Unit – 2

Theory of Consumer Behaviour

 Utility
▪ According to Prof. Waugh: “Utility is the power of commodity to
satisfy human wants.”
▪ It refers to the total satisfaction received from consuming a good
or service.
▪ Utility is a subjective concept (individuals have different levels of
satisfaction by consuming the same good).
✔ Eg: Utility from Apples, Mangoes, Chicken, Ice creams etc.
▪ Utility determines the demand for a commodity.
 Measurement of Utility/Approaches to Utility Analysis
1. Cardinal utility analysis
2. Ordinal utility analysis
 1. Cardinal Utility Analysis
▪ The Neo-classical utility analysis built by Marshall, Pigou and
others is based on cardinal measurement of utility.
▪ It assumes that utility is measurable.
▪ It is expressed as a quantity measured in hypothetical units which
are called ‘utils’.
▪ Eg: A consumer imagines that one mango has 8 utils and an apple 4
utils.
▪ Total utility (TU)
✔ TU is the total satisfaction derived from consuming a
commodity.
▪ Marginal utility (MU)
✔ MU is the change in total utility or addition made to total utility
by having an additional unit of the commodity.
 The Law of Diminishing Marginal Utility
✔ The Law of Diminishing Marginal Utility is the basic law of
consumption.
✔ Hermann Heinrich Gossen was the first to formulate this law in
1854 though the name was given by Marshall.
✔ Jevons called it Gossen’s First Law.
✔ Gossen stated it thus: “The magnitude of one and the same
satisfaction, when we continue to enjoy it without interruption,
continually decreases until satiation is reached”.
▪ When a hypothetical consumer takes the first apple he derives the
maximum satisfaction in terms of 20 utils. As he continues to
consume the second, third and the fourth units in succession, he
derives less and less satisfaction 15, 10 and 5 utils respectively.
▪ With the consumption of the 5th apple he reaches the satiety point
because the satisfaction derived from that unit is zero.
▪ Diagrammatically, the curve MU is the diminishing utility curve. It
shows that marginal utility diminishes as more and more units of
the commodity are consumed till the satiety point C is reached.
▪ Consumption of further units gives disutility, as shown by the
movement of the MU curve from point C downward below the
X-axis.
▪ Despite its limitations, The Law of Diminishing Marginal Utility has
universal application.
 2. Ordinal Utility Analysis – The Indifference Curve Theory
▪ The drawback of cardinal utility analysis is quantification of utility in
numbers.
▪ The indifference curve is a geometrical device that has been used to
replace the neo-classical cardinal utility concept.
▪ The indifference curve analysis measures utility ordinally.
▪ It explains consumer behaviour in terms of his preferences or
rankings for different combinations of two goods, say X and Y.
 Indifference Schedule
▪ It shows the various combinations of the two commodities such that
the consumer is indifferent to those combinations.
▪ In the schedule, the consumer is indifferent whether he buys the
first combination of units of 18Y+1 unit of X or the fifth
combination of 4 units of Y+5 units of X or any other combination.
▪ All combinations give him equal satisfaction.
 Indifference Curve
▪ If the various combinations on the indifference schedule are plotted
on a diagram and are joined by a line this becomes an indifference
curve.
▪ The indifference curve I1 is the locus of the points L,M,N,O,P,Q and
R, showing the combinations of the two goods X and Y between
which the consumer is indifferent.
▪ Indifference curve is also known as an iso-utility curve showing
equal satisfaction at all its points.
▪ A single indifference curve concerns only one level of satisfaction.
 Indifference Map
• The Indifference Map is the
graphical representation of two
or more ICs drawn from
different indifference schedule.

• The curves that are farther away from the origin represent higher levels of satisfaction as
they have larger combinations of X and Y.
• IC4 indicates a higher level of satisfaction than IC3 which, in turn, is indicative of a higher
level of satisfaction than IC2 and so on.
 Assumptions of Indifference Curve Analysis
▪ The consumer acts rationally so as to maximize satisfaction.
▪ There are two goods.
▪ The prices of the two goods are given.
▪ The consumer’s tastes, habits and income remain the same.
▪ Consumer prefers more of X to less of Y or more of Y to less of X.
▪ An IC is negatively inclined sloping downward.
▪ An IC is always convex to the origin.
 Properties of Indifference Curve
1. A higher indifference curve to the right of another represents a
higher level of satisfaction.
• Consider points N and A on I1
and I2. Since A is on a higher IC
and to the right of N, the
consumer will be having more
of both the goods X and Y.
2. In between two indifference curves there can be a number of other
indifference curves.
3. The numbers I1, I2, I3, I4 etc. given to indifference curves are
absolutely arbitrary. Numbers have no importance in the indifference
curve analysis.
4. The slope of an indifference curve is negative, downward sloping,
and from left to right.
5. Indifference curves can neither touch nor intersect each other.
▪ As each IC represents a different level of satisfaction, ICs can never
intersect at any point. Point C in fig. A lies on both ICs I1 and I2
which yield the same level of satisfaction. So ICs cannot intersect
each other.
▪ The same reasoning applies if two indifference curves touch each
other at point C in fig. B.
6. An indifference curve cannot touch either axis.

▪ If the indifference curve I1 touches

X-axis at M, the consumer will be
having OM quantity of good X and
none of Y. Similarly, if an indifference
curve I2 touches the Y-axis at L, the
consumer will have only OL of Y good
and no amount of X.
▪ Such curves are in contradiction to the
assumption that the consumer buys
two goods in combinations.
7. Indifference curves are not necessarily parallel to each other. The
diminishing marginal rate of substitution between the two goods is
essentially not the same in the case of all indifference schedules.

▪ The two curves I1 and I2 shown

in the figure are not parallel to
each other.
8. An indifference curve is convex to the origin. The convexity rule
implies that as the consumer substitutes X for Y, the marginal rate of
substitution diminishes.
 Marginal Rate of Substitution (MRS)
✔ It is the rate of exchange between some units of goods X and Y
which are equally preferred.
✔ The marginal rate of substitution of X for Y (MRS)xy is the amount
of Y that will be given up for obtaining each additional unit of X.
✔ To have the second combination and yet to be at the same level of
satisfaction, the consumer is prepared to forgo 5 units of Y for
obtaining an extra unit of X. The MRS of X for Y is 5:1.
✔ As the consumer proceeds to have additional units of X, he is
willing to give away less and less units of Y so that the marginal
rate of substitution falls from 5:1 to 1:1 in the sixth combination.
Principle of Diminishing Marginal Rate of Substitution (MRS)xy
▪ (MRS)xy i.e., the marginal rate
of substitution of X for Y is the
slope of the curve at a point on
the indifference curve.
▪ As the consumer moves
downwards along the curve, he
possesses additional units of X,
and gives up lesser and lesser
units of Y, i.e., MRSxy
diminishes.
 Price – Income Line or Budget Line
▪ According to Prof. Salvatore, “The budget line shows all the
different combinations of the two commodities that a consumer can
purchase, give his or her income and the price of the two
commodities”.
▪ Suppose the monetary income of a consumer is Rs. 40 which he wants to spend on 2
goods X and Y.
▪ The price of good X is Rs. 2 per unit and that of good Y Re. 1 per unit.
▪ Given his income and prices of two goods, the alternative consumption or
expenditure possibilities of a consumer are shown in the table.
▪ If the consumer spends his total income only on good X or Y, he can buy only 20 or 40
units respectively.
▪ But this is not possible because he has to buy only a combination of two goods.
▪ So, he will buy any other combination.
▪ The various combinations of the table are shown by BL line. This is the price or budget line.
▪ Given Rs. 40 with the consumer, he can buy any one combination Q, R or S of goods X and Y.
▪ But he cannot obtain any point beyond this line such as combination A because it is out of
reach of his income.
▪ On the other hand, he cannot obtain the combination even inside the BL line such as
combination N because he cannot spend all income (Rs. 40) on both good X and Y.
▪ Thus consumer’s budget line is his budget limit or budget constraint line.
 Demand
▪ Demand is defined as, “a desire for a commodity backed by
willingness and ability to pay the price”.
Law of demand
▪ It shows the relation between price and the quantity demanded.
▪ There is inverse relationship between price and quantity demanded.
▪ Law of demand according to Marshall is, “the amount demanded
increases with a fall in price and diminishes with a rise in price”.
▪ Demand curve is downward sloping from left to right.
Demand Function
▪ Law of demand is based on Ceteris Paribus assumption.
▪ Only one factor changes, other factors being constant is Ceteris
Paribus assumption (Price alone changes and other factors are
constant).
▪ Only with Ceteris Paribus assumption the law will operate.
 Factors influencing demand/Demand determinants
1. Level of income
2. Tastes and preferences of consumers
3. Existence of substitutes
4. Expectation about future
5. Type of commodity
6. Changes in weather
▪ All these factors are assumed to be constant. Price alone changes.
Substitutes
Complementary goods
 Why does the demand curve slope downwards?
1. Operation of the law of diminishing marginal utility
2. Income effect
3. Substitution effect
 Exceptions to the law of demand
1. Veblen effect
2. Speculative effect
3. Giffen effect/Giffen paradox
4. Necessaries
5. Ignorance / Price delusion
6. Fear of shortage
Demand curve under exceptional cases
 Changes in demand
▪ Expansion & Contraction of demand
It refers to change in the quantity purchased due to change in
price of a product (other factors are constant).

▪ Movement along
same demand
curve
 Increase & decrease in demand
▪ Change in demand
It refers to changes in demand due to other factors while
keeping price constant.
 Elasticity of Demand
▪ Marshall introduced the concept of elasticity of demand.
▪ It shows the extent of change in quantity demanded to a change in
price.
▪ In the words of Marshall, “The elasticity of demand in a market is
great or small according as the amount demanded increases much
or little for a given fall in the price and diminishes much or little for
a given rise in price”.
Elastic demand
▪ A change in price may lead to a great change in quantity demanded.
Inelastic demand
▪ A change in price is followed by a small change in demand.
I.Price elasticity of demand
▪ Price elasticity of demand is the extent of change in quantity
demanded to a change in price.
ep= Proportionate change in quantity demanded
Proportionate change in price

▪ Price elasticity of demand is negative.

Classifications of price elasticity of demand
1. Perfectly/Infinitely elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unit elasticity of demand
1. Perfectly / Infinitely elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand

Ep >1
4. Relatively inelastic demand

Ep <1
5. Unitary elastic demand

Ep = 1
Factors affecting elasticity of demand
1. Nature of the commodity
2. Availability of substitutes
3. Postponement of demand
4. Habits
5. Time factor
II. Income elasticity of demand
▪ It is the extent of change in demand due to change in income.
III. Cross elasticity of demand
IV. Advertising elasticity of demand
 Supply
▪ Supply means the commodity offered for sale at a price (by retailers
and wholesalers) during some given period; say a month or week or
3 months or 6 months, etc.
▪ ↑Price ↑Supply (Direct relation)
 Factors determining supply
1. State of technology
2. Cost of production
3. Natural factors
4. Labour trouble
5. Change in government policy
 Law of supply
▪ The law of supply states that, “Other things being constant, the
price of a commodity has a direct influence on the quantity
supplied. As the price of a commodity rises, its supply is extended;
as the price falls, its supply is contracted”.
Supply=f(Price) ; ↑Price↑Supply ; ↓Price↓Supply
▪ There is a direct relation between price and supply.
▪ Other factors are assumed to be constant.
Supply schedule
 Market price determination
▪ Market price is determined at a point where demand and supply are
equal.
▪ Market price is determined by the aggregate demand and aggregate
supply.
▪ The equilibrium price is determined where D=S.
Market price determination
▪ At equilibrium price, both the buyers and sellers
are satisfied (because D=S).
o If price is higher than the equilibrium price;
S>D (↑P; sellers bring down the prices to
dispose the excess stock. Ultimately, the
price reaches the equilibrium).
o If price is less than the equilibrium price;
D>S (↓P; buyers bid up the prices to get the
product. When buyers bid up the price, the
price reaches the equilibrium).
 Price Floors
▪ A minimum legal price below which a product cannot be sold; to
have an impact, a price floor must be set above the equilibrium
price.
▪ Eg: Minimum Support Price
 Price Ceilings
▪ It is a maximum legal price above which a product cannot be sold;
to have an impact, a price ceiling must be set below the equilibrium
price.
 Consumer’s Surplus
▪ Consumer surplus = Consumers’ willingness to pay – Actual price
▪ This is Consumers’ surplus according to Marshall.
▪ Eg: Matchbox, salt, post card, newspapers
Criticism of Consumer’s Surplus
▪ Utility is not measurable.
▪ A consumer does not pay more than the actual price.
▪ Not possible to know the prices consumer is willing to pay.
 Demand forecasting
▪ Demand forecasting is estimating future demand for the product.
▪ Benefits
✔ Preparing the budget
✔ Planning and scheduling production
✔ Inventory management
✔ Developing a pricing strategy
✔ Plan manpower requirements
 Methods of demand forecasting
I. Opinion polling / Survey method
▪ It is one of the most common and direct methods of forecasting
demand in the short term.
▪ In this method, an organization conducts surveys with
consumers/dealers to determine the future demand for their
products.
 1. Opinion survey method
→ It is known as sales-force-composite method or collective opinion
method.
→ Forecasting is done by getting the opinion of salesmen.
2. Expert opinion
→ Opinion from dealers or distributors
→ E.g. Automobile companies
3. Consumers’ interview method
▪ Direct interview with the consumers (about their preferences)
Consumers interview is done in 3 ways:
i. Complete enumeration method
▪ All the consumers are interviewed.
ii. Sample survey method
▪ A sample of consumers are selected for the interview
▪ It is easy, less costly and highly useful.
iii. End-use method
▪ Demand for textile machinery = f(expansion of textile industry)
II. Statistical methods
It is used for long-run forecasting.
Statistical and mathematical techniques are used to forecast
demand.
This method relies on past data.
1. Trend projection method
▪ It is concerned with the movement of variables through time.
▪ It requires long time – series data.

Year Sales (in 000s)

2016 53

2017 49

2018 61

2019 42

2020 59
▪ This method is based on the assumption that the factors liable for
the past trends in the variables shall continue to play their role in
future in the same manner and to the same extent.
▪ Trend projection method includes 2 techniques based on
time-series data. These are:
(a) Graphical method
(b) Fitting trend equation or least square method
2. Barometric technique
▪ In this method, estimation of time-series is done through certain
indicators to predict the future.
▪ Eg: Personal income – Demand for consumer durables.
▪ Eg: Automobile registration – Demand for petrol, diesel and spare
parts.
 Econometric methods of demand forecasting
▪ The econometric methods make use of statistical tools and
economic theories in combination to estimate the economic
variables.
▪ The econometric model can either be a single-equation regression
model or a system of simultaneous equations.
 ▪ The econometric methods are:
(i) Regression method
(ii) Simultaneous equation model
(i) Regression
▪ It shows the extent of relationship between variables; i.e., how the
value of the dependent variable changes when one of the
independent variable is varied, while other independent variables
are fixed.
▪ Eg: D=f(P); extent of relation i.e., 98% or 39%
▪ It focuses on the relationship between a dependent variable and
one or more independent variables (or 'predictors').
▪ In the above equation, there is only 1 independent variable ie., P
▪ If D=f(P,Y,PR, W) – There are several independent variables i.e.,
P,Y,PR,W etc.
▪ Identifying the functional relationship with 1 independent variable is
simple regression; and with several independent variables is known as
multiple regression.
Thank You