The theory of consumer behaviour

Cardinal and Ordinal Utility

Cardinal utility gives a value of utility to different options.
Ordinal utility just ranks in terms of preference.

Cardinal Utility is the idea that economic welfare can be directly observable and be given a
value.

The idea of cardinal utility is important to rational choice theory. The idea consumers make
optimal choices to maximise their utility.

Demand curve showing cardinal utility

Cardinal utility is an important concept in utilitarianism and neo-classical economics. Jeremy

Bentham talked about utility as maximising pleasure and minimising pain.

Assumptions of Cardinal Utility

The assumptions of the cardinal utility approach are as follows:

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 • Utility is measurable
• Marginal utility of money is constant
• Utilities are additive

Utility is measurable
The basic assumption of the cardinal utility approach is that utilities of commodities can be
quantified. According to Marshall, money is used to measure the utilities of commodities.
This implies that the amount of money that a customer is willing to pay for a particular
commodity is a measure of its utility.

Marginal utility of money is constant

The cardinal utility approach assumes that money must measure the same amount of utility
under all circumstances. To put simply, the utility derived from each unit of money remains
constant.

Utilities are additive

As per this assumption, the utility derived from various commodities consumed by an
individual can be added together to derive the total utility. Suppose an individual consumes
X1, X2, X3,….Xn units of commodity X and derives U1, U2, U3,….Un until respectively, the
total utility that the individual derives from n units of the commodity can be expressed as
follows:
Un = U1(X1) + U2(X2) + … + Un (Xn)
• Diminishing marginal utility: The marginal utility of a commodity diminishes as
an individual consumes successive units of a commodity. This can be expressed as
follows: MUX = f(Qx)

Where MUX is the marginal utility of commodity X, f is a function, and Qx is the

quantity of the commodity consumed.

• Rationality: Consumers are rational beings and aim to maximize their utility at the
given income level and market price.
According to the cardinal utility approach, a consumer reaches his/ her equilibrium when the
last unit of his/her money spent on each unit of the commodity yield the same utility.
Therefore, the consumer would spend his/her money income on commodity X so long as:

MUx > Px (MUm)

Where Px is the price of the commodity, MUx is the marginal utility of the commodity and
MUm is the marginal utility of money.
A utility maximising consumer reaches the equilibrium when:

MUx = Px (MUm) or = 1
This equilibrium condition derives the consumer demand curve for commodity X, which is
shown in Figure.

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The line parallel to the X-axis, Px (MUm) depicts the constant utility of money weighed by the
price of commodity X. MUx curve represents the diminishing marginal utility of commodity
X. Both the lines intersect at point E, which means the consumer reaches equilibrium at point
E.

Ordinal Utility
In ordinal utility, the consumer only ranks choices in terms of preference but we do not give
exact numerical figures for utility.

For example, we prefer a BMW car to a Nissan car, but we don’t say by how much.

It is argued this is more relevant in the real world. When deciding where to go for lunch, we
may just decide I prefer an Italian restaurant to Chinese. We don’t calculate the exact levels
of utility.

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What is Ordinal Utility?

Ordinal Utility explains that the satisfaction after consuming a good or service cannot be
scaled in numbers, however, these things can be arranged in the order of preference.
In the 1930s, two English economists, John Hicks and R.J. Allen argued that the theory of
consumer behaviour should be developed on the basis of ordinal utility.

According to the ordinal theory, utility is a psychological phenomenon like happiness,

satisfaction, etc. It is highly subjective in nature and varies across individuals. Therefore, it
cannot be measured in quantifiable terms.

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As per the ordinal utility approach, utility can be measured in relative terms such as less than
and greater than. The approach advocates that consumer behaviour can be explained in terms
of preferences or rankings.

For example, a consumer may prefer ice-cream over soft drink. In such a case, ice-cream
would have 1st rank, while 2nd rank would be given to soft drink.
Therefore, as per the ordinal utility approach, a consumer identifies several pairs of two
commodities which would provide him/her the same level of satisfaction. Among these pairs,
he/she may prefer one commodity over the other based on how he/she ranks them in order of
utility.

This implies that utility can be ranked qualitatively and not quantitatively. To better
understand the ordinal utility approach, there are certain concepts that need to be discussed.

Assumptions of Ordinal Utility

The ordinal utility approach is based on certain assumptions, which are as follows:

1. Rationality
2. Ordinal utility
3. Transitivity and uniformity of choice
4. Non-satiety
5. Diminishing marginal rate of substitution

Rationality
Consumers are rational beings and aim to maximise their utility at the given income level and
market price of commodities that they consume.

Ordinal utility
Utility cannot be measured in quantitative terms but in qualitative terms. This is because a
consumer expresses his/ her preference for a commodity out of a collection of similar goods.

Transitivity and uniformity of choice

It is assumed that a consumer’s choice is always transitive. This implies that if a consumer
prefers A to B and B to C, the consumer would prefer A to C as well. On the other hand, if
the consumer considers A=B and B=C, he must consider A=C. On the other hand, uniformity
of choice implies that if a consumer prefers A to B at one time period, he/ she does not prefer
B to A in another time period or even does not consider A and B as equal.

Non-satiety
The theory also assumes that a consumer is never oversupplied with commodities. This
means that a consumer does not reach a state of saturation in case of any commodity. Thus, a
consumer tends to prefer larger quantities of a commodity over smaller.

Diminishing marginal rate of substitution

The marginal rate of substitution refers to the rate at which a consumer is willing to substitute
one good (X) for another good (Y) in order to maintain the level of satisfaction. The marginal
rate of substitution is represented as dY/dX.

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According to the ordinal utility approach, the marginal rate of substitution goes on decreasing
when a consumer continues to substitute X for Y. The marginal rate of substitution has been
discussed in the later sections of the chapter.

Cardinal Utility Ordinal Utility

Definition

It explains that the satisfaction It explains that the satisfaction level after
level after consuming any goods or consuming any goods or services cannot be
services can be scaled in terms of scaled in numbers. However, these things can
countable numbers. be arranged in the order of preference.

Example

Pizza gives Sam 60 utils of Sam gets more satisfaction from a pizza as
satisfaction, whereas burger gives compared to that of a burger.
him only 40 utils.

Measurement

Utility is measured based on utils. Utility is ranked based on satisfaction.

Realistic

It is less practical. It is more practical and sensible.

DERIVATION OF THE DEMAND CURVE

DERIVATION OF THE CONSUMER'S DEMAND CURVE .

This section is the ultimate exposition of the theory of indifference curves analysis wherein
we are now going to discuss the derivation of the individual demand curve. The demand
curve that explicitly shows relationship between price and quantity demanded. This part of
the theory establishes superiority of the Hicksian indifference curve analyses over
Marshallian cardinal utility analysis. The indifference curve analysis enables us to understand
consumer's general demand behaviour with respect to various types of goods which Marshall
treated as special cases.

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 Derivation of the Consumer's Demand Curve: Normal Goods
We have already seen how the price consumption curve traces the effect of a change in price
of a good on its quantity demanded. However, it does not directly show the relationship
between the price of a good and its corresponding quantity demanded. It is the demand curve
that shows relationship between price of a good and its quantity demanded. In this section we
are going to derive the consumer's demand curve from the price consumption curve . Figure.1
shows derivation of the consumer's demand curve from the price consumption curve where
good X is a normal good.

FIGURE.1 Derivation of the Demand Curve: Normal Goods

The upper panel of Figure.1 shows price effect where good X is a normal good. AB is the
initial price line. Suppose the initial price of good X (Px) is OP. e is the initial optimal
consumption combination on indifference curve U. The consumer buys OX units of good X.
When price of X (Px)falls, to say OP1, the budget constraint shift to AB1. The optimal
consumption combination is e1 on indifference curve U1. The consumer now increases
consumption of good X from OX to OX1 units. The Price Consumption Curve (PCC) is rising
upwards.

Chart.1 shows the demand relationship derived from the price consumption curve.

Chart.1

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 The lower panel of Figure.1 shows this price and corresponding quantity demanded of good
X as shown in Chart.1. At initial price OP, quantity demanded of good X is OX. This is
shown by point a. At a lower price OP1, quantity demanded increases to OX1. This is shown
by point b. DD1 is the demand curve obtained by joining points a and b. The demand curve is
downward sloping showing inverse relationship between price and quantity demanded as
good X is a normal good.

Derivation of the Consumer's Demand Curve: Giffen Goods

In this section we are going to derive the consumer's demand curve from the price
consumption curve in the case of inferior goods. Figure.2 shows derivation of the consumer's
demand curve from the price consumption curve where good X is an inferior good.
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The upper panel of Figure.2 shows price effect where good X is an inferior good. AB is the
initial price line. Suppose the initial price of good X (Px)is OP. e is the initial optimal
consumption combination on indifference curve U. The consumer buys OX units of good X.
When price of X Px) falls, to say OP1, the budget constraint shift to AB1. The optimal
consumption combination is e1 on indifference curve U1. The consumer now reduces
consumption of good X from OX to OX1 units as good x is inferior. The Price Consumption
Curve (PCC) is rising upwards and bending backwards towards the Y-axis.

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Chart.1 shows the demand relationship derived form the price consumption curve.

Chart.2

The lower panel of Figure.2 shows this price and corresponding quantity demanded of good
X as shown in Chart.2. At initial price OP, quantity demanded of good X is OX. This is
shown by point a. At a lower price OP1, quantity demanded decreases to OX1. This is shown
by point b. DD1 is the demand curve obtained by joining points a and b. The demand curve is
upward sloping showing direct relationship between price and quantity demanded as good X
is an inferior good.

Derivation of the Consumer's Demand Curve: Neutral Goods

In this section we are going to derive the consumer's demand curve from the price
consumption curve in the case of neutral goods. Figure.3 shows derivation of the consumer's
demand curve from the price consumption curve where good X is a neutral good.

FIGURE.3 Derivation of the Demand Curve: Neutral Goods

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The upper panel of Figure.3 shows price effect where good X is a neutral good. AB is the
initial price line. Suppose the initial price of good X (Px) is OP. e is the initial optimal
consumption combination on indifference curve U. The consumer buys OX units of good X.
When price of X (Px)falls, to say OP1, the budget constraint shift to AB1. The optimal
consumption combination is e1 on indifference curve U1 at which the consumer buys same
OX units of good X as it is a neutral good. The Price Consumption Curve (PCC) is a vertical
straight line.

Chart.3 shows the demand relationship derived from the price consumption curve.

Chart.3

The lower panel of Figure.3 shows this price and corresponding quantity demanded of good
X as shown in Chart.3. At initial price OP, quantity demanded of good X is OX. This is
shown by point a. At a lower price OP1, quantity demanded remains fixed at OX. This is
shown by point b. DD1 is the demand curve obtained by joining points a and b. The demand

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curve is a vertical straight line showing that the consumption of good X is fixed as good X is
a neutral good.

Indifference curves and budget lines

An indifference curve is a line showing all the combinations of two goods which give a
consumer equal utility. In other words, the consumer would be indifferent to these different
combinations.

Example of choice of goods which give consumers the same utility

Table plotted as indifference curve

Diminishing marginal utility

The indifference curve is convex because of diminishing marginal utility. When you have a
certain number of bananas – that is all you want to eat in a week. Extra bananas give very
little utility, so you would give up a lot of bananas to get something else.
Indifference curve map

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We can also show different indifference curves.

All choices on I2 give the same utility. But, it will be a higher net utility than indifference
curve I1.

I4 gives the highest net utility. Basically, I4 would require higher income than I1.

INDIFFERENCE CURVES AND BUDGET LINE

Budget line

A budget line shows the combination of goods that can be afforded with your current income.

If an apple costs £1 and a banana £2, the above budget line shows all the combinations of the
goods which can be bought with £40. For example:

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 • 20 apples @ £1 and 10 bananas @£2
• 10 apples @£1 and 15 bananas @£2
Optimal choice of goods for consumer

• Given a budget line of B1, the consumer will maximise utility where the
highest indifference curve is tangential to the budget line (20 apples, 10
bananas)
• Given current income – IC2 is unobtainable.
• IC3 is obtainable but gives less utility than the higher IC1
• The optimal choice of goods can also be shown with the Equi-marginal
principle

Income-consumption curve

As income rises, you can afford to consume on higher indifference curves. This optimal
choice will shift to the right. This we can plot consumption as income rises.
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Impact of lower price

With a lower price of bananas (from £2 to £1.50), we can now afford more bananas with the
same income. The budget line shifts to the right

With lower prices, we can now consume at a higher indifference curve of IC2, enabling more
bananas and apples.

Income and substitution effect of a rise in price

When the price of a good rises. People buy less for two reasons

2. Income effect. This looks at the effect of a price increase on disposable

income. If the price of a good increases, then consumers will have relatively
lower disposable income. For example, if the price of petrol rises, consumers
may not be able to afford to drive as much, leading to lower demand.
3. Substitution effect. This looks at the effect of a price increase compared to
alternatives. If the price of petrol rises, then it is relatively cheaper to go by
bus.
Income and substitution for a normal good

• A rise in price changes the budget line. You can now buy less of good
Bananas. The budget curve shifts to B2
• Consumption falls from point A to point C (fall in Quantity of bananas from
Q3 to Q1

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To find different substitution and income effects.
❖ We draw a new budget line parallel to B2 but tangential to the first indifference curve.
❖ Being tangential to first indifference curve it enables the consumer to obtain the same
utility as before (as if there was no change in income.)
❖ By focusing on B-3, we are examining the effect of price change – ignoring any income
effect.
❖ The change from A to B (Q3 to Q2) is purely due to the substitution effect and relative
price change.
Income effect
❖ However, income has fallen causing the consumer to choose from a lower
indifference curve I2. The change due to income is, therefore, b to C (Q2 to Q1.)
❖ In this case of a normal good, the income and substitution effect reinforce each other
– both leading to lower demand.
Effect of a rise in the price of an inferior good

❖ The substitution effect (using a parallel budget line of B-3) causes a big fall from a to b.
❖ However, the income effect leads to an increase in demand (Q1 to Q2)
❖ Overall demand falls, but the substitution effect is partly offset by the income effect.
❖ This is because when income falls, the decline in income causes us to buy more inferior
goods because we can’t afford normal / luxury goods anymore.

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Giffen goods

A Giffen good occurs when the income effect outweighs the substitution effect. This is quite
rare, but it is theoretically possible for poor peasants who have a choice between expensive
meat and cheap rice.

We start at Q2, the rise in the price of rice, reduces the budget line for rice to B2. But, the fall
in income causes a large income effect that outweighs the substitution effect. Demand for rice
rises to Q3 with a big fall in demand for meat.

The Engel Curve (With Diagram)

The Engel curve, named after the German statistician Ernst Engel (1821-96), is a relation be-
tween the demand for a good and the income of its buyers, the former depending on the latter.

The Engel curve of an individual consumer can be obtained from his ICC. As, every point on
the ICC for an individual consumer like the curve given in Fig. 6.17, is a combination of
three items—his money income (M), his demand for good X and that for good Y.

For example, the point E1 is a combination of money income, L1M1 i.e., the money income
represented by the budget line L1M1, demand for good X = x1 and the demand for good Y =
y1, i.e., the point E1 is a combination (L1M1, x1, y1). Similarly, the point E2 is a combination
of (L2M2, x2, y2), and so on.
Therefore, the points on the ICC in Fig. 6.17 gives a set of combinations of money income
and demand for X like (L1M1, x1), (L2M2, x2), etc. and another set of combinations of money
income and the demand for good Y like (L1M1, y1), (L2M2, y2), etc.

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The first set of combinations, if plotted explicitly in a diagram would give the consumer’s
Engel curve for good X like the one given in Fig. 6.18, and the second set of combinations
would give us his Engel curve for good y—this is given in Fig. 6.19.

Since the ICC in Fig. 6.17 is sloping upward towards right throughout its length, the
consumer purchases more of both the goods as his money income increases, prices remaining
the same.

What is Consumer Surplus?

Consumer surplus, also known as buyer’s surplus, is the economic measure of a customer’s
excess benefit. It is calculated by analyzing the difference between the consumer’s
willingness to pay for a product and the actual price they pay, also known as the equilibrium
price. A surplus occurs when the consumer’s willingness to pay for a product is greater than
its market price.

Consumer surplus is based on the economic theory of marginal utility, which is the additional
satisfaction a person derives by consuming one more unit of a product or service. The
satisfaction varies by consumer, due to differences in personal preferences. According to the
theory, the more of a product a consumer buys, the less willing he/she is to pay more for each
additional unit due to the diminishing marginal utility derived from the product.

Calculating Consumer Surplus

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The point where the demand and supply meet is the equilibrium price. The area above the
supply level and below the equilibrium price is called product surplus (PS), and the area
below the demand level and above the equilibrium price is the consumer surplus (CS).

While taking into consideration the demand and supply curves, the formula for consumer
surplus is CS = ½ (base) (height). In our example, CS = ½ (40) (70-50) = 400.

Consumer Surplus and the Price Elasticity of Demand

Consumer surplus for a product is zero when the demand for the product is perfectly elastic.
This is because consumers are willing to match the price of the product. When demand is
perfectly inelastic, consumer surplus is infinite because a change in the price of the product
does not affect its demand. This includes products that are basic necessities such as milk,
water, etc.

Demand curves are usually downward sloping because the demand for a product is usually
affected by its price. With inelastic demand, consumer surplus is high because the demand is
not affected by a change in the price, and consumers are willing to pay more for a product.

In such an instance, sellers will increase their prices to convert the consumer surplus to a
producer surplus. Alternatively, with elastic demand, a small change in price will result in a
large change in demand. It will result in a low consumer surplus as customers are no longer
willing to buy as much of the product or service with a change in price.

Law of Diminishing Marginal Utility

According to economist Alfred Marshall, the more you consume a certain commodity, the
lower the satisfaction derived from each additional unit of consumption. For example, if you
buy one apple for $0.50, you are not willing to pay more for the second apple. At the same
time, the utility derived from consuming the second apple is lower than it was for the first
apple. The concept is described in the table below:

According to Alfred Marshal: Consumer Surplus = Total Utility – (Price x Quantity)

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Assumptions of the Consumer Surplus Theory

1. Utility is a measurable entity

The consumer surplus theory suggests that the value of utility can be measured. Under
Marshallian economics, utility can be expressed as a number. For example, the utility derived
from an apple is 15 units.

2. No substitutes available

There are no available substitutes for any commodity under consideration.

3. Ceteris Paribus

It states that customers’ tastes, preferences, and income do not change.

4. Marginal utility of money remains constant

It states that the utility derived from the income of a consumer is constant. That is, any
change in the amount of money a consumer has does not change the amount of utility they
derive from it. It is required because without it, money cannot be used to measure utility.

5. Law of diminishing marginal utility

It states that the more a product or service is consumed, the lower the marginal utility is
derived from consuming each extra unit.

6. Independent marginal utility

The marginal utility derived from the product being consumed is not affected by the marginal
utility derived from consuming similar goods or services. For example, if you consumed
orange juice, the utility derived from it is not affected by the utility derived from apple juice.

Conclusion

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Consumer surplus is a good way to measure the value of a product or service and is an
important tool used by governments in the Marshallian System of Welfare Economics to
formulate tax policies. It can be used to compare the benefits of two commodities and is often
used by monopolies when deciding the price to charge for its product.

Additional Resources

Thank you for reading CFI’s guide to Consumer Surplus. To keep learning and advancing
your career, the following CFI resources will be helpful:

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