economics+module 3

8/8/2019 Economics+Module 3

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Module-3

Analysis of Consumer Behaviour-

The Utility Theory


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Introduction

The theory of consumer behaviour tries toexplain the decision-making behaviour of theconsumer in demanding a particular commodity.

The law of demand states that, other thingsbeing equal, as the price of a commodity falls,the consumer tends to buy more of it and vice-versa

But why is he behaving like this?

The reason behind such a decision makingprocess is sought to be explained by the theoryof demand or consumer behaviour theory


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Utility Theory

Economists have offered their theories of

consumer behaviour on the basis of the

measurement of utility

There are two major approaches regarding the


1) Cardinal Utility theory of Consumer Behaviour

2) Ordinal Utility Theory of Consumer Behaviour.This is popularly known as Indifference Curve

Analysis


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Origins of Utility Theory

The utility analysis of demand behaviourwas originated in the early 1870s by threecontemporary economists, Jevons,

Menger and Walras. It however received perfection and

systemic presentation at the hands of

Alfred Marshall when his celebrated bookPrinciples of Economics was published in1890.


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Basic Concepts of The Utility

Theory The Marshallian approach is based on

the following postulates

1. The concept of utility2. Cardinal or numeric measurement of

utility

3. Total utility4. Diminishing marginal utility

5. Equi-marginal utility


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The Concept of Utility-1

When the consumer consumes or buys acommodity, he derives some benefit in the formof satisfaction of a certain want. This benefit orsatisfaction experienced by the consumer is

referred to by economists as utility. Utility is a subjective term. It relates to the

consumers mental attitude and experienceregarding a given commodity or service.

Utility of a commodity may differ from person toperson as every individual has his own choices.

So it derives from above that utility is a relativeterm


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The Concept of Utility-2

Utility depends on time and place.

The same consumer may experience a

higher or lesser utility at different timesand different places.

Utility is a function of intensity of want.

In other words, when we have more of acertain thing, the less and less we want it.


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Cardinal Measurement of Utility

Marshall assumes cardinal or numeric


Marshall believed that utility could be measured

in numerical terms in its own units called utils.

According to Marshall utility is quantifiable and

so can be measured numerically

An apple may have 10 utils of utility (satisfaction)and a mango may have 30 utils of utility, three

times that of the apple.


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Total Utility

Total utility means total satisfaction

experienced or attained by the consumer

regarding all the units of a commodity

taken together in consumption or acquired

at a time.

Total utility tend to be more with a larger

stock and less with a smaller stock.


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Marginal Utility

Marginal utility is the extra utility obtained

from an extra unit of any commodity

consumed or acquired.


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The Law of Diminishing Marginal

Utility The law states that, other things being

equal, as the quantity of a commodityconsumed or acquired by the consumer

increases, the marginal utility of thecommodity tends to diminish

This means each additional unit of

consumption adds relatively less and lessto the total utility obtained by theconsumer


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Assumptions of the Law of

Diminishing Marginal Utility The law is based on following assumptions:-1. The consumer behaves rationally, seeking

maximization of total utility

2. All the units of the commodity in considerationare homogeneous, i.e. identical in all respects

3. The units consumed or acquired are takensuccessively without any interval of time

4. There is no change in income, taste, habit orpreference of the consumer

5. Utility is measurable in cardinal terms


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Equi-marginal utility

The law of equi-marginal utility is an extension of the lawof diminishing marginal utility.

This law is also called the law of substitution or the lawof maximum satisfaction.

The law of diminishing marginal utility is applicable onlyto a single want with a single commodity in use

But in reality there may be a number of wants to besatisfied at a time and they can be satisfied with several

goods To analyze such a situation the law of diminishingmarginal utility is extended and such extended form iscalled the law of equi-marginal utility .


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Statement of the law of Equi-

Marginal Utility Other things being equal, a consumer gets

maximum total utility from spending his

income, when he allocates his expenditure

to the purchase of different goods, in such

a way that the marginal utilities derived

from the last unit of money spent on each

item of expenditure tends to be equal


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Significance of the law

1. It applies to consumption: It indicates how to getmaximum satisfaction

2. Production:- in the very principle of substitution lies theoptimum allocation of resource

3. Distribution :- It has an important bearing on thedetermination of value. It helps in readjustment ofresources

4. Welfare and public finance:- the principle of maximum

social advantage involves the law of substitution whenit proposes that the revenue must be distributed insuch a way that the last unit of expenditure bringsequal welfare and satisfaction to all classes of people.


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Substitution Effect

According to Marshall when the price of a commodityfalls, the consumer is induced to substitute more of therelatively cheaper commodity (whose price has fallen) forthe dearer one (whose price has remained unchanged)

When the price of a commodity falls the consumer findsit worthwhile to purchase more of the cheapercommodity as against dearer one.

Since substitution effect is always positive, a largerquantity of the commodity will be purchased at a lowerprice


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Income effect

This refers to the change in the real

income of the consumer due to changes in

price.

When the price of a commodity falls, the

real income of the consumer rises. So the

consumer can now purchase the same

amount of commodity with less money ORmore quantities with less money.


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Positive Income Effect

When a commodity has relatively higher

marginal utility, the Income Effect will be

positive

The extra income generated due to fall in

price will be spent on buying more

quantities of the same commodity


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Negative Income Effect

When the quantity of the commoditypurchased is less than before with a fall inthe price of a given commodity.

This phenomenon is described as GiffensParadox

This generally happens in the case of

inferior goods In case of inferior goods, when price falls,

the demand also falls


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The Paradox of Value

This proposition states that, the value (price) of a

good is determined by its relative scarcity, rather

than by its usefulness.

Water is extremely useful and its Total Utility isquite high, but because it is so abundantly

available its Price (marginal utility) is low

Diamonds, by contrast are much less useful than

water, but their great scarcity makes their price

very high


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Consumers Surplus

The extra satisfaction or utility gained by

the consumer from paying an actual price

for a good which is lower than that which

they would have been prepared to pay

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