Unit I

THEORY OF UTILITY AND CONSUMER'S CHOICE

WHO IS A CONSUMER?
A consumer is an economic agent who uses goods and
services for the direct satisfaction of his/her wants.
Consumer can be individuals, households, institutions etc.
Consumer behavior refers to the way in which consumers
spend their income.
The consumer derives utility from his expenditure. The
consumer chooses his expenditures and maximizes his
utility with the given income and given prices of goods and
services.

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Theory of consumer
behaviour
How does a consumer decide how much of a commodity to
buy at a given price?
How does the consumer respond to change in price of the
commodity, given his income, and prices of the related
goods?
These questions takes us to the theory of consumer
behaviour.
The theory of consumer behaviour is based on the
assumption that a consumer is a utility maximizing entity.

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Concept of Utility
Concept was introduced by social thoughts by Bentham in
1789 and to economic thoughts by Jevons in 1871.
Utility is a measure of the satisfaction, happiness, or benefit
that results from the consumption of a good.
Utility is defined as the power of a commodity to satisfy a
human want.
Economic term referring to the added value or “usefulness”
of a product.

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Utility in Money
Util: An artificial construct used to measure utility.
Utility also measured in monetary terms by converting ‘util’
into money by using the following formula:
Utility in Money = Utility in Util/Utility of a rupee.
Utility of rupee can be assumed to be any number such as
1, 2, 3 ... . Let utility of a rupee is assumed to be 2 utils.
Then 10 utils = 10/2 = ₹ 5.

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Measurement of utility
Economists hold different views on whether utility is
measurable in absolute terms.
The classical and neo-classical economists held the view
that utility is cardinally or quantitatively measurable.
Modern economists, on the other hand, hold the view that
utility is not cardinally measurable.
It can be measured in ordinal terms.

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Cardinal & Ordinal
measurement
There are two views of utility:
◦ Cardinal Utility / Marshallian approach
◦ Cardinal utility is the belief that utility can be measured
in ‘utils’ and compared on a unit by unit basis.
◦ Ex - A utility measure of 200 is twice as big as a utility
measure of 100.
◦ Ordinal Utility / J.R. Hick approach
◦ Ordinal utility is where you rank bundles of goods, but
cannot say how much greater one bundle is to another.
◦ Ranking is the only thing that matters when dealing
with ordinal utility.

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 Consumer equilibrium
Equilibrium means a state of rest from where there is no tendency to
change.
Consumer’s equilibrium refers to a situation where the consumer has
achieved maximum possible satisfaction from the quantity of the
commodities purchased given his/her income and prices of the
commodities in the market.
There are two main approaches to study consumer’s equilibrium. They
are as follows:
1. Cardinal utility approach (or Marshall’s utility analysis)
2. Ordinal utility approach (or Indifference curve analysis)

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Laws of Cardinal utility
analysis
Cardinal utility analysis consists of two important laws:
1. Law of Diminishing Marginal Utility.
2. Law of Equi-Marginal Utility.

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Concepts of Total & Marginal utility
Total Utility: Total utility means the total satisfaction
obtained by the consumer from the consumption of all
units at a time.
TU = Sum total of MU
TUn = MU1 + MU2 + .....+ MU

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Marginal Utility
Marginal utility refers to the additional utility a person
receives from consuming an additional unit of a good.
It refers to the net addition made to the total utility by
consuming one more unit
In mathematical terms,
MU= Δ Total Utility/ Δ in units of consumption of a
commodity
or MU = TU n – TU n-1
◦ Note that Δ means change

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Law of Diminishing Marginal
Utility
The law of DMU is central to the cardinal utility analysis of the
consumer behaviour.
Concept developed by Alfred Marshall.
Psychologically, intensity of desire for a commodity tends to
decrease as more and more units (standard) are consumed at a
point of time.
Other things being equal, as the quantity consume increases the
MU of that commodity tends to diminish.
It means more we have of a thing, the less we want to have of it
because the utility of every additional unit appears to go on
diminishing.
The relationship between quantity consumed and utility derived
from each successive unit consumed is called the law of DMU.

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 Assumptions
1. Homogeneous – Various units are alike in all aspects
2. Continuity – Continuous consumption
3. Standard unit – Standard size of all units
4. No change in taste or habit of the consumer
5. Rationality – Behaviour of consumer is normal and
rational
6. Cardinal measurement – Utility is measurable in
numerical units

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Numerical example
Commodity Total Utility Marginal Utility
1 40 40
2 70 30
3 90 20
4 100 10
5 100 00
6 90 -10

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 Graphical illustration

TU/MU

Units consumed

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Relationship between TU & MU
Total utility follows marginal utility. TU = ΣMU
1. When the MU decreases, TU increases at decreasing rate.
2. When MU becomes zero, TU is maximum. It is a
saturation point.
3. When MU becomes negative, TU declines.
4. Decreasing MU implies that the TU increases at a
decreasing rate (MU is the rate of change of TU).

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 Importance of law of DMU

1. The law explains the Water - Diamond paradox.

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Law of equi-marginal utility

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Consumer’s equilibrium /
Utility maximization
Consumer's equilibrium refers ta a situation wherein a consumer
gets maximum satisfaction out of his given income and he has no
tendency to make any change in his existing expenditure.
The consumer is in equilibrium if he consumes up to the point
where the MU of the goods equals the market price of the good.
MUx = Px
Analyzing consumers equilibrium requires answering the
question how does a consumer allocate his money income
among the various goods and services he consumes to arrive at
his equilibrium?

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 Assumptions
1. Rationality
2. Limited money income
3. Maximization of satisfaction
4. Utility is cardinally measurable
5. Diminishing marginal utility
6. Constant marginal utility of money - It means that
importance of money remains unchanged. Marginal utility of
money is addition made to utility of the consumer as he
spends one more unit of the money income.

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 Consumer equilibrium: one
commodity case
Consumer’s equilibrium in case of a single commodity can
be explained on the basis of the law of diminishing marginal
utility.
How does a consumer decide as to how much to buy of a
good? It will depend upon:
1. The price s/he pays for each unit which is given and
2. The utility s/he gets
3. MU of money

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What is MU of Money?
It refers to worth of a rupee to a consumer.
What is worth of a rupee?
A consumer defines it in terms of utility that he derives from a
standard basket of goods that he can buy with a rupee.
Example: If a rupee can buy 100 gm of sugar, 500 gm of rice, and
if the TU from these goods is 4 utils to the consumer, then 4 is to
be taken as MU of money (MUM).
Thus, MUM becomes a measuring rod for a rupee worth of
satisfaction.

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At the time of purchasing a unit of a commodity, a
consumer compares the price of the given commodity with
its utility. The consumer will be at equilibrium when
marginal utility (in terms of money) equals the price paid
for the commodity say ‘x’ i.e. MUx = Px. (Note that marginal
utility in terms of money is obtained by dividing marginal
utility in utils by marginal utility of one rupee).
This is sometimes loosely called the ‘Marginal Utility = Price
(MUx=Px) principle. It refers to Marginal utility of X in terms
of money equals price of the good X.

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Marginal Utility of a Product / Marginal Utility of a Rupee =
Its Price
We can rewrite the above equation as:
Marginal Utility of a Product / Its Price = Marginal Utility of
a Rupee / MUM
The above equations shows consumer’s equilibrium.

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Example
Let MUM for the consumer = 2 utils (referring to the utility
he expects to receive when he spends ₹)
Let X be the commodity he intends to buy.
Let Px = ₹ 4 per unit
MU schedule of X is taken to be as follows:

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MU schedule of commodity X
Units of Commodity X MUx (utils)
1 20
2 18
3 16
4 8
5 0
6 -5

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Conversion of MUx into ₹ worth
Units of Commodity X MUx (utils) MU in terms of ₹
(money worth of MU
when 2 utils = ₹ 1)
1 20 20/2 = 10
2 18 9
3 16 8
4 8 4
5 0 0
6 -5 -2.5

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Consumer equilibrium: One
Commodity Case

The equilibrium price is given at OP. The consumer will buy OQ quantity of X in
order to maximize his utility. Total gain falls if more is purchased after
equilibrium.

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Two Commodities Case -
Law of equi-marginal utility
In real life, consumer purchases many goods with the help
of their income.
He has to decide how he should spend his limited income
on different goods so as to get maximum possible
satisfaction.

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We assume that a consumer consumes only two commodities X
and Y and their prices are Px and Py respectively.
MUx/Px = MUy/Py
This is called the law of equi-marginal utility. The law states that
a consumer will so allocate his expenditure so that the utility
gained from the last rupee spent on each commodity is equal.
MU from last rupee spent on X equals MU from last rupee spent
on of Y. In other words, a consumer buys each commodity up to
the point at which MU per rupee spent on it is the same as the
MU of a rupee spent on another good.

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MU schedule of consumer
Good X (Px=1) Good Y (Py=1)
Units of X MUx Units of Y MUy
1 80 (1) 1 60 (4)
2 72 (2) 2 58 (5)
3 64 (3) 3 56 (6)
4 56 (7) 4 54 (8)
5 48 (11) 5 52 (9)
6 40 (13) 6 50 (10)
7 24 7 48 (12)
8 8 8 40 (14)

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 Criticisms / Limitations of
marginal utility analysis
1. Cardinal measurement – Utility cannot measured numerically
2. Unrealistic assumptions – Difficult to satisfy the conditions of
homogeneity, continuity, rationality conditions
simultaneously
3. Inapplicability in case of indivisible goods (goods cannot be
broken into pieces for consumption) – Ex – T.V., Scooter,
House
4. Constant MU of money – MU of money never remains
constant
5. Law is based on observation – Scientific validity has not been
tested
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Consumers' equilibrium –
Indifference curve analysis
The IC analysis of consumer's equilibrium discards the
assumption of cardinal measurement of utility. Instead, it is
based on the concept of ordinal measurement of utility.
According to this concept, utility is only ranked as high or
low (more or less). It is never expressed in terms of units
like 10, 20, 30, etc.

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ASSUMPTIONS of IC analysis of
Consumer’s equilibrium
1. The consumer is rational. He always maximizes his
satisfaction.
2. Money income of the consumer is given and does not
change.
3. The consumer spends his income on such goods which
can be substituted for each other, like laptop/tablet
and desktop.
4. The consumer's preference (or scale of preference) for
the two goods is well defined. His intensity of desire for
a good would decrease when he has more of it.
(Diminishing Marginal Rate of Substitution)

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5. More of a good always gives more satisfaction to the
consumer. This is called ‘monotonic preference' for a
good.
6. Consumer is consistent in his choice. It means that if
good X is preferred over good Y in one time period,
then consumer will not prefer Y over X in another time
period.
7. Consumer’s choices are characterised by the property
of transitivity. If good X is preferred to good Y and good
Y is preferred to good Z, then good X is preferred to
good Z or X > Z.

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 Indifference Curve and
Indifference Set/schedule
Indifference curve shows different combinations of two
goods that yield the same level of utility or satisfaction to
the consumer.
Indifference Set/schedule: It is a tabular presentation of
various combinations of two goods that yield the same level
of satisfaction to the consumer.

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Different combinations of
Apples & Oranges
Combination No. of Apples No. of Oranges
A 1 10
B 2 7
C 3 5
D 4 4

• Each combination offers the same level of satisfaction to the

consumer.
• As there is no difference among combinations A, B, C and D, we may
say that the consumer is indifferent across these combinations.
Together, these combinations form an ‘Indifference Set’ of the
consumer.

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Indifference curve

Indifference Curve shows different combinations of two goods offering the

same level of satisfaction to the consumer.

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Indifference Map
A family of indifference curves is called an Indifference Map.
It gives a complete picture of a consumer’s scale of preference for two
goods.
An IC which is to the right and above another IC corresponds to higher
level of income and therefore; represents higher level of satisfaction.

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 Features of indifference
curves
1. IC Slopes Downward: IC slopes downward from left to
right. It means that IC has a negative slope. It implies
that if the quantity of one good is reduced then the
quantity of the other good is increased.
It is only then that the satisfaction level would remain
constant at different points of the IC.

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2. IC is Convex to the origin
An indifference curve is convex to the origin because of
diminishing marginal rate of substitution.
The slope of IC is called Marginal Rate of Substitution (MRS) of X
for Y, symbolically denoted as MRSxy. It is defined as the amount
of Y that a consumer is willing to substitute for an additional unit
of X.
The slope measures the substitution ratio between the two
goods.
The slope of IC tends to decline, as we move along the IC from
left to right. It implies indifference curve is convex to the origin.

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Combinations X Y MRSxy
A 1 12 -
B 2 8 1x:4y
C 3 5 1x:3y
D 4 3 1x:2y
E 5 2 1x:1y

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MRSxy

MRSxy must be diminishing as consumer moves along the curve to the

right. This is because as the consumer has more and more of X, its
subjective worth or marginal significance to him declines and that of
scarce commodity Y goes up.

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3. Higher IC shows Higher
Level of Satisfaction

Each lC in the indifference map corresponds to different Ievel of

consumer’s income. Higher IC corresponds to higher Ievel of income.

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4. ICs do not Cross or
intersect each other

Points A and B lie on the same indifference curve L1. So, the
consumer must be indifferent between them. By the same logic
consumer must be indifferent between points B and C lying on L2.

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5. ICs does not touch X-axis
or Y-axis
This is because IC analysis considers the consumption of
two goods simultaneously.
If IC touches Y-axis it would mean that the consumption of
Good-X is zero.
If IC touches X-axis it would mean that the consumption of
Good-Y is zero.

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Consumers Budget / Budget
Line / Income Line
A budget line is a line which shows all possible combinations of two
goods that a consumer can buy with his given income and prices of the
commodities.
Budget Set: It is the collection or set of all the possible bundles or
combinations of two goods that the consumer can buy with his income
and prevailing prices of the commodities.

Budget Constraint: The budget constraint shows that a consumer can

choose any bundle as long as it costs less or equal to the income
s/he has, given income and prices of goods.

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Budget Line

PX = Price of commodity X
X =Quantity of commodity X
PY = Price of commodity Y
Y =Quantity of commodity Y
M = Total income of consumer

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Slope of the budget line
Slope of the budget line measures the amount of change in
good Y required per unit change in good X along the budget
line.
In other words, to obtain 1 more units of Good X, how
many units of Good Y is to be sacrificed. Thus, the price of
Good X is expressed in terms of the sacrifice of Good Y for
obtaining every additional unit of Good X.
Slope of budget line is also called Marginal rate of exchange
(MRE).

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Shifts in Budget Line
A budget line is based on consumer’s income and prices of
the commodities.
Therefore, if any one of these determinants are changed
then budget line will definitely change.

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1. Change in income

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 2. Changes in the price of
commodities

Change in Price of Change in Price of Simultaneous Change in

Commodity X Commodity Y Price of Both
Commodities

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 Consumer’s Equilibrium
A consumer is in equilibrium when he maximises his utility, given
income and market prices.
In other words, equilibrium is attained when the consumer
reaches the highest possible indifference curve given his budget
constraint.
Two conditions that must be fulfilled by the consumer to be in
equilibrium by indifference curve approach are:
1. MRSxy= Px / Py
2. Diminishing MRS - It means, for a stable equilibrium, MRS must
be continuously falling. This condition means that the
indifference curve is strictly convex.

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At point E, the consumer’s budget line is tangent to the indifference curve I2. It
is the point of consumer’s equilibrium. At point E,
[Slope of indifference curve] = [slope of budget line]

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