Unit 2: Theory of Consumer Behaviour
Utility: Meaning, Types of Utility
Meaning of Utility
Utility is the want-satisfying power of a commodity or service. It is a subjective concept, meaning it varies from person to person and from time to time.
In economics, there are two main approaches to measuring utility:
- Cardinal Utility (Marshall): Assumes that utility can be measured and expressed in numerical units, called "utils." (e.g., "This apple gives me 10 utils of satisfaction"). The Law of Diminishing Marginal Utility is based on this approach.
- Ordinal Utility (Hicks & Allen): Assumes that utility *cannot* be measured, but it can be *ranked* in order of preference. (e.g., "I prefer an apple to a banana," but not by "how much"). The Indifference Curve analysis is based on this approach.
Types of Utility
- Total Utility (TU): The total satisfaction derived from consuming *all* units of a commodity. As the consumer consumes more units, TU increases, but usually at a decreasing rate.
- Marginal Utility (MU): The additional satisfaction derived from consuming *one more* unit of a commodity.
MU = (Change in TU) / (Change in Quantity)
or
MU_n = TU_n - TU_(n-1)
Law of Diminishing Marginal Utility
The Law of Diminishing Marginal Utility states that, ceteris paribus, as a consumer consumes more and more units of a specific commodity, the marginal utility derived from each successive unit goes on diminishing.
Example: The first glass of water to a thirsty person gives immense satisfaction (high MU). The second glass gives less satisfaction (lower MU). The third glass gives even less, and eventually, MU may become zero or even negative.
Relationship between TU and MU:
- When MU is positive and falling, TU increases at a diminishing rate.
- When MU is zero, TU is at its maximum. (This is the point of saturation).
- When MU is negative, TU starts to fall.
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Exam Tip: This law is the foundation for the downward-sloping demand curve. Because the marginal utility (and thus the price a consumer is willing to pay) falls as quantity increases, the demand curve slopes down.
Indifference Curve and Indifference Map
Indifference Curve (IC)
This is based on the ordinal utility approach.
An Indifference Curve is a curve that shows all the different combinations of two goods that give a consumer the same level of satisfaction (utility).
The consumer is "indifferent" between any of the combinations (e.g., bundles A, B, C) on the same curve.
Properties of Indifference Curves:
- Downward Sloping: To get more of one good, you must give up some of the other to maintain the same level of satisfaction.
- Convex to the Origin: This is the most important property. It reflects the Diminishing Marginal Rate of Substitution (MRS).
- MRS: The rate at which a consumer is willing to substitute Good Y for Good X. It is the slope of the Indifference Curve.
- Diminishing MRS: As a consumer has more of Good X, they are willing to give up *less* of Good Y to get even more X.
- Higher IC represents Higher Satisfaction: A curve further from the origin (e.g., IC2) represents combinations with more of both goods, and thus a higher level of utility than a lower curve (IC1).
- Two ICs Never Intersect: This would violate the assumption of transitivity (if A=B and A=C, then B must=C).
Indifference Map
An Indifference Map is a set or family of indifference curves (e.g., IC1, IC2, IC3...). Each successive curve moving away from the origin represents a higher level of utility.
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Budget Constraint and Consumer's Equilibrium
Budget Constraint (or Budget Line)
This line shows all the combinations of two goods that a consumer can afford to buy, given their limited income (M) and the prices of the goods (Px and Py).
Budget Line Equation: (Px * X) + (Py * Y) = M
The slope of the budget line is the ratio of the prices: -Px / Py. It represents the rate at which the market *forces* the consumer to trade one good for another.
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Consumer's Equilibrium
The consumer wants to reach the highest possible indifference curve (maximize satisfaction) while staying on or inside their budget line (affordability).
This equilibrium occurs at the point of tangency between the budget line and an indifference curve.
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At the point of tangency (E), two conditions are met:
- The slope of the Indifference Curve = The slope of the Budget Line.
MRS_xy = Px / Py
- The consumer is spending their entire income.
This means the rate at which the consumer is *willing* to trade (MRS) is exactly equal to the rate at which the market *lets* them trade (Px/Py).
Price Effect, Income and Substitution Effects (Hicks and Slutsky)
Price Effect (PE)
The Price Effect shows what happens to the consumer's equilibrium when the price of one good changes (holding income and the other price constant). A change in price pivots the budget line.
The Price Effect is the total movement from the original equilibrium (E1) to the new equilibrium (E2). This total effect can be broken down into two parts: the Substitution Effect and the Income Effect.
Price Effect (PE) = Substitution Effect (SE) + Income Effect (IE)
Substitution Effect (SE)
- Definition: The change in consumption that results from a change in the relative prices of goods.
- Logic: When Good X becomes relatively cheaper, the consumer will *always* substitute away from the more expensive Good Y and towards the cheaper Good X.
- The substitution effect is always negative (a price decrease *always* leads to an increase in consumption of that good, and vice versa).
Income Effect (IE)
- Definition: The change in consumption that results from the change in real income (purchasing power) caused by the price change.
- Logic: When the price of Good X falls, the consumer's purchasing power increases. They feel "richer."
- The direction of the IE depends on the type of good:
- Normal Good: Real income up → Consumption up. (IE is negative, reinforcing the SE).
- Inferior Good: Real income up → Consumption down. (IE is positive, working against the SE).
Hicks and Slutsky Decomposition
Hicks and Slutsky provide two ways to "decompose" the total Price Effect into its SE and IE components. They differ in how they define "real income."
- Hicksian Method (Compensating Variation): To find the SE, we "compensate" the consumer to keep them on the original indifference curve (original satisfaction level) at the new prices.
- Slutsky Method (Cost Difference): To find the SE, we "compensate" the consumer so they can afford the original bundle of goods at the new prices.
(Both methods give similar results, but the Hicksian method is more common in introductory texts).
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Derivation of Demand Curve
The individual consumer's demand curve can be derived directly from the indifference curve analysis.
Derivation using the Price Effect:
- Start with the consumer in equilibrium at point E1, with price P1 and quantity Q1. (This is our first point on the demand curve: P1, Q1).
- Now, let the price of Good X fall to P2. This pivots the budget line outwards.
- The consumer finds a new equilibrium (a new tangency point) at E2, on a higher indifference curve. This new equilibrium corresponds to a lower price P2 and a higher quantity Q2.
- Plot this second point (P2, Q2) on a new graph below the IC-budget line graph.
- Let the price fall again to P3. The budget line pivots out further, leading to equilibrium E3, with quantity Q3.
- Plot this third point (P3, Q3) on the lower graph.
- Connecting these points (P1,Q1), (P2,Q2), (P3,Q3) on the lower graph creates the consumer's downward-sloping demand curve.
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