Published on February 20, 2014
THEORY OF CONSUMER BEHAVIOUR CARDINAL AND ORDINAL UTILITY ANALYSIS
LEARNING OBJECTIVES • To understand the economic aspects of consumer behaviour through cardinal and ordinal approaches • To study Cardinal Utility theory • To study Ordinal Utility theory, i.e. Indifference Curve Analysis
Introduction to Consumer Behaviour • In economics the study of consumer behaviour occupies an important place • The problem of a consumer consists of three things: (a) the object, (b) the constraints, and (c) the decision variable • Object – To maximize total utility (Satisfaction) • Constraint – Limited Resources (Income) • Decision Variable – the quantity purchased using limited resources
Cardinal Utility Approach • Developed by Alfred Marshall • The numbers 1, 2, 3, 4, 5… are cardinal numbers. In contrast, the numbers • Utility is the want satisfying power of a commodity or a service. It is a subjective concept and it resides in the mind of the consume • The concept of cardinal utility assumes that the measurement of utility of different commodities is possible. For example, the consumption of an apple may give 50 units of utility whereas an orange may give only 40 units
• Total utility is the sum of the utilities obtained from all units of a commodity consumed. The more of a commodity consumed per unit of time, the greater will be the total utility or satisfaction from it up to a certain point • At some point total utility will reach a maximum and this is called the saturation point beyond which there is no satisfaction from the consumption. After attaining the saturation point, if there is more consumption, it will cause the total utility to decrease. Symbolically, total utility can be expressed as:
Total Utility… n TU n = ∑ Xi i =1 Where TU n = total utility of n units X i = utility of the ith unit ∑ = the notation of the sum total (sigma) n = total number of units consumed
Total Utility and Marginal Utility… • Marginal utility is defined as the change in total utility caused by the consumption of one more unit of a commodity per unit of time. Mathematically, marginal utility of nTh unit is the difference between total utility of n units and total utility of n-1 units of the commodity. Symbolically: • MU n = TU n – TU n-1 • MU n = marginal utility of n units • TU n = total utility of n units • TUn-1 = total utility of n-1 units
LAW OF DIMINISHING MARGINAL UTILITY • The Law of Diminishing Marginal Utility is a generalization formulated from the observation of human nature. As we get more and more of a commodity, the satisfaction from it diminishes at some point of time. According to Alfred Marshall the additional benefit( marginal utility ) which a person derives from a given increase of his stock of a thing, diminishes with every increase in the stock that he already has. • The tendency towards diminishing utilities from successive doses of the same commodity is operative in all types of commodities and services. The rate of diminishing utility may be slow for some commodities, or rapid for others, but the tendency to diminish is operative.
Law of DMU…Assumptions • The units of the commodity must be relevantly defined. A unit must be complete for its use. • The tastes and preferences of the consumer are given and unchanged. • The units of the commodity are homogeneous – in size, quality etc. • There is no time-lag between the consumption of the two units of a commodity. • The income of the consumer, the price, and the substitutes are given.
• This law was developed by Alfred Marshall. He defined this law as “If a person has a thing which he can put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all. For, if it had a greater marginal utility in one use than another, he would gain by taking away some of it from the second use and applying it to the first”. Thus a consumer attains maximum total utility from his available resources (income) only when the marginal utilities of all goods consumed are equal Symbolically, MU1 = MU2 = MU3 = ... MUn MU1/P1 = MU2/P2 = MU3/P3 = MUn/Pn
• The weakness of Alfred Marshall’s approach was related to its cardinal measurement of utility • The technique of indifference curves was originally developed by F.Y.Edgeworth and later elaborated by J.R.Hicks and Allen • Consumer can simply compare the utility of different combinations of goods within the constraints of his income. A consumer possesses a definite scale of preferences for goods and services. Each scale of preference consists of a number of alternative combinations of two or more goods, which give the consumer same level of satisfaction. Therefore, the consumer is indifferent towards these combinations
INDIFFERENCE CURVE – DEFINITION, MEANING • An indifference curve is a locus or path indicating different combinations of two commodities, X and Y, which yield an equal level of satisfaction • For convenience it is assumed that there are only two commodities under consumption • An indifference schedule may be defined as a schedule of various combinations of the two commodities that will equally be acceptable to the consumer
INDIFFERENCE SCHEDULE… Combinations Quantity of X Quantity of Y Total Satisfaction I 1X + 20Y = Z II 2X + 12Y = Z III 3X + 7Y = Z IV 4X + 4Y = Z V 5X + 3Y = Z
PROPERTIES OR CHARACTERISTICS OF INDIFFERENCE CURVES • Indifference curves have a negative slope. • Indifference curves are convex to the origin. It implies that the consumer is prepared to sacrifice decreasing quantities of Y for each given increment in the quantity of X. • Indifference curves never intersect. Each curve represents a particular level of satisfaction. • Indifference curves need not be parallel to each other. This is because the MRS between two commodities need not be the same in all indifference curves. • A higher indifference curve is always preferred to a lower one.
INDIFFERENCE MAP… • A family of indifference curves is known as indifference map. The higher the indifference curve, the more will be the level of satisfaction
MARGINAL RATE OF SUBSTITUTION - MRS • The marginal rate of substitution of X for Y (MRSxy) is defined as the amount of Y the consumer is willing to give up to get an additional unit of X. As the consumer gets more and more units of X, he is willing to surrender less units of Y for each additional unit of X. this is because, the relative importance of X in terms of Y goes on diminishing. This feature of the consumer’s behaviour is known as the principle of diminishing marginal rate of substitution • A consumer gets the same level of satisfaction along a given indifference curve. It means that an increase in the quantity of commodity X is always accompanied by a similar decrease in the quantity of commodity Y. Thus, the marginal rate of substitution must be negative. Symbolically, • MRSxy = − ∆Y ∕ ∆X • Where ∆X represents change in X and ∆Y change in Y. The above equation represents the slope of the indifference curve at a particular point
Budget constraint line or the Price line • A consumer would like to go to the highest indifference curve to gain maximum satisfaction. However, in the real world, the power of decision making is confined to the given constraints of the consumer. The constraints are referred to as the opportunity factors which consist of three elements: (i) given money income, (ii) price of commodity X, (iii) price of commodity Y. There may be a number of combinations of X and Y which can be purchased by the given budget constraint. A budget or price line is an illustration of the various combinations of two commodities (X and Y) which can be purchased by the given money income
• Determination of the rate of exchange: The first application of indifference curves relates to the determination of the rate of exchange between two commodities bartered by two individuals. • Determination of the tax policy: With the help of indifference curves it is possible to show that direct taxes are better than indirect taxes. • Explaining the effects of subsidies: Subsidy is generally provided by the government to help the low-income groups in such a way that they are able to purchase goods at a price lower than the market price. The question whether the benefit to the consumers is more than the cost of the subsidy to the government can be answered with the help of indifference curve analysis. • Explaining the effects of Rationing: Indifference curves can be used to analyze the various methods of rationing.
USES OF INDIFFERENCE CURVES… • Explaining the theory of Index Numbers: Index number indicates the changes in the price level, and thus enables us to compare the standards of living in two different periods or situations. Here it is assumed that the consumer’s preference between the two goods remains the same, i.e., the same indifference curves apply for both periods. • Explaining changes in tastes and preferences: The slope of an indifference curve explains the relative preferences and tastes of the consumer between two commodities. • Measurement of Consumer’s Surplus: Indifference curve analysis is also of much help in the measurement of consumer’s surplus which is of paramount importance in various welfare policy decisions.
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