INTERMEDIATE MICROECONOMICS
THE THEORY OF CONSUMER BEHAVIOUR
Introduction
To understand the theory of consumer behavior, it is essential to understand the concept of utility.
UTILITY
Definition
A utility is a number that represents the level of level of satisfaction that the consumer derives from a
particular market basket.
Marginal utility
Measures the additional satisfaction derived from an additional unit of a commodity (the consumption of
other commodities being held constant), the marginal utility of the commodity eventually will tend to
decline.
The rational consumer
The consumer is assumed to be rational. This assumption means that given his or her income and the
market prices of various commodities the consumer plans the spending of his/her income so as to attain
the highest possible satisfaction or utility. The consumer thus tries to maximize utility.
In this context it is assumed that the consumer has full knowledge of all the information relevant to
his/her decision. That is that the consumer has complete knowledge of all the available commodities,
their prices and his/her income.
In order to attain this objective of utility maximization, the consumer must be able to compare the
utility (satisfaction) of the various “basket of goods” which she/he can buy with his income.
There are two approaches to the problem of comparison of utilities.
1. The cardinalist approach
2. The ordinalist approach
THE CARDINAL UTILITY THEORY
The cardinalist school postulated that utility can be measured.
Various suggestions have been made for the measurement of utility. Some economists have suggested that
utility can be measured in monetary units by the amount of money the consumer is willing to sacrifice for
another unit of commodity. Others suggested the measurement of utility in units called utils.
Assumptions of The Cardinal Utility Theory
The objective of the consumer is to maximize utility or attain the highest possible satisfaction.
1. Rationality
The consumer is rational. He/she aims at the maximization of his/her utility subject to the
constraint imposed by his/her given income.
2. Utility is measurable
Utility of each commodity is measurable in a cardinal sense (in monetary units or in utils). The most
convenient measure is money. The utility is measured by the monetary units that the
consumer is prepared to pay for another unit of the commodity.
1
,3. Constant marginal utility of money
This assumption is necessary if the monetary unit is used as a measure of utility. The essential
feature of a standard unit of measurement is that it should be constant. If marginal utility of
money changes as income increases (or decreases), then it becomes inappropriate for
measurement.
4. Diminishing marginal utility
The utility gained from successive units of a commodity diminishes. In other words, the marginal
utility of a commodity diminishes as the consumer acquires larger quantities of it. This is the
axiom diminishing marginal utility.
5. The total utility
The total utility of a basket of goods depends on the quantities of individual commodities. If there
are n commodities in the bundle with quantities X1 , X2,--,X4, then the total utility.
U = f (X1, X2,----, X4)
EQUILIBRIUM OF THE CONSUMER
(THE EQUILIBRIUM MARKET BASKET),
UNDER CARDINAL UTILITY THEORY)
Consider a single commodity X. The consumer can either buy X or retain his money income Y.
If marginal utility of X (denoted by MUx) is greater than its price (Px), the consumer can increase
his welfare by purchasing more units of X.
Similarly, if the MU of X is less than its price, the consumer can increase his/her total satisfaction
by cutting down on the quantity of X and keeping more of his/her income in spent.
Therefore, the consumer attains the maximization of his utility when
MUx = Px
This is the equilibrium condition of the consumer.
If there are ‘n’ commodities, the equilibrium condition of the consumer is the equality of the ratios o
f the marginal utilities of the individual commodities to their prices.
MUx = MUy = ---- = MUn
PxPyPn
N.B
MUx is the marginal utility of the last “dollars” worth of commodity X
Px
Illustration
We consider a numerical example which shows the marginal utility the consumer derives from
various amounts of two commodities X and Y. We measure the commodities in terms of the
amount of money spent on them.
CONSUMER’S MARGINAL UTILITY FROM CONSUMING X AND Y
Dollars worth of each commodity
X Y
2
, 1st 9 4
2nd 7 3
3rd 4 2
4th 3 1
5th 2 0
Given the information above, how much of each commodity should the consumer buy if his/her mo
ney income is only $4?
MUTU
1st dollar - spent on X 9 9
2nd dollar - spent on x 7 16
3rd dollar - spent on X or Y 4 20
4th dollar - spent on Y or X 4 24
A rational consumer will allocate $3 of his/her income to (X) and $1 to (Y)
This is the equilibrium market basket, the market basket that maximizes consumer satisfaction. Note
that the marginal utility derived from the last dollar spent on X is equal to the marginal utility derived
from the last dollar spent on Y.
MUX = MUY
$1 $1
Thus this market basket has the expected characteristic that is the marginal utility of the last dollar
spent on all commodities purchased is the same
Critique Of The Cardinal Approach
Three basic weaknesses:
1. That utility is measurable. This assumption of cardinal utility is extremely doubtful.
i.e. the satisfaction derived from various commodities cannot be measured objectively.
2. The assumption of constant utility of money changes. Thus, money cannot be used
as a measuring rod since its own utility changes.
3. The axiom of diminishing marginal utility has been established from introspection, it
is a psychological law which must be taken for granted.
THE ORDINAL UTILITY THEORY
The ordinalist school postulated that utility is not measurable, but it is an ordinal magnitude. The
consumer need not know in specific units the utility of various commodities to make his choice. He can
rank the various baskets of goods according to the satisfaction that each bundle gives him. He must be
able to determine his order of preference among the different bundles of goods.
The main ordinal theories are the indifference – curve approach and the revealed preference hypothesis
The Indifference- Curves Theory
Assumptions
Rationality
The consumer is assumed to be rational. He aims at the maximization of his utility given his
income and market prices.
3
THE THEORY OF CONSUMER BEHAVIOUR
Introduction
To understand the theory of consumer behavior, it is essential to understand the concept of utility.
UTILITY
Definition
A utility is a number that represents the level of level of satisfaction that the consumer derives from a
particular market basket.
Marginal utility
Measures the additional satisfaction derived from an additional unit of a commodity (the consumption of
other commodities being held constant), the marginal utility of the commodity eventually will tend to
decline.
The rational consumer
The consumer is assumed to be rational. This assumption means that given his or her income and the
market prices of various commodities the consumer plans the spending of his/her income so as to attain
the highest possible satisfaction or utility. The consumer thus tries to maximize utility.
In this context it is assumed that the consumer has full knowledge of all the information relevant to
his/her decision. That is that the consumer has complete knowledge of all the available commodities,
their prices and his/her income.
In order to attain this objective of utility maximization, the consumer must be able to compare the
utility (satisfaction) of the various “basket of goods” which she/he can buy with his income.
There are two approaches to the problem of comparison of utilities.
1. The cardinalist approach
2. The ordinalist approach
THE CARDINAL UTILITY THEORY
The cardinalist school postulated that utility can be measured.
Various suggestions have been made for the measurement of utility. Some economists have suggested that
utility can be measured in monetary units by the amount of money the consumer is willing to sacrifice for
another unit of commodity. Others suggested the measurement of utility in units called utils.
Assumptions of The Cardinal Utility Theory
The objective of the consumer is to maximize utility or attain the highest possible satisfaction.
1. Rationality
The consumer is rational. He/she aims at the maximization of his/her utility subject to the
constraint imposed by his/her given income.
2. Utility is measurable
Utility of each commodity is measurable in a cardinal sense (in monetary units or in utils). The most
convenient measure is money. The utility is measured by the monetary units that the
consumer is prepared to pay for another unit of the commodity.
1
,3. Constant marginal utility of money
This assumption is necessary if the monetary unit is used as a measure of utility. The essential
feature of a standard unit of measurement is that it should be constant. If marginal utility of
money changes as income increases (or decreases), then it becomes inappropriate for
measurement.
4. Diminishing marginal utility
The utility gained from successive units of a commodity diminishes. In other words, the marginal
utility of a commodity diminishes as the consumer acquires larger quantities of it. This is the
axiom diminishing marginal utility.
5. The total utility
The total utility of a basket of goods depends on the quantities of individual commodities. If there
are n commodities in the bundle with quantities X1 , X2,--,X4, then the total utility.
U = f (X1, X2,----, X4)
EQUILIBRIUM OF THE CONSUMER
(THE EQUILIBRIUM MARKET BASKET),
UNDER CARDINAL UTILITY THEORY)
Consider a single commodity X. The consumer can either buy X or retain his money income Y.
If marginal utility of X (denoted by MUx) is greater than its price (Px), the consumer can increase
his welfare by purchasing more units of X.
Similarly, if the MU of X is less than its price, the consumer can increase his/her total satisfaction
by cutting down on the quantity of X and keeping more of his/her income in spent.
Therefore, the consumer attains the maximization of his utility when
MUx = Px
This is the equilibrium condition of the consumer.
If there are ‘n’ commodities, the equilibrium condition of the consumer is the equality of the ratios o
f the marginal utilities of the individual commodities to their prices.
MUx = MUy = ---- = MUn
PxPyPn
N.B
MUx is the marginal utility of the last “dollars” worth of commodity X
Px
Illustration
We consider a numerical example which shows the marginal utility the consumer derives from
various amounts of two commodities X and Y. We measure the commodities in terms of the
amount of money spent on them.
CONSUMER’S MARGINAL UTILITY FROM CONSUMING X AND Y
Dollars worth of each commodity
X Y
2
, 1st 9 4
2nd 7 3
3rd 4 2
4th 3 1
5th 2 0
Given the information above, how much of each commodity should the consumer buy if his/her mo
ney income is only $4?
MUTU
1st dollar - spent on X 9 9
2nd dollar - spent on x 7 16
3rd dollar - spent on X or Y 4 20
4th dollar - spent on Y or X 4 24
A rational consumer will allocate $3 of his/her income to (X) and $1 to (Y)
This is the equilibrium market basket, the market basket that maximizes consumer satisfaction. Note
that the marginal utility derived from the last dollar spent on X is equal to the marginal utility derived
from the last dollar spent on Y.
MUX = MUY
$1 $1
Thus this market basket has the expected characteristic that is the marginal utility of the last dollar
spent on all commodities purchased is the same
Critique Of The Cardinal Approach
Three basic weaknesses:
1. That utility is measurable. This assumption of cardinal utility is extremely doubtful.
i.e. the satisfaction derived from various commodities cannot be measured objectively.
2. The assumption of constant utility of money changes. Thus, money cannot be used
as a measuring rod since its own utility changes.
3. The axiom of diminishing marginal utility has been established from introspection, it
is a psychological law which must be taken for granted.
THE ORDINAL UTILITY THEORY
The ordinalist school postulated that utility is not measurable, but it is an ordinal magnitude. The
consumer need not know in specific units the utility of various commodities to make his choice. He can
rank the various baskets of goods according to the satisfaction that each bundle gives him. He must be
able to determine his order of preference among the different bundles of goods.
The main ordinal theories are the indifference – curve approach and the revealed preference hypothesis
The Indifference- Curves Theory
Assumptions
Rationality
The consumer is assumed to be rational. He aims at the maximization of his utility given his
income and market prices.
3
