Theory of Consumer Behaviour- Indifference Curve

Approaches to Consumer Behaviour

Cardinal Utility Approach

• Propounded by Marshall
• Known as Marshalling Approach

Ordinal Utility Approach

• Propounded by Hicks & Allen
• Known as Indifference Curve Analysis

Utility

• Utility is synonymous with "Pleasure", "Satisfaction" & a Sense of Fulfillment of Desire.

• Utility → "WANT SATISFYING POWER" of a Commodity.

• Utility         is         a         Psychological Phenomenon.

• Utility refers to Abstract Quality whereby an Object Serves our Purpose. - Jevons

• Utility is the Quality of a Good to Satisfy a Want. -Hibdon

• Utility  is  the  Quality  in  Commodities  that makes Individuals want to buy them. Mrs. Robinson

Features of Utility

• Utility is Subjective

– It deals with the Mental Satisfaction of a Man. For Example, Liquor has Utility for a Drunkard but for a Teetotaler, it has no Utility.

• Utility is Relative

– Utility  of  a  Commodity  never  remains  same.  It varies  with  Time,  Place  &  Person.  For  Example, Cooler has utility in Summer but not during Winter.

• Utility is Not Essentially Useful

– A Commodity having Utility need not be Useful.

E.g., Liquor is not useful, but it Satisfies the Want of an Addict thus have Utility for Him.

• Utility is Ethically Neutral

– Utility  has  nothing  to  do  with  Ethics.  Use  of Liquor may not be good from the Moral Point of View, but as these Intoxicants Satisfy wants of the Drunkards, they have utility

Concepts of Utility


Initial Utility
• The  Utility  Derived  from  the Consumption of Ist Unit of Commodity.

Total Utility
• The Aggregate of Utilities obtained from the Consumption of Different Units of Commodity.
• TUn= U1+U2+U3+U4+…..+Un

Marginal Utility
• Change in Total Utility resulting from the change in Consumption.
• MU = TUn+TUn-1

Types of Marginal Utility

Positive Marginal Utility
• With Consumption of an Additional Unit of a Commodity, Total Utility Increases.


Zero Marginal Utility
• With Consumption of an Additional Unit of a Commodity, Total Utility Remains Same.

Negative Marginal
• With Consumption of an Additional Unit of a Commodity, Total Utility Decreases

Marginal Utility Analysis (MUA)

• Formulated by Alfred Marshall.

• Theory  Explains  How  a  Consumer spends his Income on Different Goods & Services so as to attain Maximum Satisfaction.

• Based on Certain Assumptions.

Assumptions to MUA

  1. • Cardinal Measurability of Utility
    1. – Utility is a Measureable & Quantifiable Entity.
    2. – Money is the Measuring Rod of Utility i.e. The amount of Money which a Person is prepared to Pay for a Unit of Good rather than go without it is a Measure of Utility Derived.
  2. • Constancy of the Marginal Utility of Money
    1. – MU of Money remains Constant.
    2. – Not  Realistic.  But  has  been  made  in order to Facilitate the Measurement of Utility   of   Commodity   in   Terms   of Money.
  3. • Hypothesis of Independent Utility
    1. – Theory       Ignores       Complementarity Between Goods.
    2. – Total    Utility    derived    from    Whole Collection of Goods Purchased is the Sum Total of Separate Utilities of the Good.

Laws of Diminishing Marginal Utility

• The  Additional  Benefit  which  a  Person derives from a given Increase in Stock of a thing Diminishes with Every Increase in the Stock that he already has. -Marshall

• As  the  Amount  Consumed  of  a  Good Increases,  the  Marginal  Utility  of  the Good tends to Decrease. - Samuelson

Assumptions to Law of Diminishing Marginal Utility

  1. • Other things being equal
    1. - Utility  can  be  Measured  in  the  Cardinal Number System.
    2. - Marginal    Utility    of    Money    remains Constant.
    3. - Marginal  Utility  of  Every  Commodity  is Independent.
    4. - Every Unit of the Commodity being used is of Same Quality & Size.
  2. • There is a Continuous Consumption of the Commodity.
  3. • Suitable   Quantity   of   the   Commodity   is Consumed.
  4. • There is No Change in the Income, Tastes, Character, Fashion and Habits of the Consumer.
  5. • There  is  No  Change  in  the  Price  of  the Commodity and its Substitutes.

Explanation

Quantity of Tea
(Cups per Day)
Total Utility Marginal Utility
1

30

30
2 50 20
3 65 15
4 75 10
5 83 8
6 89 6
7 93 4
8 96 3
9 98 2
10 99 1

 

Law of Diminishing Marginal Utility

 


Limitations of the Law

• Utility considered as Cardinally measureable is   Untenable   as   Utility   is   a   Subjective Concept.

• Unrealistic  Assumption  regarding  Marginal Utility  of  Money being Constant. Money is subject to change.

• No Empirical Verification.

• The    Derivation    of    Law    is    based    on assumption   of   Ceteris   Paribus   which   is unrealistic.

Marshallian Consumer’s Surplus

• Marshall  defined  Consumer’s  Surplus  as "the excess of the Price which a Consumer would be willing to Pay rather than go without the thing, over that which he actually does pay."

• Consumer’s Surplus = What a Consumer is Willing to Pay – What he Actually Pays.

• Derived   from   the   Law   of   Diminishing Marginal Utility.

Assumptions to Marshallian Consumer’s Surplus

• Perfect Competition prevails in Market

• Consumer       purchases       only       one Commodity.

• Price Of the Commodity is Fixed.

• Marginal Utility of Money is Constant.


Limitations of Marshallian Consumer’s Surplus


• Consumer’s Surplus cannot be Measured precisely because it is difficult to measure the Marginal Utilities of different units of a Commodity consumed by a person.

• In   case   of   Necessaries,   the   Marginal Utilities of earlier units are infinitely large. In   such   cases,   Consumer’s   Surplus   is always Infinite.

• Consumer’s    Surplus    derived    from    a Commodity is Affected by the Availability of Substitutes.

• No  Simple  rule  for  deriving  the  Utility Scale of Articles of Distinction e.g. Diamonds.

• Marginal Utility of Money is Assumed to be Constant which is Unrealistic.


Indifference Curve


• A  Single  Indifference  Curve  shows  the different Combinations of X and Y that yield Equal Satisfaction to the Consumer. - Leftwitch

• An Indifference Curve is a Combination of Goods,  each  of  which  yield  the  Same Level of Total Utility to which the Consumer is Indifferent. - Ferguson

Assumptions to Indifference Curve Analysis

• Rationality of Consumer

– The Consumer is Rational & aims at maximizing his Total Satisfaction.

• Ordinal Utility

– Utility    can    be    expressed    Ordinally    i.e. Consumer  is  able  to  tell  only  Order  of  his Preferences.

• Nonsatiety

– Consumer is not Oversupplied with Goods in Question.

• Transitivity of Choice

– Means that if a Consumer prefers A to B & B to C, he must prefer A to C.

• Consistency of Choice

– Means that if a Consumer prefers A to B in one period, he will not prefer B to A in another period or Treat them as Equal.

• Diminishing Marginal Rate of Substitution

 

Marginal Rate of Substitution (MRS)

• The Rate at which an Individual must give up "Good A" in order to obtain One More Unit of "Good B", while keeping their Overall Utility (Satisfaction) Constant. The MRS  is  Calculated between Two Goods placed on an Indifference Curve, which displays a Frontier of Equal Utility for Each Combination of "Good A" and "Good B".

• MRS  Keeps  on  Declining  since  Consumer  has more & more units of one Good, he gives up Less units of other good.

• An Indifference Curve has a Negative Slope i.e. it Slopes Downwards.

Properties of Indifference Curve

  1. • An  Indifference  Curve  has  a  Negative Slope i.e. it Slopes Downwards.
  2. • Indifference Curves are always Convex to the Origin.
  3. • Two  Indifference  Curves  never  Intersect  or become Tangent to Each other.
  4. • Higher  Indifference  Curve  represents  Higher Satisfaction

• An  Indifference  Curve  has  a  Negative Slope i.e. it Slopes Downwards.

– This    Property    Implies    that    when    the amount of one Good in Combination is Increased, the amount of the Other Good is reduced. This is Essential if the Level of Satisfaction is to remain the same on an Indifference Curve.

• Indifference Curves are always Convex to the Origin.

– This implies that the Two Commodities are Imperfect Substitutes for each other & that the MRS between the two Goods Decreases as a Consumer moves along an Indifference Curve.

• Indifference Curves are always Convex to the Origin.

– Two Extreme conditions also exists.

• When    2    Goods    are    Perfect    Substitutes, Indifference Curve  will  be  a  Straight  Line  on which MRS is Constant.

• When      2      Goods      are      Complementary, Indifference  Curve  will  consist  of  2  Straight Lines with a Right Angle bent which is convex to the Origin i.e. it will be L Shaped.

• Two Indifference Curves never Intersect or become Tangent to Each other.

– If Two Indifference Curves Intersect or are Tangent, it would imply that an Indifference Curve indicates Two different Levels of Satisfaction (One Being Larger than the Other) yield the Same Level of Satisfaction. This will Violate the Rule of Transitivity.

• Higher Indifference Curve represents Higher Satisfaction

– This is because the Combinations lying in Higher Indifference Curve Contain More of either one or Both Goods and More Goods are preferred to Less of them.

Price Line or Budget Line

• The    Budget    Line    shows    all    those Combinations of Two Goods which the Consumer can buy Spending his Given Money Income on two Goods at their given Prices.

• Remember, that the Amount of a Good that a Person can buy will depend upon their Income and the Price of the Good.

Consumer Equilibrium

• Consumer Equilibrium will be reached when he is deriving Maximum possible Satisfaction from   the   Goods   &   is   in   no   Position   to Rearrange his Purchase of Goods.
• The Indifference Map in Combination with the Budget Line allows us to Determine the One Combination of Goods and Services that the Consumer most wants and is able to Purchase. This is the Consumer Equilibrium.


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