignoring the negative sign)

Therefore, the condition for consumer's equilibrium is:

$ MRS_{xy} = \frac{P_x}{P_y} $

Since we also know that $ MRS_{xy} = \frac{MU_x}{MU_y} $, the condition can be rewritten as:

$ \frac{MU_x}{MU_y} = \frac{P_x}{P_y} \implies \frac{MU_x}{P_x} = \frac{MU_y}{P_y} $

This means the consumer is in equilibrium when the ratio of marginal utilities to prices is equal for all goods consumed. This is the Law of Equi-Marginal Utility.

Demand

Demand for a commodity is the quantity of that commodity that a consumer is willing and able to purchase at a given price, during a given period of time.

Demand Curve And The Law Of Demand

A demand curve is a graphical representation of the relationship between the price of a good and the quantity demanded. The Law of Demand states that, other things being equal (ceteris paribus), the quantity demanded of a good increases when its price falls, and decreases when its price rises. This inverse relationship is why the demand curve slopes downwards.

Deriving A Demand Curve From Indifference Curves And Budget Constraints

We can derive the demand curve by examining how the consumer's optimal choice changes as the price of a good changes. By plotting the price of Good X and the corresponding equilibrium quantity demanded, we trace out the demand curve.

Normal And Inferior Goods

• Normal Goods: Goods for which the demand increases as consumer income rises. The demand curve for a normal good shifts to the right when income increases.
• Inferior Goods: Goods for which the demand decreases as consumer income rises. Consumers switch to better quality substitutes as they become richer. Example: coarse grains like jowar. The demand curve shifts to the left when income increases.

Substitutes And Complements

• Substitute Goods: Goods that can be used in place of each other, like tea and coffee. An increase in the price of a substitute good leads to an increase (rightward shift) in the demand for the other good.
- Complementary Goods: Goods that are consumed together, like cars and petrol. An increase in the price of a complementary good leads to a decrease (leftward shift) in the demand for the other good.

Shifts In The Demand Curve

A shift in the demand curve occurs when there is a change in any factor affecting demand other than the good's own price. These factors include:

• Change in consumer's income.
• Change in the price of related goods (substitutes or complements).
• Change in consumer's tastes and preferences.

An increase in demand is shown by a rightward shift, and a decrease in demand is shown by a leftward shift.

Movements Along The Demand Curve And Shifts In The Demand Curve

It is crucial to distinguish between these two concepts:

• A movement along the demand curve (also called a change in quantity demanded) is caused by a change in the good's own price. An upward movement is a 'contraction' of demand, and a downward movement is an 'expansion' of demand.
• A shift in the demand curve (also called a change in demand) is caused by a change in any other determinant of demand (income, tastes, etc.).

Market Demand

Market demand for a good at a particular price is the sum of the quantities demanded by all individual consumers at that price. The market demand curve is derived by the horizontal summation of individual demand curves.

Adding Up Two Linear Demand Curves

To find the market demand, we add the quantities demanded by each individual at every possible price.

Answer:

Elasticity Of Demand

The Price Elasticity of Demand ($e_d$) measures the degree of responsiveness of the quantity demanded of a good to a change in its price. It is the percentage change in quantity demanded divided by the percentage change in price.

Formula:

$ e_d = (-) \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}} = (-) \frac{\frac{\Delta Q}{Q} \times 100}{\frac{\Delta P}{P} \times 100} = (-) \frac{\Delta Q}{\Delta P} \cdot \frac{P}{Q} $

The negative sign is often added to make the coefficient a positive number, as price and quantity demanded are inversely related.

Elasticity Along A Linear Demand Curve

Along a straight-line demand curve, the slope ($ \Delta Q / \Delta P $) is constant, but the elasticity is not. Elasticity changes at every point. It is high at high prices and low at low prices.

Geometric Measure Of Elasticity Along A Linear Demand Curve

At any point on a linear demand curve, elasticity can be measured as:

$ e_d = \frac{\text{Lower segment of the demand curve}}{\text{Upper segment of the demand curve}} $

This shows that at the mid-point, $e_d=1$. Above the mid-point, $e_d>1$. Below the mid-point, $e_d<1$.

Factors Determining Price Elasticity Of Demand For A Good

• Nature of the good: Necessities (like salt, foodgrains) have inelastic demand, while luxuries (like sports cars) have elastic demand.
• Availability of close substitutes: Goods with many substitutes (like soft drinks) have highly elastic demand.
• Proportion of income spent: Goods that take up a small part of income (like a matchbox) have inelastic demand.
• Time period: Demand tends to be more elastic in the long run as consumers have more time to adjust their consumption patterns.

Elasticity And Expenditure

The relationship between a price change and the total expenditure (TE = P x Q) on a good depends on its elasticity.

Summary

The theory of consumer behaviour explains how a consumer makes choices to maximise satisfaction. It begins with the concept of utility, analysed through both cardinal (Law of DMU) and ordinal (Indifference Curves) approaches. The consumer's choices are constrained by their budget, represented by the budget line. The optimal choice is found where the budget line is tangent to the highest possible indifference curve, a point where the Marginal Rate of Substitution equals the price ratio ($MRS_{xy} = P_x/P_y$).

From this analysis, we derive the concept of demand and the Law of Demand, which states an inverse relationship between price and quantity demanded. The aggregation of individual demands gives us the market demand. Finally, the concept of price elasticity of demand measures the responsiveness of demand to price changes, which is a crucial concept for businesses and policymakers in understanding market behaviour.