Theory Of Consumer Behaviour

Class 12 – CBSE

Economics (Part – 1)

Synopsis1. Concept Of Utility

2. Consumer Budget

3. Budget Set, Budget Constraint, Budget Line

4. Budget Line Equation

5. Slope of the Budget Line

6. Changes In Budget Line

7. Changes In Income and Price

8. Preference of a Consumer

9. Indifference Curve Analysis

10. Marginal Rate of Substitution

11. Consumer Equilibrium in case of Indifference Curve

12. Approaches of Utility Analysis

13. Relation between TU and MU

14. Consumer Equilibrium in case of Single Commodity and in case of Two Commodities

Concept of utilityConsumer - A consumer is one who buys goods and services for satisfaction of his wants.

Utility - The want satisfying power of a commodity.

Consumption Bundle - An individual's consumption bundle is the collection of all the goods and services consumed by that individual.

Consumer BudgetA budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income.

Consumer Budget states the real income or purchasing power of the consumer from which he can purchase certain quantitative bundles of two goods at given price.

It means, a consumer can purchase only those combinations (bundles) of goods, which cost less than or equal to his income.

Budget SetA budget set or opportunity set includes all possible consumption bundles that someone can afford given the prices of goods and the person's income level.

Budget ConstraintA budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income.

The inequality shown below is a Budget Constraint.

P1:Price of good 1

P2:Price of good 2

X1:Units of good 1

X2: Units of good 2

M: Income of a consumer

Budget LineBudget line is a graphical representation of all possible combinations of two goods which can be purchased with given income and prices, such that the cost of each of these combinations is equal to the money income of the consumer.

Budget Line EquationGiven the money income of the consumer and prices of the two goods, every combination lying on the budget line will cost the same amount of money and can therefore be purchased with the given income.

The budget line can be defined as a set of combinations of two commodities that can be purchased if whole of the given income is spent on them and its slope is equal to the negative of the price ratio

Slope Of Budget LineP1X1 + P2X2 = M (1)

P1(X1 +ΔX1) + P2(X2 + ΔX2) = M (2)

Subtracting equation (2) from (1)

We get:

P1*ΔX1 + P2*ΔX2 = 0

Rearranging terms, we get the slope of the budget line

Changes In Budget Line

A Budget set or a Budget line shifts due to :

1. Change in Income: Increase in IncomeDecrease in Income

Budget line rotates due to:

2. Change in prices of the commodity

Changes In Income

Changes In Prices

Preferences Of A ConsumerConsumer’s behaviour is governed by monotonic preferences. Monotonic Preferences refers to a situation, where the consumer will prefer more of a commodities than the combination providing lesser commodities.

OR

A consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle. Example: (9,8) > (9,7)

Indifference Curve AnalysisAn indifference curve is the curve, which represents all those combinations of two commodities, which give same level of satisfaction to a consumer. Each point on IC represent same level of satisfaction.

Properties of Indifference curve:

It slopes downward to the right.

It is convex to the origin.

Two indifference can never intersect.

It never touches any axis.

Higher indifference curve shows higher satisfaction level.

Indifference Curves

Marginal Rate Of SubstitutionMRS refers to the rate at which the consumer substitute one good to obtain one more unit of the other good.

Key points about MRS:

•The slope of the Indifference curve is MRS = Δy/Δx

•MRS is never constant, it varies over the IC.

•As we move along Indifference Curve, MRS falls also called Diminishing Marginal rate of substitution.

Calculating Marginal Rate Of Substitution

Consumer’s Equilibrium Using Indifference Curve Analysis

According to indifference Curve Analysis the conditions required to achieve consumer equilibrium are:

1. Where the slope of the indifference curve is equal to the slope of budget line

MRSxy=Px/Py

Slope of IC = Slope of Budget line

2. The indifference curve must be convex to the origin at the point of tangency.

Graphical Presentation Of Equilibrium Under IC Analysis

Approaches Of Utility Analysis1. Cardinal Utility Approach: It was given by Alfred

Marshall. It refers to the measurement of utility in terms of numbers as 1,2,3, etc. The unit of measurement under this approach is ‘utils’. Example: A basket of oranges offers 10 utils of utility to a consumer.

2. Ordinal Utility Approach: It was given by Allen and Hicks. It refers to the measurement of utility in terms of psychological satisfaction and a consumer can just rank his preference from a set of most preferred to least preferred bundles.

Cardinal Utility Analysis

Cardinal utility has two concepts:

1. Total Utility

2. Marginal Utility

1. Total Utility: It refers to total satisfaction obtained from the consumption of all possible units of a commodity.

TUn = U1+ U2+ U3

TUn = MU1+ MU2+ MU3

TUn = ∑MU

Cardinal Utility Analysis

2. Marginal Utility (MU) : It is the additional utility derived from the consumption of one more unit of the given commodity.

MUn = TUn – TUn-i

MUn = Change in Total Utility/ Change in number of units

MUx = ΔTUx/ΔQx (When units do not change in consecutive order)

Relation between TU and MU

Law Of Diminishing Marginal Utility

This law states that ‘as a consumer consumes more and more units of a specific commodity, utility from the successive units goes on diminishing’ – Mr H. Gossen was the first to explain this law in 1854.

Assumptions Of LDMU:

Rationality: Consumer aims at maximum utility

Constant MU of Money: MU of money for purchasing goods remains constant

Diminishing MU: Utility falls from successive units

Continuous Consumption: No time gap

Income : Income of a consumer remains the same

Law Of Equi-Marginal UtilityAccording to this law, a consumer gets maximum satisfaction, when ratios of Marginal Utility of 2 commodities and their respective prices are equal and MU falls as consumption increases. Same Assumptions apply as LDMU.

Consumer’s Equilibrium Using Marginal Utility Analysis

The Conditions of a Consumer equilibrium using Marginal Utility analysis occurs in two cases:

1. In case of single commodity: Consumer attains equilibrium when following conditions are met.

It implies that ratio of MU of x over price of x is equal to MU of money.

Consumer’s Equilibrium Using Marginal Utility Analysis

2. In case of two commodities: In case of two commodities, consumer attains equilibrium when:

It implies that in state of equilibrium, utility per rupee obtained by the consumer from good X or good Y should be equal to Marginal Utility of money.

Consumer Equilibrium In case Of Single Commodity

Consumer Equilibrium In case Of Two Commodities

Thank You!

Lesson by

Anjali Kaur SuriTGT Maths, PGT Economics

M.A. Economics, M.Com (Finance), PGD Banking & Finance, B.A. Hons (Economics), B.Ed (Maths & SST), NISM, NSDL and IELTS certified.

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